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Watson Wyatt Sees No Shortage of Capacity Worry

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LONDON (–Pension fund trustees wanting to invest in a fund of funds may want to consider the full effect of their asset allocation decision.

According to a paper published by Watson Wyatt LLP Investment Consulting on the topic of capacity, pension funds and other institutional investors may find themselves competing with funds of funds to place money with the best and brightest.

Calculating that roughly one-third of capacity available from highly talented hedge fund managers is taken up by funds of funds, the amount of capacity available to other investors annually dwindles by US$33 billion on an annual basis.

“The concern for pension funds is how to successfully access this pool of talent,” wrote Watson Wyatt officials in the report.

An estimate of an additional US$50 billion in capacity available to all each year is based on the assumption that new fund launches will continue at the rate of 500 to 1,000 per year and that about 5% of the managers are highly skilled and could manage US$1 billion in assets.

Watson Wyatt warned investors about some potential problems inherent to growing fund of funds inflows. The concern is heightened by the preference institutional investors have for these managers.

In a poll of 18 funds of funds managers, the surveyors found that the funds’ assets grew by 33% over the first six months of 2004. Researchers said that growth beyond US$2 billion per year for each of the best funds of funds would be difficult to sustain.

Specifically, the problem of continuous inflow momentum over the last year has pushed down the performance spread between the best and the worst managers, resulting in lower overall returns for absolute return managers. Even though the stock market may have been to blame, Watson Wyatt consultants still expressed worry over future return prospects

The firm estimates that pension funds need to achieve a 2.5% to 3% return above that of cash in order to improve the efficiency of a portfolio with a 5% allocation to hedge funds.

In certain segments of trading, hedge funds now make up a far larger percentage, and depending on the timing the assets deployed in such strategies could become their undoing.

For example, within the equity market, hedge funds account for approximately 1.5% of the total stock market’s capitalization. The higher turnover of hedge fund portolios means that they account for 10% to 30% of all equity trading, Watson Wyatt officials calculated. In some cases, they may dominate the trading of particular security, although it’s unusual.

Convertibles and fixed-income markets tend to see higher participation levels by hedge funds, with arbitrageurs accounting for as much as 70% to 90% of the convertibles market. In the case of fixed-income, statistical, convertible and merger arbitrage, managers all have struggled with decreasing “spreads” due to more assets flowing into those strategies, researchers said.

Managers need to be skilled to operate in markets that may become dominated by their fellow hedge funds. Watson Wyatt only views 300 to 600 managers in the market today as being skilled enough to add significant value after fees. In that group, only about US$75 billion to US$150 billion in spare capacity may be left.

Those figures may sound impressive, but as the industry surpasses the US$1 trillion mark, such asset totals become diminished.

For pension funds, Watson Wyatt suggests core multi-strategy funds of funds as viable investments, but not with the ringing endorsement they once had. Less capacity-constrained strategies such as long/short equity may prove fruitful for pension funds wanting direct investments, although the pension trustees may be competing with fund of funds managers.

Future Watson Wyatt research will center on long/short equity funds and also will look into the growing number of niche/specialist funds of funds managers. The April issue of HedgeWorld’s Accredited Investor will include Watson Wyatt’s full report on hedge fund capacity.

Contact Bob Keane with questions or comments at: [email protected].

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