NEW YORK (HedgeWorld.com)–Putnam Lovell NBF* and NewRiver predict that hedge fund assets will grow fourfold to US$2 trillion by 2010, with U.S. and public pension plans alone accounting for US$527 billion.

In a white paper titled, “Institutional or Institutionalized–Are Hedge Funds Crazy?” the firms show an industry poised for growth and, at the same time, enormous change. The study estimates that worldwide US$800 billion of new money will flow into hedge funds this decade, almost quadrupling assets. Another US$700 billion is predicted to come from market appreciation.

Thanks to sub-par performance in traditional asset categories, the paper’s authors assert that more investors will be attracted to absolute return strategies. On average this means that hedge fund assets will grow due to new allocations and performance by 17% a year.

The paper’s authors expect that adoption rates of hedge funds will rise from 1.2% to 3.0% of global high-net-worth individual and institutional assets. According to NewRiver, high-net-worth investors will boost their allocation to hedge funds from the US$393 billion they had invested in hedge funds in 2001 to US$1.2 trillion in 2010.

But the area to watch remains institutional investment, which is poised to grow dramatically in a few short years. U.S. endowment and foundation allocations should grow by US$150 billion, reaching 15% of assets. Corporate and state pension fund allocations should quadruple sparking an increase of hedge fund assets by US$450 billion.

The white paper’s predictions are built on a series of assumptions and previous research done on the hedge fund industry. The authors have assumed that the rate of net inflows in 2002 will equal the TASS database rate of inflow in the first half of 2002 or 7.8% of the assets at the year’s start. From there, they predict a steady increase of 2.5% a year to reach the US$800 billion in inflows. Hedge fund yields are assumed to be 0% this year and 9% annually thereafter.

Despite the accuracy of these estimates and assumptions, it’s evident nonetheless that with allocations from pension funds such as the California Public Employees’ Retirement System, Pennsylvania State Employees’ Retirement System and the entry of General Motors into the hedge fund business (Previous HedgeWorld Story) the industry is going to grow. And with that growth comes new hedge fund creation and consolidation, according to the white paper.

Implications for the Industry

With the projections in the Putnam Lovell/NewRiver research, an additional 16,000 funds will need to be created or, if the current number of funds remains constant, the average fund size will increase to US$275 million from US$75 million to US$85 million. The drivers of hedge fund replication though are many, with funds of funds looking for new hedge funds as capacity constraints and competition in the asset class heats up. According to the report’s authors, no more than a third of hedge fund managers are potentially attractive to hedge funds of funds. Also, new hedge funds will be launched as prime brokers and incubators offer access to capital and infrastructure for the promising talent of traditional asset management.

Concentration, too, is inevitable as the industry matures because larger firms with deeper business infrastructure will better be able to meet the standards that institutional demand will impress upon the industry.

Other trends include the development of an industry created out of the anticipation, identification and measurement of hedge fund process and performance. The ability to provide metrics to help investors evaluate the impact of hedge funds on their portfolios will become a competitive factor for hedge fund managers. The institutionalization of the hedge fund industry will not alter the entrepreneurial character of hedge funds and ultimately will accommodate it, according to the study.

For single-strategy hedge fund managers, there will be a choice as to whether they want to build capabilities in high capacity strategies or to establish an infrastructure to compete for institutional assets. Then for hedge funds of funds, the challenge will be to upgrade their abilities to track, source and combine single-strategy managers into competitive funds. Funds of funds will also consolidate or move down market to serve smaller institutional investors and the mass affluent individual investors.

*Putnam Lovell NBF, New York, a minority investor in HedgeWorld.

SBarreto@HedgeWorld.com