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| March 1998 | The Coming Evolution of the Hedge Fund Industry | ||||||||||||||||||||
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III. The Future Outlook for the Hedge Fund Industry |
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| III.(a) Demand for Investment Management Services | |||||||||||||||||||||
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Even given the significant growth over the past few years in the hedge fund industry, there appears to be strong evidence that this growth will continue. A combination of factors point to this conclusion. There continues to be an increase in demand for investment management products and services across the board. Over the next five years, this demand is expected to continue growing. According to Putnam, Lovell & Thornton, total financial assets, including both US household and institutional, are expected to increase from $27.3 trillion in 1996 to $42.4 trillion by 2001. In 1996, approximately 42% or $11.6 trillion of the these assets were professionally managed. This percentage is expected to increase to over 48% or $20 trillion of assets by 2001. Concurrently, there will be a slight shift in the composition of that demand from institutions to households, the largest investor segment for hedge funds. In 1996, 30% of the demand for money management came from households and nearly 70% from institutions. By 2001, 33% of the demand is expected to come from households and 64% from institutions (9). Exhibit
10 Hedge funds stand to benefit disproportionately from the growth in demand for investment management due to their better return and non-correlation characteristics. As demand for traditional investments has grown, the market has become saturated. Innovative mutual fund managers have seen their returns fade as their styles are copied and the inevitable regression to the mean takes hold. Many successful mutual funds are now so large that they are no longer nimble enough to achieve superior returns. It is a well documented fact that a majority of mutual funds under perform the S&P 500 index. As a result, sophisticated investors are looking for other investment alternatives that can produce "market beating" returns. Hedge funds represent the next logical choice for their investment.
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| III.(b) Hedge Fund Investor Segment Trends | |||||||||||||||||||||
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Trends in the size and investment philosophies of the different segments of hedge fund investors also bode well for the growth of the industry. The growth of potential hedge fund investor segments and their increasing acceptance of alternative investments should produce superior growth for the industry. As mentioned previously, the most important investor segment for the majority of hedge funds is the high net worth individual. There has been an extraordinary growth in the affluent population in the United States in recent years. Affluent households control over $7 trillion of financial assets. The affluent segment (over $100,000 of income or $500,000 of net worth excluding primary residence) is growing at an annual rate of 5% while the wealthy segment (over $1 million of investable assets) of the population is growing at approximately 14%. This compares with the population as a whole which is only growing at around 1% (14). This growth of affluent households and the shift within the affluent market from the $500,000 - $1 million net worth segment to the $1 million-plus net worth segment is driving demand for financial services across the board. Exhibit
11
Exhibit
12
In addition to the net increase in wealthy individuals and the shift to greater concentration of wealth, there will also be an unprecedented transfer of wealth through inheritance in the near future. Estimates of the coming "inheritance boom" point to over $10 trillion dollars passing from one generation to the next over the next fifty years (15). This generational shift of wealth from the parents of baby boomers to their children presents both an opportunity and a challenge for hedge funds. These young investors are more sophisticated and have a higher tolerance for risk, but also are more demanding in terms of investment performance which bodes well for hedge funds which generally have higher absolute returns. Exhibit
13 Strong asset growth is also projected for the next ten years among the institutional segments of hedge fund investors. The assets available for investment are expected to grow from $10 trillion in 1996 to over $16 trillion by the year 2001(9). Among institutional investors, pension funds control the largest pool of investment capital. The overall pension market is estimated at $5.5 trillion dollars in the US alone and expected to grow at over 10% annually over the next five years (9). However, pension plan sponsors are subject to strict fiduciary requirements under ERISA and, as a result, have been less enthusiastic about hedge fund investments. This view, however, is changing. Recent court rulings have expanded the "prudent investor rule" to include Modern Portfolio Theory (MPT), thereby providing more leeway to ERISA managers in applying MPT to their funds. These changes open the door to higher allocations to alternative investments including hedge funds. Exhibit
14
Nonprofit organizations are an important segment of institutional investors for hedge funds. In the US, they hold approximately $1 trillion in financial assets and are expected to grow at 10% annually over the next five years. Among institutional investors, foundations and endowments have the largest percentage of their assets allocated to hedge funds. There is also evidence that this allocation will continue to grow. One recent study revealed that the average dollar weighted endowment allocation to hedge fund investments increased by almost 4% in the period 1995-1996 alone(16). As more and more non-profit institutions look to their endowments to cover shortfalls in operating cash flow, the superior returns of hedge fund investments should generate even greater interest. One other segment of the institutional investor community that deserves mention as a potential source of growth is the insurance industry. US insurance companies currently control approximately $3 trillion of assets with expected growth at 9% per annum (9). These organizations are constantly looking for new ways to diversify their holdings and to generate future cash flows needed to fund future policy claims. However, current regulations limit the total allocation that insurance companies can make. Many insurers are currently prohibited from investing over 5% of their capital in limited partnership vehicles. These rulings limit insurers’ participation in a number of alternative investments (venture capital funds, oil & gas funds, real estate limited partnerships) in addition to hedge funds. The particular risk/reward structure of hedge funds does indicate, however, that hedge funds are well positioned among alternative investments to capture a greater share of the insurance market. Many of the same demands on portfolio return will be placed on the investments of banks and corporations. These investor segments currently represent a small piece of the hedge fund pie, but they also hold the potential for growth. Since asset allocation decisions in these organizations are made by a variety of methods and for the benefit of varied constituencies, it is unclear how rapidly hedge funds will be able to penetrate these investor segments. Exhibit
15
Source: Putnam, Lovell & Thornton
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| III.(c) Future Growth Projections for Hedge Funds | |||||||||||||||||||||
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Based on the analysis of the underlying forces described above, the outlook for the future growth of the hedge fund industry is very promising. We predict a period of extended rapid growth for the hedge fund industry. To estimate the future growth, we considered three variables: (i) financial asset growth of each major segment of hedge fund investors, (ii) asset allocation or penetration rates for hedge funds, and (iii) intrinsic growth or hedge fund investment rate of returns. The Exhibit below illustrates our estimation of projected growth over the period 1996-2006. The underlying assumptions are; (i) investor financial assets grow at rates ranging from 9% to 14%, (ii) allocation rates to hedge funds grow between 2% and 12%, and (iii) hedge fund returns average 17%. Exhibit
16
These assumptions result in over $500 billion of assets by 2001 and a ten fold increase to over $1.7 trillion in ten years. Though the assumption of increased allocation rates mayt appear somewhat aggressive, these growth projections equate to a compound growth rate of approximately 26%. If this estimate of future growth is compared to the historical growth trends, it is apparent that our projection yields growth rates below the recent accelerated growth rates and about in line with the ten year trend. Exhibit
17
Source: Bekier, RRCM, KPMG
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rrao@ramarao.com