A new white paper forecasts the “institutionalization” of the hedge fund industry, and predicts that institutional investors and high-net-worth individuals worldwide will pour an estimated US$800 billion of new money into hedge funds this decade, almost quadrupling assets to about US$2 trillion by 2010.

Jointly prepared by investment bank Putnam Lovell NBF (a subsidiary of National Bank Financial Inc.) and New River Inc., a consulting and business development firm for the financial industry. The paper, “Institutional or Institutionalized — Are Hedge Funds Crazy?”, estimates that U.S. and public pension plans alone will have about US$527 billion invested in hedge funds by 2010, up from US$87 billion at yearend 2001. Globally, high-net-worth individuals will more than double their investments to hedge funds by 2010, to more than US$1.2 trillion from almost US$400 billion in 2001.

According to the paper, sub-par performance in traditional asset categories are luring institutional investors to explore absolute return strategies. It predicts that more attention and assets from institutional investors will also result in more scrutiny, forcing transparency and coherence on the secretive hedge fund world.

Of the US$1.5 trillion increase in global hedge fund assets by 2010, about US$800 billion will be new money and an estimated US$700 billion will come from market appreciation.

“In a world where investors have suffered three straight years of stock market losses, even anemic recent hedge fund gains are tempting U.S. pension plans and other institutions to entrust their money to “absolute return’ strategies,” said Joseph Hershberger, Putnam Lovell NBF managing director, investment banking.

But a stock market recovery will not derail growing demand and hedge funds will enter the institutional mainstream because they introduce a compelling new money management model with new investment opportunities to exploit, Hershberger says. The successful hedge funds and funds of hedge funds will be those that gain the trust of institutional investors by demonstrating control of process and risk and consistent performance, he says.

The sophistication and rigor that institutional investors bring to the investment process will serve as an important catalyst for refining standards of practice that will have lasting and beneficial effect for all hedge fund market participants, according to the study. But the industry’s high fees will also attract managers with poorly established and executed strategies, resulting in potential grim surprises for their investors.

Among the paper’s major conclusions are:

  • successful hedge funds and funds of hedge funds are establishing themselves as ongoing, permanent entities;
  • large financial institutions are making the investments necessary to develop and distribute hedge fund-based products;
  • concentration will occur as the industry matures;
  • the search for absolute returns demands skill, focus, independence, and specialization;
  • an entire industry will be created out of the anticipation, identification, and measurement of hedge fund process and performance; the industry is embracing FoHFs; and
  • financial services institutions building proprietary platforms will have an advantage, since they will own the performance and have complete transparency.