NEW YORK (HedgeWorld.com)–Morgan Stanley’s former chief investment officer and chief U.S. investment strategist, Steven Galbraith, argued that economic forces would continue to push institutional assets into hedge funds but that declining returns are a danger.

Mr. Galbraith, currently partner at hedge fund firm Maverick Capital, was speaking at a Managed Funds Association conference. Compared to the historical pattern, the last 20 years have been Nirvana in terms of stock and bond returns, but the exceptional environment is no more, he said. That leaves investors with a hole to fill.

In response, one can invest in a low-cost index that provides beta exposure or in alternatives run by people with the skill to generate alpha. Demand for alpha is so strong that Mr. Galbraith expects assets coming into hedge funds to exceed mutual fund inflows in the next 12 to 24 months. It might even happen this year.

“If you come, we’re going to build it,” he said, regarding the institutional influx to hedge funds. As he sees it, hedge funds are maturing as an industry and are becoming the next generation of asset management firms, but if investors focus on pursuing the next hot manager, it will result in mistakes and blowups.

Among mutual funds there is a reversion to the mean, with top performers one year going to the bottom of the list the next year, and the same pattern tends to occur in hedge funds, he said.

Despite the tremendous growth potential, or perhaps because of it, a dark cloud of diminishing returns hangs over the industry. Mr. Galbraith pointed out that the spread between hedge fund returns and cash has been narrowing and, if that continues, investors will end up with a very bad deal.

Come what may, he does not see any downward pressure on hedge fund fees–that has not happened in mutual funds, he said. Instead, he predicts that weak returns will show up in higher failure rates.

CKurdas@HedgeWorld.com

Contact Robert F. Keane with questions or comments at:

bkeane@ia-mag.com.