Serious Money: The hedge fund industry has experienced phenomenal growth in recent years, writes Charlie Fell

What was once the exclusive preserve of the ultra-wealthy investors has become increasingly mainstream as the industry's client base has broadened to include large institutional investors such as pension funds and insurance companies. Worldwide assets under management have grown almost threefold from less than $500 billion at the turn of the new millennium to $1.3 trillion (€1.01 trillion) today.

The enthusiasm for hedge funds and their favourable performance characteristics reached fever pitch in 2002 as stock markets endured three consecutive years of decline for the first time in 60 years. Hedge fund returns exhibited low correlations with general stock market movements and had historically delivered stock-like returns with bond-like volatility. Not surprisingly, since hedge funds could potentially enhance the risk/return characteristics of investment portfolios, investors' allocations to the "absolute" return model began to increase.

Hedge funds have typically exhibited low correlations with other asset classes and amongst different "absolute return" strategies, which would appear to confirm their allure as a diversifying tool. However, investors need to be alert to the fact that their risk/return characteristics do not conform to a normal or bell-shaped distribution. Hedge funds occasionally exhibit "phase-locking" behaviour. Borrowed from the physical and natural sciences, "phase-locking" describes how systems, whose behaviour is usually uncorrelated, can temporarily become locked together in the same phase. A perfect example occurs in southeast Asia, where swarms of male fireflies congregate in trees and move from random to synchronous flashing.

The domino effect that occurred during the Long Term Capital Management hedge fund meltdown in autumn 1998 is a perfect example in the financial markets - hedge fund returns were negative across the majority of hedge fund strategies. During periods of financial distress, hedge funds may be more highly correlated with traditional financial asset classes than they are during normal market periods and consequently, they should not be used to manage downside risks.

Distributions of hedge fund returns exhibit other unfavourable characteristics that negate their diversification benefits. Most importantly, they exhibit "fat left tails". This means that hedge funds can suffer catastrophic losses on a bad day, which could wipe out years of positive compounding.

Investors need to be alert to the risks of hedge fund investing, but many of these pertain to "black swans", eg the rare event. However, a growing number of hedge fund risk and performance theories adjust for these non-normalities, imparting a more accurate view of the risk/return relationship.

In reality, it is the returns profile of hedge funds that will come under increased investor scrutiny. Too much money appears to be chasing too few opportunities and the returns earned by hedge funds have steadily declined in recent times. Indeed, returns have been single-digit in each of the past two years and have lagged stocks and bonds in the year to date.

The hedge fund industry appears to be a victim of its own success. The increase in assets under management, combined with hedge fund managers' dogged pursuit of market inefficiencies, means prices are probably more correctly aligned today than ever before. Indeed, market volatility has returned to historically low levels following the brief pick-up during the summer. Consequently, return opportunities would appear to be low at this time.

Convertible arbitrage, a strategy that typically involves the purchase of a convertible bond and the short sale of shares in the same company, provides a perfect example. The strategy delivered annualised returns of almost 13 per cent per annum from the mid-1990s to 2003. However, years of outsized returns led to massive injections of investor capital and not surprisingly, the increased level of competition caused returns to drop. Indeed, convertible arbitrage posted a negative return last year.

Additionally, there have been calls for the greater regulation and transparency as the industry has grown. The greater transparency will make it more difficult to earn high returns. Furthermore, as the larger hedge funds have increased in size, they have diversified into other areas such as private equity, and in some cases, are rapidly becoming as bureaucratic as the financial institutions the original founders chose to leave behind. Flexibility is critical to hedge fund performance so this is a trend that warrants attention.

There is little doubt that hedge funds are here to stay as investors will continue to embrace the true active management the industry provides over the traditional long-only model. However, the industry has reached a crossroads and although it should continue to deliver respectable returns, they should be lower than in the past.