The Coming Evolution of the Hedge Fund

Industry:

A Case for Growth and Restructuring

Rama Rao Jerry J. Szilagyi

Founding & Managing Partner Director, Financial Services
RR Capital Management KPMG Consulting

EXECUTIVE SUMMARY
It is our view that the hedge fund industry is at a defining point in its evolution. After a few
decades of modest growth, the hedge fund industry has experienced a dramatic
acceleration in growth starting in 1990. It is estimated that hedge fund assets grew from
under $20 billion in 1990 to over $170 billion in1996. The number of funds also grew
dramatically from under 500 to over 2500 in little more than five years.

The driving forces behind the growth of the hedge fund industry are increasing acceptance
of these “alternative investments” and the increase in the base of “sophisticated” investors,
especially high net worth private investors. The search for greater returns has led
sophisticated investors to ever more exotic asset classes, including hedge funds. As hedge
funds can go short, use leverage and take very concentrated positions, they can significantly
enhance the performance. Various studies indicate that hedge funds as a group provide
superior returns on average compared to the S&P 500 and demonstrate a low correlation
with traditional investments like stocks and bonds. Higher and superior returns bode well
with private investors who are always looking for “market beating” returns while willing to
bear the higher risks associated with those higher returns. Institutions are attracted to
hedge funds more because of their non-correlation characteristics. According to Modern
Portfolio Theory, including hedge funds in a balanced portfolio consisting of stocks and
bonds, can significantly improve overall portfolio returns while simultaneously lowering
volatility.

The affluent private investors represent more than 80% of the hedge fund assets; the
balance of almost 20% is made up of institutional investors including pension funds,
endowments, foundations and insurance companies. In recent years there has been
extraordinary growth in the affluent population in the US.
Affluent households, those with investable assets of more than $1 million, control about $5
trillion of financial assets. This affluent segment of the population is growing at 14%
annually while the population as a whole is growing at 1%. Strong asset growth is also
projected for institutional investors. The financial assets available for investment are
expected to grow from $10 trillion in 1996 to over $16 trillion by the year 2001.

Based on the analysis of the underlying forces, the outlook for the future growth of the
hedge fund industry is very promising. We project an annual growth rate of about 26% to
over $500 billion of assets by 2001 and a tenfold increase to over $1.7 trillion in ten years.

A study of the MAR/HEDGE database reveals that the top 15% of the population of funds
control in excess of 80% of all assets under management. The industry appears to be
concentrated at the top and very fragmented at the bottom. The hedge fund industry, as it
exists today, features two strategic segments. At one end, there is a small group of very
large “superfunds” and on the other end a large number of small niche players. The
superfunds are an outgrowth of the original global macro players, generally having more
than $5 billion of assets with extremely high minimums and long lock-up requirements. Most
of these ultra-exclusive funds are closed to new investors. The majority of other hedge funds
(more than 80%) are niche players and are run by one or a small group of individuals, each
with their own investment strategy, market identity and support structure. These niche
players have assets of less than $100 million with more than half of them having assets
under $20 million.

The net result of these two extreme groups is that a void exists. There are no real market
leaders with national or global reach and efficient customer and operations support available
to the average sophisticated investor. The industry is looking for market leadership and we
see a clear opportunity for a market leader to emerge and lead the industry into the next
century. We believe that the present structure of the hedge fund industry will change from a
fragmented one with thousands of small niche players into one made up of a small group of
branded large organizations providing leadership in the global marketplace.

It is our view that the structure of the industry will also evolve to accommodate this
sustained growth and the maturation of the industry. We believe that the entire hedge fund
industry will move from a relatively local and private business to a more mature, globally
operating and institutionalized industry. One structure that holds significant promises is a
Family of Hedge Funds (FHF). Modeled after the family of mutual funds concept, the FHF
brings together a variety of different hedge funds under a single unified organization. It
would be structured such that each participating fund would operate autonomously with
regard to the investment decision making process, while marketing and sales,
communication with investors, customer support and services, account reporting, operations
and legal compliance would be centralized. In essence, in this new structure, the hedge fund
managers would focus on what they do best; managing money, while the centralized FHF
focuses on client management and operations. In this paper we have outlined how this
structure would be beneficial to both investors and managers.

The authors believe that there is a parallelism between the mutual fund industry and hedge
fund industry. Although there are some fundamental differences between mutual funds and
hedge funds, it appears that both industries are following very similar patterns in terms of
growth of assets and number of funds. However, the mutual fund industry entered its growth
period in 1980 whereas hedge funds began their growth in 1990. Based on the life cycle
theory and the assumption that similar products require similar times to reach maturity,
hedge funds may be at the beginning of an extended period of growth lasting well beyond
2005. It is our observation that in the last 15 years, the mutual fund industry has gone
through several phases of evolution; from stand-alone small funds to large families of funds
and now a period of consolidation and globalization. It is our view that the hedge fund
industry will also follow a similar course of evolution in the next decade.

There seems to be some evidence that evolution has already started. Within the last six
months we have seen two examples of at least rudimentary attempts at consolidation within
the hedge fund industry. Neither group has yet emerged as a fully-formed Family of Hedge
Funds. There is no clear brand identity established nor is there an established centralized
administration, sales, marketing or operating function. It is our view that the FHF should not
be a holding company but rather an operating partner that uses its size and strength to help
affiliated firms unlock new opportunities on a global basis. The question remains open “Who
will play the role of the Fidelity of Hedge Funds?”