Dr. Rama Rao



Financial Physics

financial physics

Read this in-depth Study of the
Hedge Fund Industry

Hedge fund book


Praise for the book

"A provocative study that makes one think about the future structure of the hedge fund industry. A timely study released as major deals are coming to light."

Lois Peltz, Managing Editor-MAR/HEDGE

"Exceptionally solid work, clear reasoning and well documented. Conclusions are both logical and insightful."

Hunt Taylor, Executive Director- Tass Management, Inc.

"This report addresses the rising tide of wealth in the U.S. and the bright future for alternative asset managers going into the next century. It also suggests we may begin to see a consolidation among alternative asset managers similar to what has been occurring in the traditional asset management industry over the last decade."

H. Bruce McEver, President-Berkshire Capital Corp.

"I read the report with admiration and recognition. It presents a very credible vision of the future of the hedge fund industry."

Arthur J. Samberg, Chairman & CEO- Dawson-Samberg Capital Management, Inc.

"This is a wonderful report on the hedge fund industry and the evolution concept is well articulated. We believe one day it will be considered imprudent not to hedge. Interestingly, Harvard, Yale, Stanford and Duke Universities already subscribe to that philosophy."

E. Lee Hennessee-Hennessee Hedge Fund Advisory Group

"This report puts a unique perspective on the hedge fund industry, and shares insight that was not previously available anywhere."

Peter W. Testaverde Jr., Partner Financial Services Group- Goldstein Golub Kessler & Co.

As seen September/October 1999 in


The numbers are staggering. Between 1990 and early last year, hedge fund assets exploded twentyfold, from $20 billion to $400 billion, reports Joseph Nicholas in his book Investing in Hedge Funds (Bloomberg Press, 1999). Not surprisingly, the number of hedge funds soared as well to more than 3,000 from 200, Nicholas adds. Even more impressive than numbers is the impact that hedge funds are having (and already have had) on Wall Street and beyond. For instance, the launch within the past several years of so-called market neutral funds had its roots in the hedge fund business.

During the 1990s, hedge funds were among the hottest growth stories around. As a result, hedge funds went from relative obscurity to front-page business news. But where does the hedge fund business go from here, and what, if any, are the implications for the money management business? It was this and related topics that were fodder for discussion at Forum 99, sponsored by the Managed Funds Association, a Washington, D.C., trade group representing hedge funds and managed futures funds.

Is it only a matter of time before the equivalent of a Fidelity or a Vanguard arrives on the hedge fund scene? At least one of the speakers at Forum 99, held recently at the Plaza Hotel in New York, thinks so. A "natural process of evolution" is under way in the hedge fund business, said Rama Rao, president and CEO of RR Capital Management, a Bohemia, New York-based hedge fund. Rao told attendees that the money management business is poised for a major restructuring.

Referring to a March 1998 study that he co-authored, Rao predicted the hedge fund industry will consolidate along the lines of the mutual fund evolution that has unfolded over the past two decades. (Rao's study, "The Coming Evolution of the Hedge Fund Industry: A Case for Growth and Restructuring" is available at his firm's Web site. Point your browser to www.rrcm.com/f_ reporthome.htm to read it.) The hedge fund industry in the years ahead, he went on to say, will shed its current status as a localized, fragmented industry and become an institutionalized, globalized business.

Drawing on the theories put forth by Harvard's Michael Porter, Rao noted the hedge fund industry is driven by a life cycle that's applicable to most businesses and products. He divided that cycle into four stages: introduction, growth, maturity, and decline. Having gone through the introduction phase in the 1980s, hedge funds reached an "inflection point" around 1990 when assets and the number of funds began growing at a substantially higher rate (see bar graph above), be explained. At that point, the business moved from its introduction phase -characterized by relatively sluggish growth-to its growth phase. "When an industry undergoes this inflection point, the balance of forces changes from the old way of doing business to the new way of doing business," he added.

Hedge fund growth in recent years, Rao observed, is reminiscent of the mutual fund industry's growth in the 1980s. In the 1980s, Rao continued, mutual funds began to post dramatically stronger growth rates. The expansion phase subsequently led to consolidation, globalization, and the development of more sophisticated analytics. The distribution of the information arising out of that analysis also began in the 1980s. he said, with the founding of Chicago-based Morningstar.

In their March 1998 study, Rao and his co-author, Jerry Szilagyi, who at the time the study was written was in the financial services division of KPMG Consulting, pointed out that since the early 1980s "the mutual fund industry has gone through several phases of evolution-from stand-alone small funds to large families of funds and now a period of consolidation and globalization." Rao and Szilagyi believe the hedge fund industry will follow a similar course over roughly the next decade.

They explained that, though highly fragmented, the industry is generally profitable. "Historically, the combination of fragmentation and high profitability has presented significant opportunity for evolution or consolidation," they wrote. "The profitability makes the industry attractive, and the lack of dominant players creates an opportunity for a motivated, well-funded consolidator to create an organization that represents the next evolutionary step," Rao and Szilagyi concluded. In his presentation at Forum 99, Rao stressed that the hedge fund business today, like mutual funds in the early 1980s, is dominated by a relatively small number of independent organizations. Many of these companies, he observed, have a lone star manager and offer a handful of products, if not a sole portfolio. According to Rao, roughly 80 percent of all hedge funds have under $100 million in assets.

During the question and answer session that followed Rao's talk, an attendee noted that the popularity of hedge funds is closely tied to the industry's independence from the Wall Street establishment. The fact that many of "the best and the brightest" leave the Goldman Sachses and the Morgan Stanleys to launch their own hedge funds suggests as much.

