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Alternative Investments - August 10, 2005

EDHEC survey shows that industry professionals do not feel overly threatened by the “capacity effect”

In a major survey of 183 industry players, including institutional investors and hedge fund and fund of hedge fund managers, conducted from May 31st to July 8th 2005, the EDHEC Risk and Asset Management Research Centre has found that alternative investment professionals are upbeat about future prospects for the industry and do not see the so-called “capacity effect” as a major threat to future profitability.

The principal findings of the EDHEC survey are as follows:

  • Professionals are confident about the future of the industry and its capacity to keep growing. More than 65% of the respondents think that industry assets will grow at a minimum annual rate of 10% over the next five years with a large number of respondents putting this growth at between 10% and 15%.
  • 70% of respondents are aware of hedge funds' exposures to alternative betas as a source of return.
  • 70% of the respondents consider that cyclical factors were among the main reasons behind recent lower-than-expected returns (for 42% cyclical factors were the only reason).
  • 71% think that arbitrage opportunities will be difficult to find in future years due to capacity constraints. The opinions of professionals seem to be somewhat contradictory here, because while they attribute the fall in hedge fund returns to cyclical factors, which is consistent with EDHEC's research on betas, they worry about a capacity problem (pure alpha arbitrage).
  • The results refute the idea of a critical size for hedge funds. Half of the respondents think that there is no size limit for a fund of hedge funds, whereas the other half thinks that a critical size exists. However, for 23% of respondents the critical size of the fund of hedge funds depends on the underlying strategies. For 18% the size is around $500 million and for 22% the critical size is between $1 billion and $2 billion.

The idea that hedge funds are not absolute return funds still seems to be difficult for the industry, even though the risk factors (betas) and the prevailing variations in the premiums that are attached to these (cyclical factors) are increasingly gaining acceptance.

However, as 81% of the respondents acknowledge, the hedge fund industry is becoming more professional. With professionalism and innovation, they feel that the industry is more likely to keep growing and creating high and stable returns.