Could FoFs Derail HF Gravy Train?

Oct 13 2006 | 3:32pm ET

A pair of new studies offer a potentially conflicting picture of the future of hedge fund investing. The Bank of New York and Casey, Quirk & Associates predict that worldwide institutional demand for hedge funds will soar threefold by 2010 to more than $1 trillion. Currently, institutions have about $360 billion with hedge funds. But a report from Fitch Ratings shows investors becoming impatient with underperforming funds of hedge funds, a popular vehicle which BoNY expects to be the beneficiary of half of institutional flows over the next four years.

According to the BoNY study, fully one-quarter of institutional investors will be invested with hedge funds by 2010, up from 15% today, and that, as institutions become more comfortable with hedge funds, they may even dabble in hedge fund techniques including shorting, derivatives and leverage.

“The study shows that today’s hedge fund techniques will be tomorrow’s mainstream investing,” according to Casey, Quirk partner Kevin Quirk. What’s more, institutions will, according to the report, get better at picking good hedge fund managers, and hedge fund managers will have to improve their operational capacity and risk management systems to get a piece of the lucrative pie. The study does indicate that underperformance in the sector could dull growth forecasts, and that’s exactly what Fitch says is happening.

With fund of funds returns down, many investors are rethinking their investments, questioning whether the extra layer of fees can be justified when returns tank, the Fitch report found. With greater competition and increasing correlation between single-manager funds and funds of funds, the diversification benefit of the latter has been disappearing, leading to the first outflows from FoHFs in a decade during the second half of last year.


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