2006 Predictions: Hedge Fund Doomsday in 2010 (McKinsey)

If Ed says something like "over time, institutional investors are going to realize that at least half of all hedge funds do not justify their performance overhead," it is simply added to the pile of ramblings already here on the blog.

If McKinsey says the same thing, and puts a date on their prediction, well, that's news! Institutional Investor has the scoop:

Considering all the naysayers who have long predicted the demise of hedge funds for one reason or another, one may not take seriously the latest dreary forecast from McKinsey & Co. However, the consultancy does make some points that may serve as survival tips for the future. “We expect the recent proliferation of hedge funds will stall and then reverse itself by 2010,” the report says.

The bottom line: Investors are getting wise to HF managers. McKinsey cites Bridgewater Associates research which found that hedge funds that invested in five strategies couldn’t beat a synthetic passive index. And once institutional investors – the biggest source of HF flows these days – realize that, they will “be unwilling to pay for it. Instead they will switch to the true (and fewer) generators of alpha.”

According to McKinsey, those relying too much on producing beta are going to run up against competition from other beta-users, such as quantitative managers, while traditional managers will increasingly look to maximize returns by exploiting leverage, just as hedgies do. “Investors will realize there is no such thing as a hedge fund asset class,” Bridgewater founder Ray Dalio told Financial News.

(I like this phrase: "the true generators of alpha." If I had no idea what that actually meant, I could see an alt-rock band using this for a name.)

McKinsey's original report is on the web here. The passage referenced above is on page 28-29.

My thoughts: In order for institutional investors, a group with the thought process of a pack of lemmings but the momentum of an avalanche, to decide that the hedge funds they've chosen were the wrong place for their assets, I see basically two scenarios:

1. Rational realization they are overpaying for average performance
2. Rational realization they are $500 million in the hole with retirement obligations to fill

Which do you think is more likely?

In the first scenario: assuming the hedge fund didn't blow up, an average hedge fund will say that his returns are due to superior risk management with lower volatility, and an above average hedge fund will say he's just smarter than everyone else.

Because both of those explanations would quite plausibly placate an investment committee, I think the only way McKinsey's prediction comes true is in the second scenario, which requires another major bear market. That way, poor performance and a need for cost cutting will dictate the changes. Just count me as skeptical that there will be an influenza of rationality among the asset allocator community.

Regarding predictions in general, I only put dates on macro events to amuse myself, but perhaps if I took it more seriously, I could make a career out of it. See "2006 prediction: real estate bubble a 2007 item" for my last attempt at reading the macro-economic crystal ball. - Ed

Comments

[Vladimir Orlt]

For an explanation of alpha & beta, see e.g. http://www.investopedia.com/terms/p/portablealpha.asp

Hedge fund, long-only fund, whatever... money can be made in up, down and sideways markets (i.e. in all markets), and nowadays you can do it via discount brokerages if you want. Most financial talk focuses on up markets, perhaps because we live a growth-oriented world: for example, securities regulations restrict profiting from down markets to some extent. Is there a bear statue in New York for us to sit on?

PS you look somewhat like the CEO of JDS Uniphase (I forget his name, Joseph something?)