Peter Douglas, CAIA, the founder of Singapore-based hedge fund consultancy and money management firm GFIA, is a well known and often-quoted figure in the alternative investment industry.  Regular readers may recall our conversation with him in his Singapore offices last fall (see post).  But Douglas also has another claim to fame.  As the Asia-based director of the Chartered Alternative Investment Analyst (CAIA) designation, he is a pioneer-cohort charterholder, and was the first CAIA in Singapore.  So we are pleased to bring you Douglas’ latest comments on the hedge fund industry as part of our monthly column featuring the ruminations of a CAIA charterholder, “Alternative Viewpoints”.

Today, Douglas pulls out his crystal ball to look at the future of the hedge fund industry.  He says that a dearth of alpha-seeking capital will usher in a “golden age” for alternative investing.  He also foresees larger hedge funds regulated as investment banks, and most large multi-strategy funds morphing or fading.  He says that as boutiques flourish, diversification across funds will become easier and price differentiation will finally take hold.  In addition, predicts Douglas, leverage will fall out of favour, operational expertise will become even more critical, and regulatory arbitrage will remain alive and well.

Alternative Viewpoints: What Next for the Hedge Fund Industry?

Special to AllAboutAlpha.com by: Peter Douglas, CAIA, Founder, GFIA pte.

The future will (not ‘may’) hold many surprises, and some could make a huge difference to our world view.  However, here are our thoughts on how the hedge fund world may pan out over the next 2-3 years.

In summary, the hedge fund world will (i) see higher returns (ii) see strong new manager formation (iii) be dominated by small boutique managers (iv) have relatively few very large funds.

Returns will be higher, possibly much higher, than they were 2006-2008

Of (very roughly, erring on the conservative side) US$2tn of hedge fund assets, and >US$4tn of investment bank trading assets, at the beginning of this year, we will, by the beginning of 2009, have lost perhaps 1/3 of the hedge fund assets and 3/4 of the world’s banks’ prop trading assets.  Assuming (and this is perforce guesswork) that aggregate leverage in the hedge fund ecosystem falls from 3x to 1.5x, and that ditto in the prop desks drops from 20x to 10x, that means that US$86tn of alpha-seeking capital will become US$12tn, an almost 90% implosion.  This is conservative. At a recent conference, we heard Paul Marshall, of Marshall Wace, estimate that half of all hedge fund capital, and 80% of investment bank trading capital, would evaporate.

(Goldman Sachs’ reduced their overall leverage from 24x to 16x, still, to our mind, an extraordinary number. We’re assuming that the majority of the new owners of investment banks will not be as confident of their new-found treasure’s ability to manage risk and will run significantly lower leverage. Professional trading units outside banking, such as Cargill, typically run at around 10x and we feel this is a realistic estimate.) More…