Alternative investment products will be in demand in the New Year as markets improve and both individual and institutional investors look to diversify their portfolios.
Analysts said banks, brokers, and other financial institutions will add hedge funds, exchange-traded funds, private equity, real estate, and funds of funds to their product lineups in 2005 in order to remain competitive.
Garry Moody, a global managing partner in Deloitte & Touche's investment management services unit, said having a solid mutual fund lineup used to be enough but that to remain competitive investment management companies will have to broaden their menus of investment options.
"I think the hedge fund industry will find growth similar to how the mutual fund industry did," Mr. Moody said. "It is moving from a market that institutional investors considered to be high-risk to now being seen as another method to diversify."
A banking company investment executive agreed that diversification is desirable but said he thinks hedge funds are not the only path to that goal.
Neil Wolfson, Wilmington Trust Corp.'s chief investment officer, said investors will have to use a variety of products to maintain proper diversification next year but he believes hard alternative assets such as private equity and real estate products will prosper over hedge funds.
"Hedge funds are an area that should be considered, but expectation of easy money in hedge funds is not there right now," he said.
Indeed, hedge fund growth slowed in the third quarter. Tremont Capital Management Inc. has reported that the industry's assets grew by 4.2%, or about $25.1 billion, in the quarter. They had grown $43.3 billion and $38.2 billion in the first and second quarters, respectively.
Nevertheless, the $106.6 billion of asset growth in the first three quarters more than doubled the growth pace of the year earlier, Tremont said. Hedge funds gained $24.6 billion in the third quarter of 2003 and $45.4 billion for the first nine months, it said.
Banks that offer hedge funds have been able to gather assets with the products in the past year. For example, Bank of New York's hedge fund unit, Ivy Asset Management, had $8 billion of assets under management at Sept. 30, 2003, and $14.6 billion a year later.
Mr. Moody said hedge funds are growing because institutional investors are becoming more and more comfortable investing in the product. As institutional investors use hedge funds and other alternative products to diversify pension plan investments, he said, the products will grow substantially.
"Institutional investors are putting a piece of their assets in hedge funds, and that piece is a large piece of the business," he said. "This is a business that is about to see substantial growth just as institutions use these products as a way to diversify."
Hedge fund companies will grow quickly in 2005, Mr. Moody said. He expects most companies to create new hedge portfolios, and this will create a larger industry that individual investors will become comfortable investing in, he said.
"The retailization of hedge funds is happening now," Mr. Moody said. "With new registered funds of hedge funds, retail investors are getting comfortable investing and diversifying with these products."
Wilmington Trust's Mr. Wolfson said the rate of return for most hedge funds has been sub par. As the product has gained popularity, he said, interest rates have declined, and there has been less volatility in the equity markets. As a result, many hedge funds have not been having the explosive returns some enjoyed in the late 1990s.
"I still believe hedge funds can be a part of your portfolio," Mr. Wolfson said. "I continue to believe that they have tremendous benefits, but I think people have to carefully consider the product before adding it. This is not a home run."
Mr. Moody said 2005 could be a significant year of change for the hedge fund industry in terms of regulation. In October, the Securities and Exchange Commission adopted a rule requiring for the first time that hedge fund advisers be registered and submit to SEC examinations.
The SEC required that hedge fund advisers disclose basic information on themselves as well as opening their books to inspection. Funds with less than $25 million under management would generally be exempt.
Though 40% to 50% of hedge fund advisers are already registered, Mr. Moody said, the tougher regulations could significantly shape the industry. Larger companies will absorb many midsize hedge fund companies that find the new regulations too costly to comply with, he predicted.
The hedge fund industry can expect an evolution similar to what the mutual fund industry faced 20 years ago, he said, and in the long run the regulations will be a positive for the industry.
"The additional regulations will give investors more comfort," he said. "Over time, investors will be more comfortable putting money into products that are well-regulated."
"Inflows follow the yields," he said. "On a net basis, funds may have outflows, but four- and five-star products are always gathering assets. People will invest in strong products. That is the ultimate driving factor."
