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New investment landscape will produce hedge fund winners and losers, says Watson Wyatt

Date: Wednesday, November 26, 2008
Author: Hedgeweek.com

Many hedge funds will be forced to close and there will be significant consolidation because of market conditions and unprecedented changes to the regulatory landscape, according to global consulting firm Watson Wyatt.

However, the firm believes the best managers in the industry will emerge in a better position to exploit investment opportunities characterised by greater market dislocations and lower prices, and this will be made easier by the absence of banks' proprietary trading desks.

Watson Wyatt believes long-term investors are likely to be the beneficiaries of this development, mainly through improved fee structures that better align interests. In addition, the firm suggests that certain hedge fund strategies will struggle in future amid a fundamentally changed investment environment.

'In absolute terms, general hedge fund returns do not look good this year, but it is likely that they will have performed better than some other strategies, long-only equity funds for example,' says Craig Baker, global head of manager research at Watson Wyatt.

Baker notes that hedge funds have outperformed equities despite various headwinds facing the industry in the last year, including reduced availability of leverage, higher borrowing and trading costs, new regulation and the threat of more, and large redemptions.

Says Baker: 'It is our belief that the current crisis will expose those that are not structured to add value for investors and will provide the most skilled with attractive opportunities and potential for substantial returns in the future.'

According to the firm, there are early signs that increasing numbers of skilled hedge fund managers are becoming more flexible in the negotiation of fees, having been persuaded of the benefits of receiving long-term capital from the likes of pension funds, rather than 'hotter money' from other investors.

'While we strongly believe skilled managers should be fairly compensated, fees are generally still too high for the value they deliver, particularly as we enter a lower-return environment,' Baker says.

'Also, performance fees introduced to align interests have been less than effective because they are generally poorly designed and tipped in managers' favour. For a number of years we have been trying to rectify this situation and negotiate a fairer deal on fees, but only now we are seeing real progress.'

Watson Wyatt argues that certain hedge funds should benefit in the future from increased opportunities as a result of market dislocations, lower competition as the number of hedge funds declines, a reduction in the overall level of leverage, fewer competing proprietary trading desks, and lower fees that make them more attractive to investors.

These factors will create winners and losers, the firm says. It believes the outlook for the average fund of hedge funds is impaired, in part due to significant redemptions at the end of the year and high overall costs, although high-quality funds of funds should be able to capitalise on opportunity sets when they become available.

By contrast, Watson Wyatt argues, multi-strategy managers are well placed to capitalise on opportunities and are arguably less affected by legislative changes, although some have very illiquid assets which, combined with large redemptions, could cause problems.

Macro managers should be largely unaffected although highly leveraged funds, concentrated in a small number of bets, could struggle. Equity long-short managers should be also largely unaffected, on the understanding that the availability and cost of borrowing stock has not materially changed. However, these strategies may suffer if regulation forces them to disclose short positions.

Fixed income managers that use high levels of leverage will be adversely affected, particularly those that rely on a limited range of financing options. Credit-focused managers that do not rely heavily on leverage are likely to benefit, although Watson Wyatt says it will be important to distinguish between those opportunities that require hedge fund skill, such as distressed debt, and those that are more long-only in nature, such as bank loans, and should be accessed more cheaply.

'With such a rapidly changing and uncertain environment, we think it sensible for pension funds looking to invest in hedge funds to hold off until there is greater stability and current redemptions play their way through the system,' Baker says. 'But for those already invested we would not recommend any action, although there may be fund and manager-specific considerations that require extra vigilance.'