Might hedge funds run by the equivalent of a Fidelity or a Vanguard be viewed as second-tier products next to those run by independent hedge fund managers? Rao conceded that injecting the aura of Wall Street into the hedge fund business could backfire. However, he underscored his belief that the opportunities to tame and exploit the business will offset any potential fallout. Considering that institutions, such as pension funds, remain a minority of the investors in hedge funds, the capacity for additional growth by cultivating those clients is substantial. Institutional investors, he added, would respond to reliable, one-stop shopping services offered by the hedge fund equivalent of a Fidelity or a Vanguard.

If Rao and Szilagyi are correct that the hedge fund business is destined for a fundamental realignment, it will be a high-stakes proposition. According to Rao, hedge fund assets should grow to $1.4 trillion by 2006. What will drive that growth? So-called high-net-worth investors, a critical source of hedge fund capital, are expected to expand their ranks at an above-average rate relative to general population growth. Whereas "all households" (that is, those with investable assets) are expected to increase by one percent over the coming decade, those households with investable assets of over $1 million are expected to increase by 14 percent. That trend, Rao added, will drive demand for hedge funds, as high-net-worth individuals pour $400 billion into the funds over the next 10 years.

Wealthy investors, particularly younger ones. Rao emphasized, are more aggressive in investing than previous generations, which explains the growing lure of hedge funds. Rao said that from 1992 through 1996, for example, hedge funds overall produced higher and superior returns both in terms of absolute and risk-adjusted returns, relative to the stock market. That, in turn, attracted high-net-worth investors to the niche.

Institutional investors also have been increasing their allocations to hedge funds, and Rao expects that trend to continue. Again looking at the period from 1992 through 1996, hedge funds produced returns that were generally non-correlated to conventional stock/bond investment portfolios. That characteristic understandably appeals to institutional investors.

D. Dixon Boardman, managing general partner of Optima Fund Management, L.P, a New York hedge fund, underscored Rao's point that the hedge fund business is evolving. Reflecting on the changes that have taken place over the past decade or so, Boardman also noted that the number of hedge fund choices has gone from several hundred to several thousand. "The hedge fund universe not only was a lot smaller a decade ago, but it also was less diverse and less visible." He added that 10 years ago there wasn't a plethora of mortgage arbitrage funds, emerging market debt funds, or market neutral funds.

Finding a "suitable" hedge fund was also a good deal more difficult, Boardman emphasized. "Today, you can use not one but several Internet-based systems to run multicriteria screens to identify manager candidates. You can use those same Internet-based systems to perform in-depth statistical analysis on a universe of managers," he added.

That said, Boardman cautioned his audience not to confuse ease of quantitative analysis with thinking. "While the information technology available to hedge fund investors has changed, one very important fundamental aspect of the process has remained the same: judgment." Data, quantitative analysis, and even general due diligence are mere tools, he emphasized. "They will not in and of themselves tell you who really are the best and the brightest in the business," Boardman stressed. The search for high-quality managers who exercise intelligent risk controls still requires judgment, Boardman observed.

Judgment, as Boardman sees it, comes only by way of experience. "Judgment tells me markets go in cycles. Of course, the only cycle we have seen for quite some time is an up cycle," he observed. "I'll not presume to be some great market guru. Nonetheless, Boardman said he felt compelled to predict that one day, the markets will go down. "Even more likely, [the market] might just become a bit more volatile, or perhaps it will continue to go up at a much more modest pace. If these shifts do occur, judgment tells me it will probably be more difficult to be a long-only equity manager." As a result, "investors' expectations, which I believe are highly inflated will certainly change. Investors will seek alternative investment strategies." At that point, hedge funds, or at least some hedge funds, will reap big rewards, Boardman suggested.

If a bear market isn't on the horizon, alternative investment strategies might get a helping hand from an investor's other nemesis: volatility. Boardman warned that when a bear market arrives (as it most surely will), hedge fund managers had "better get it right or their credibility will come into question, especially after periods like 1994 and 1998."

The hedge funds that are destined to capture investors' attention in a bear market or a period of increased volatility, according to Boardman, will be those run by managers who "buy stocks they like and short stocks they don't like, based on fundamental analysis." In particular, "the most effective and successful hedge funds will be those that focus on a specific industry or theme." What matters is that they "possess superior breadth and depth of knowledge" in their niche.

The move from the general to the specific, Boardman noted, marks the history of his firm. Starting with a diversified fund of funds, Optima now offers a "broad" menu of hedge fund products, including portfolios targeting small caps, technology companies, and Japanese equities. Boardman announced to his audience that later this year Optima will launch an energy hedge fund. "The point I'm trying to make is that our business has evolved in the direction of much more focused, strategic types of hedge funds."

Boardman added that his comments weren't meant to condemn other hedge fund strategies, such as arbitrage, futures trading, and equity generalists. "Some of my best friends are arbitrageurs, futures traders, and equity generalists," he joked. Still, Boardman stressed that he expects the more focused funds to become the leaders in terms of consistent forward performance. Like Rao, Boardman also expects greater institutional participation in hedge funds. Ten years ago, perhaps 90 percent of the money going into hedge funds was from private investors and 10 percent was institutional. Ten years from now, those numbers will probably be reversed," be predicted.

Some things won't change, Boardman said. Despite predictions that investors will demand lower fees, Boardman forecasted that the standard 20 percent performance-based fee will remain intact. Nevertheless, he did hold out the possibility for a greater use of hurdle rates (predetermined returns that must be "hurdled" before managers earn a performance-based fee). How will hedge fund managers get away with charging fees that appear exorbitant, even by Wall Street standards? "They can only justify these fees if they deliver what their investors expect, which is either superior absolute returns, risk-adjusted returns, or diversification and down-side protection," Boardman concluded.