Monday, August 17, 2009

Future of Hedge Funds

The future of hedge funds is under microscope. Some believe, hedge funds are evil and hence would die. Others believe higher regulatory burden will spell doom. I believe reality might be contrary.

Flexibility in capital allocation is critical

The need for flexibility is the central lesson from recent toxic asset debacle. Funds that are flexible are better suited to surviving the near future. Hedge Funds derive a little advantage flexible than private equity and lot of advantage over pension funds.

Flexibility applies to strategies as well

A flexible strategy may be better than a sector specific or other constraining strategies. So between strategies it might be better to allocate more capital to flexible ones.

Stock selection will undergo a change

Within the investment process changes will happen.

1) Currently, lot of funds use "owning stocks" mentality. Fund managers try to foresee how demand for those stocks will move. They are not buying companies like Warren Buffet. Due to higher volatility with lower volumes owning stocks is likely to work with very large caps (blue chips). Further, any long term (>6 months) investments will have to be "owning companies" type of investments. Some funds already work with this mindset and are consequently better off.

2) Focus on macro drivers will increase. Macro drivers impact capital flows into markets and therefore can make or break portfolios.

3) Holding periods will decline. Given the volatility in stocks, flexible managers can take advantage of capital flows.

Employment generation

Given the changes above, we are likely to see more diversely talented and diversely located teams supporting investment managers. Further, we might see a drop in capital/manager to ensure higher flexibility.

The survival game

Survival is the name of the game for next 3-5 years. Both for funds and companies. We are likely to see a drop in total money supply in the next few years. Capital will be destroyed through two ways. First through companies going bankrupt. Second volatility impacting AUM of asset managers. So picking survivors is the key.

So if any hedge funds have an opportunity for me, check out my profile and drop me a line. ;)