Effect of the savings glut on hedge funds

03Nov05

Per our earlier post the perceived savings glut has implications for every asset class and investor. Hedge funds have been among the most prominent asset accumulators during this period. Other writers have noted the effect of excess capital on hedge funds.

The Stalwart notes that traditional arbitrage strategies have seen their returns diminish through time. While there are hedge funds out there, discovering and implementing novel strategies, these old line strategies will no longer generate the outsized returns of the past.

Justin Fox in Fortune notes that hedge funds were designed to allow managers the flexibility to earn abnormal returns. The lack of regulation of hedge funds is in direct contrast to mutual funds. Mutual funds were created in such a way as to eliminate the risk of fraud, but also limits their flexbility. However, the push to increase disclosure at hedge funds and the rush of money into them may lead to lower returns:

So far, that’s the kind of disclosure that regulators and hedge fund clients seem most interested in. The far bigger challenge for the industry may simply be that the flow of new money will make it harder to find moneymaking opportunities. The CSFB/Tremont hedge fund index, after achieving 25% annual gains in the mid-1990s, has lately posted increases mostly in the sub-10% range. “This is what the economy does,” says Cliff Asness. “It finds things that seem to work and pours money into them until they become not necessarily a bad deal but a fair deal.” Increasingly, hedge funds are selling themselves less as market beaters than as investments returns that zig when the market zags.

It may take a worldwide correction to generate significant opportunites for the large number of new hedge funds. From the Ip and Whitehouse Wall Street Journal article, hedge funds could be a shock absorber to the economic system if there are stresses caused by the Savings Glut.

Similarly, the explosive growth in hedge funds in the past several years — they number more than 8,000 now — may mean there are more sophisticated investors willing to jump in and buy if asset prices fall sharply. “I don’t see a systemic crisis,” Mr. Häusler says. “As long as the speed and extent of the widening [in risk premiums] is within reasonable boundaries, we should welcome it.”

The savings glut is due in part to the fact that technology and the Internet has changed the way capital markets work. If hedge funds, in toto, can no longer effectively manage the capital they have accumulated in this environment, the money will rush out just as quickly seeking higher returns elsewhere