Sharp falls in the world's major markets have encouraged investors to diversify out of mainstream assets into hedge funds. Despite returns on these vehicles being far off their historic highs, money continues to flood into an ever-growing number of funds as pessimism grows about the prospects for returns from traditional bond and equity investments.

By all accounts, 2001 was a record year for hedge funds, with the highest estimate putting growth at $140 billion including capital appreciation. More than this is expected to pour into the industry this year. European hedge fund assets alone have quadrupled to more than $60 billion in the past three years. Most accepted figures now estimate total industry assets to be between $500 billion and $600 billion, managed in more than 6,000 funds.

The rampant growth has raised fears that hedge funds are yet another financial bubble that will inevitably burst, with potentially serious consequences for the investment industry.

Clients come first

Our view of the hedge fund phenomenon is not so apocalyptic. We believe that diversifying into alternative assets is a very sensible strategy to pursue - and we have been making this point since long before the markets cracked. Hedge funds naturally play a big part in this alternative scenario. However, there are disturbing signs that in the headlong expansion, increasing numbers of hedge funds might be starting to lose alignment with their clients' interests.

Before delving into the issues, it is important to point out that 'hedge funds' embrace such a huge variety of skill-sets and strategies that they cannot rightly be viewed as a single asset class. They are more a collection of alternative strategies, or perhaps more precisely, a collection of different risks. General talk about investing in 'hedge funds' thus misses out on countless important distinctions.

Hedge fund indices recognise many different categories of hedge fund, split out by manager type or strategy. Depending on the index, these include convertible arbitrage, merger arbitrage, fixed-income arbitrage, long/short equity, equity market neutral, event driven, global macro, and distressed securities. All these strategies are exposed to different risk factors, managed in different ways by different funds with varying levels of skill.

So most hedge fund groups have little in common except that they aim for absolute returns and performance uncorrelated with mainstream markets and managers.

However, although we recognise hedge funds' different risk characteristics, we are growing nervous about the industry as a whole.

Our first major area of concern is fees. The explosion in providers and assets threatens the core tenet of hedge fund investing, which is to pay premium fees for superior skill. This holds good only as long as hedge funds deliver the promised level of alpha, which is typically targeted at between 10% and 20% a year, depending on the strategy.

High returns have been achieved with a strong market tailwind and with smaller amounts of capital than are now flowing into the industry. But although many hedge funds have outperformed in the equity downturn, returns have fallen this year, and if this trend continues, fees will soon be higher than the alpha generated. While this is sadly true of the asset management industry in general, the fee structure of hedge funds makes it a harder pill for investors to swallow.

Hedge funds typically charge management fees of 1% to 2% a year, so most of those that gather substantial assets will be making a good living even if they do not achieve the alpha required for their 15% to 20% performance fee to kick in. The management fee may seem particularly punishing to investors when many funds have been holding large amounts of cash to protect against market volatility.

From the fee perspective, therefore, many hedge funds no longer seem to be wholly motivated with their clients' best interests in mind. This is despite hedge managers' preference for investing most of their own wealth alongside their clients, so demonstrating a commonality of interest.

The fact that asset management houses and investment banks are turning to hedge funds to bolster their sagging profits further fuels investors' fears. Some of the best funds have also raised management fees and others are rethinking their 'high water mark' performance hurdles (most have to regain last year's loss before charging a fee for this year's profit).

An overheated industry?

Our second concern is the potential dilution of skill. Institutions invest in hedge funds in order to have access to the most skilled managers, capable of squeezing alpha out of complex strategies or arcane areas of the market. Traditionally, the industry has been dominated by individuals with a high conviction about their strategies and a passion to exploit them. Now, it is moving to a 'business' mentality with mainstream firms eager to capitalise on the high fees, and funds of funds selling out to financial service companies.

It defies belief that the 6,000 or so hedge funds that are now estimated to exist are all run by managers possessed of exceptional skill. This is a common sense conclusion based on the observation that demand is currently outpacing supply in most hedge fund strategies. Skill simply cannot be manufactured on demand.

This worry also applies to funds of funds, which are proliferating at an alarming rate as well. Funds of funds charge an extra layer of fees for their expertise in putting together a collection of hedge fund risks in such a way as to maximise return and minimise volatility. But some managers report that due diligence at some of these entities amounts to little more than 'box ticking' by inexperienced staff. The moral is to choose your manager with care. This requires considerable investment in due diligence.

We are also concerned that excessive inflows may be swamping some strategies and pushing down returns. We would like to stress that this is not due to greed on the part of individual hedge fund managers. Most are acutely aware of the capacity of their strategies, and impose rigorous constraints on assets under management in order to preserve performance.

Hedge managers, however, understandably cannot account for how many other players are lining up to benefit from the same market inefficiency. Convertible arbitrage is a case in point. Market participants say that hedge funds now account for at least 50% of demand for convertible securities, up from about 10% five years ago.

The upshot is that investors who do not tread carefully may well be disappointed. Hedge funds have already suffered in this year's poor markets: returns are about flat through July (according to the CSFB/Tremont index) although returns have far outpaced falls of more than 25% in the S&P500 and the Nasdaq. However, 2002 may well turn out to be the worst year for hedge funds since 1998 - the year of LTCM's collapse and the emerging markets crisis. Before this, hedge funds' annus horribilis was 1994, when the Fed's unexpected February rate hike wrongfooted the big macro funds, causing big losses and much soul searching.

Many of today's hedge funds are too young and small to survive a protracted spell of adverse market conditions. Poor markets are making it very difficult for these funds to generate the returns that will enable them to charge performance fees to support their businesses. As a result, observers expect the pace of fund closures to pick up. Recent research by EuroHedge indicates that one quarter of European hedge funds hold assets below the $25 million 'critical mass' level that makes them truly viable.

Choose with care

A hedge fund shakeout would not be such a bad thing. Though traumatic, bad times have in the past had long-term positive effects on the industry. They permit investors to distinguish skill from luck, and strong hedge funds to differentiate themselves from weak ones.

Post 1994 and 1998, hedge funds made huge strides in both risk control and transparency, recognising quite rightly that investor communication is vital to maintaining trust. The SEC is currently applying yet more pressure on US hedge funds to improve the transparency of their decision-making processes. Such pressure is long overdue.

There are, of course, situations in which a lack of transparency is warranted (such as outright disclosure of certain trades), and we also recognise that investors cannot be too demanding and still expect access to the best funds.

However, without a greater attempt at transparency, the industry will continue to lay itself open to accusations ranging from deliberate obfuscation to outright fraud - whether these charges are justified or not.

To sum up, we continue to believe that there is a place in institutional portfolios for 'best in class' hedge funds. Indeed, we regard well-structured long/short investment strategies as a sensible expression of a good investment process. However, we are increasingly concerned about the outlook for the hedge fund industry.

We believe that disappointing returns, unsustainable fee structures, questionable skill advantage, and accusations of a lack of transparency are factors that will haunt the industry for some time, and that many of today's hedge funds will not survive. This contraction will inevitably result in significant losses for some investors. Our message to investors is to be increasingly selective if they wish to invest in hedge funds.

Nick Watts and Chris Mansi are consultants at Watson Wyatt in the United Kingdom.