Merrill Lynch analysts say that rules-based passive hedge fund strategies could provide an increasingly attractive alternative to active hedge fund management as the industry continues to mature.
They expect strategies will increasingly emerge that aim to replicate hedge fund performance, either by using liquid assets like stocks or by mechanically executing hedge fund strategies, enabling investors to achieve similar returns to hedge funds with lower fees. Investors in such instruments may also benefit from greater liquidity and transparency.
No asset class has seen such tremendous growth as hedge funds have seen over the past 15 years and few financial instruments command such high fees.
“Passive strategies, some of which are increasingly the focus of academic research, aim to provide returns similar to hedge funds without the need for active management,” says Benjamin Bowler, the co-head of Global Equity-Linked Research at Merrill Lynch. “Because of their lower cost, we believe these vehicles have the potential to outperform actively managed hedge fund investments on an after-fee basis.”
Since 1990, hedge fund assets have grown to an estimated USD 1.2 trillion, while the number of hedge funds has risen to around 7,000 globally, according to Hedge Fund Research. Investors seeking absolute returns and a source of diversification for their core portfolio continue to invest money into hedge funds at a record pace, with USD 66 billion being added in the first half of 2006.
“Competitive pressures are increasing the value of high quality active management that can generate superior returns,” adds Heiko Ebens, the head of US Equity Derivatives Research at Merrill Lynch. “However, with thousands of active managers competing with each other, it may be increasingly difficult for investors to justify paying hedge fund fees for the performance of the average active manager if passive alternatives are available.”