Is the rise in hedge fund inflows a negative lead-indicator for the stock market?

Barrons' lead story this weekend about hedge funds contained three interesting statistics. Barrons didn't interpret the statistics; but experience suggests they are a worryingly negative lead-indicator for the stock market. First, here are the three statistics in Barrons' own words:

1 ) "Studies by the New York-based Institute for Private Investors, which represents individuals and families with generally at least $50 million in assets, show that the members' average allocation to alternative assets -- a category now dominated by hedge funds -- soared to 41% in 2003 from 27% in 1999. Equity holdings, in contrast, fell to 35% from 53% over the same period, and fixed-income held about even at 15%."

2) "Pension funds, often pioneers in new investment strategies, were allocating less than 8% of their portfolios to alternatives as of 2003, says research and consulting firm Greenwich Associates."

3) "The number of hedge funds alone now outstrips the number of Taco Bell outlets in the United States, with some 7,000 hedge funds in existence at last count."

The Barrons article was strangely silent about why wealthy investors are moving assets into hedge funds with the encouragement of their bankers. After all, wealthy investors, like professionals in the industry, know that rising inflows are making it harder for hedge fund managers to generate alpha (due to greater competition), and are therefore reducing expected returns from hedge funds as an asset class. Steve Mandel's recent decision to launch a long-only fund because of the increasing difficulty of shorting stocks is a case in point.

Also, private wealth managers certainly earn comfortable fees from introducing clients to, and screening hedge funds. And those fees are even higher when the large asset managers get into the hedge fund (or fund of fund) business themselves, as we've recently seen. But at the same time, most private wealth managers tend to get paid an asset-based fee. So the extremely high fees charged by hedge funds relative to separately managed accounts or mutual funds, in as much as they reduce clients' returns, reduce the profits of the private wealth managers.

So why would the private bankers be so enthusiastic about hedge funds?

I think there are two reasons. The first is that wealth management using conventional asset classes is becoming easier and cheaper. Although it sounds bizarre, there's no reason to hire Goldman Sachs when you can have Ameritrade allocate your assets among ETFs and email you when you need to rebalance (with one click). All for 35 basis points. In light of that, pushing hedge funds - which require substantial due diligence and screening - justifies the bankers' fees and differentiates them.

The second reason is perhaps more fundamental. Their dramatic shift of assets into hedge funds suggests that these private wealth managers are sceptical of the economic recovery, and concerned about a down-market in 2005. (Or at the very least their clients are more risk averse.) One response to poor projected stock market returns is to follow John Mauldin's advice to put your money in absolute return strategies.

And although Barrons failed to mention this, the track record of private wealth managers investing for their wealthy clients is historically better than the track record of the average retail investor. Which perhaps means that the sharp increase in assets flowing into hedge funds is another negative leading indicator for the economy and the stock market.

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The full Barrons article, titled "Hedged Bets - Private Bankers are guiding the wealthy to hedge funds", is available here (subscription required).
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