Human Resources: Dim Outlook for Average Hedge Funds as Investment Landscape Evolves, According to Watson Wyatt

WASHINGTON, D.C., Nov. 24, 2008 — Many hedge funds will be forced to close and there will be significant consolidation among the remaining, due to current market conditions and unprecedented changes to the regulatory landscape, according to Watson Wyatt, a leading global consulting firm.

However, the best managers in the industry will emerge better positioned to exploit investment opportunities characterized by greater market dislocations and lower prices and this will be made easier by the absence of proprietary trading desks.

Watson Wyatt asserts that long-term investors are likely to be the beneficiaries of this evolution, mainly through improved fee structures that better align interests. In addition, it suggests that certain hedge fund strategies will not perform as well as they have historically, given a fundamentally changed investment environment.

“In absolute terms, general hedge fund returns do not look good this year, but it is likely that some strategies will perform better than others – long-only equity funds for example,” said David Gold, manager research consultant at Watson Wyatt. “This has come about despite the well-publicized headwinds facing the industry in the last year, including reduced availability of leverage, higher costs of borrowing and trading, new regulation and the potential for more, and larger, redemptions.”

“The current crisis will expose those that are not structured to add value for investors and will provide the most skilled with attractive opportunities and potential for substantial returns in the future,” said Gold.

Watson Wyatt has identified early signs that increasing numbers of skilled hedge fund managers are becoming more flexible in the negotiation of fees, having been persuaded of the benefits of receiving long-term capital, provided by the likes of pension funds, rather than ‘hotter money’ that comes from other investors.

“While we strongly believe skilled managers should be fairly compensated, fees are generally still too high for the value they deliver, particularly as we enter a lower-return environment. Also, performance fees introduced to align interests have been less than effective because they are generally poorly designed and tipped in managers’ favor. For a number of years we have been trying to rectify this situation and negotiate a fairer deal on fees, but only now are we seeing real progress,” said Gold.

A number of factors should help certain hedge funds in the future, including: increased opportunities as a result of recent market dislocations; lower competition as the number of hedge funds declines; a reduction in the overall level of leverage; fewer competitive proprietary trading desks; and lower fees making them more attractive to investors. These factors will have different impacts on hedge funds depending on the range of strategies they use, resulting in some winners and losers:

The outlook for average fund of hedge funds (FoHFs) is impaired, in part due to significant redemptions at the end of the year and high overall costs. However, high-quality FoHFs should be able to capitalize on opportunity sets when they become available.
Multi-strategy managers are well placed to capitalize on opportunities and are arguably less affected by legislative changes, although some have very illiquid assets, which, combined with large redemptions, could cause problems.
Macro managers should be largely unaffected, although highly leveraged funds, concentrated in a small number of bets, could struggle.
Equity long-short managers should also be largely unaffected, on the understanding that the availability and cost of borrowing stock has not materially changed. However, these strategies may suffer if regulation forces them to disclose short positions.
Fixed income managers that use high levels of leverage will be adversely affected, particularly those that rely on a limited range of financing options.
Credit focused managers that do not rely heavily on leverage are likely to benefit, although it will be important to distinguish between those opportunities that require hedge fund skill (e.g. distressed debt) and those that are more long-only in nature (e.g. bank loans) and should be accessed more cheaply.

“In such a rapidly changing and uncertain environment, we think it is sensible that those pension funds looking to invest in hedge funds should hold off until there is greater stability and current redemptions play their way through the system. But for those already invested we would not recommend any action, although there may be fund and manager-specific considerations that require extra vigilance,” said Gold.

About Watson Wyatt Investment Consulting
Watson Wyatt Investment Consulting, a division of Watson Wyatt, is focused on creating financial value for institutional investors through independent, best-in-class investment advice. We are specialist investment professionals who provide coordinated investment strategy advice based on expertise in risk assessment, strategic asset allocation, and investment manager selection. Watson Wyatt Investment Consulting provides investment advice to some of the world’s largest pension funds and institutional investors, and has more than 500 associates in Europe, the Americas and Asia.

In the US investment advisory and investment consulting services are provided by Watson Wyatt Investment Consulting, Inc., which is a subsidiary of Watson Wyatt Worldwide Inc. Watson Wyatt Investment Consulting, Inc., is a registered investment adviser with the Securities and Exchange Commission.

About Watson Wyatt
Watson Wyatt (NYSE, NASDAQ: WW) is the trusted business partner to the world’s leading organizations on people and financial issues. The firm’s global services include: managing the cost and effectiveness of employee benefit programs; developing attraction, retention and reward strategies; advising pension plan sponsors and other institutions on optimal investment strategies; providing strategic and financial advice to insurance and financial services companies; and delivering related technology, outsourcing and data services. Watson Wyatt has 7,600 associates in 32 countries and is located on the Web at www.watsonwyatt.com.