Institutionalisation has secured the future of hedge funds, but the industry must further evolve

Reading some of the mainstream financial press, you would be forgiven for thinking that the hedge fund business model is dead. One august news organisation headlined one particularly gloomy story, “The Golden Era of Hedge Funds Draws to a Close With Clients in Revolt”. The media narrative is of industry contraction, investor redemptions and poor performance (derived from misleading comparisons between hedge fund indices and equity indices).

It is undoubtedly the case that the hedge fund industry faces a highly challenging external environment, characterised by scrutiny, hostility and negativity. However it is worth considering the underlying “mega-trends” that are really driving the hedge fund industry: institutionalisation, globalisation, regulation and retailisation.

Let’s take institutionalisation first. The biggest post-crisis trend in the hedge fund industry globally has been that the new money coming in has been very largely institutional, typically from pensions, endowments and sovereigns, while much of the high net worth money has left the industry. That has meant that the overall balance of assets under management has gone from being roughly 50-50 high net worth/institutional pre-crisis to a big majority institutional now. That has been a game-changer for the industry.

It has meant that the industry has had to become much more institutional itself in terms of operational infrastructure, risk management and governance to attract that institutional money, given all the demands of due diligence. It has meant the industry has a far more clearly defined social role, because many of these institutional investors like pensions and endowments are socially important investors who allocate on behalf of working people and educational institutions. That, in turn, has meant that there has been greater political scrutiny of the industry which has necessitated greater transparency by the industry.

But the big picture point is that this institutionalisation has secured the future of the industry. Institutional investors do have concerns about fees and performance, but consider their portfolios. They will typically have very large allocations to equities. They like the returns from equities they have had post-crisis, but they remember 2008, and they have concerns about the volatility of equities. They need something in their portfolio to complement equities, to provide diversification. That was traditionally provided by sovereign debt, but there are now many questions mark there. That is why these institutions have been turning to alternative managers like private equity, infrastructure, and hedge funds.

And it is likely that there will be a continuing need by these institutions for hedge funds. The rise of passive investing is clearly hugely important and may well have a dramatic impact on the future of asset management. However, while it is great to be passively long in good times, it’s not so smart in bad times. That means that there is still a role for active management, whether in heavily regulated retail funds that are restricted in their investment approach, or less constrained and more specialised funds for qualified investors.

For all the loaded connotations associated with the term “hedge fund”, that’s all we’re talking about, the niche space on the asset management spectrum for less regulated, more specialised managers who have access to a wide variety of investment instruments and because of that are more expensive than their more vanilla mutual fund counterparts. I know one institutional investor that doesn’t talk about “hedge funds”, they just refer to them as “less constrained funds”. And there is still a role for those “less constrained funds” in their portfolio.

Globalisation has accompanied institutionalisation. Increasingly, larger hedge funds have offices in the US, Europe and Asia. This is being driven by the need to raise money globally. For US hedge funds, the EU is a big market in terms of investors (accounting for an estimated 10-20% of AUM). For UK hedge funds, the US is a massive market (US institutional investors account for an absolute majority of all capital invested in hedge funds globally). For both UK and US hedge funds, the Asian and Middle Eastern markets are growing in importance (with Australian supers, Japanese pension funds, and sovereigns in Singapore and the Gulf). For Asian hedge funds, the US and European markets are critical, something like 90% of capital managed by Asian hedge funds is non-Asian.

One major positive for the industry from this globalisation is that new investor markets are emerging, even as some traditional investor markets are diminishing. There is growing evidence of Asian family offices and pension funds increasing their allocations to hedge funds, for example. Increasing pension provision in many Asian economies is creating significant pools of assets to be invested, with those funds often looking globally for their managers. In Korea, for example, several major institutions have begun allocating to hedge funds recently. The world’s biggest investor in hedge funds is a sovereign wealth fund, and as these sovereigns internationally build their in-house expertise they typically have become more ambitious investors in alternatives.

The practical impact of industry-wide regulation post-crisis has been that it has significantly raised compliance costs for managers, which in turn has raised barriers to entry. That in turn has clearly resulted in a lower levels of new managers, to the detriment of the industry. However there appears to be growing sentiment that those managers that are launching at such a difficult time are of greater quality and are managing to build impressive infrastructure despite all the challenges they face.

Finally, the industry is becoming transformed by retailisation thanks to liquid alts. Through UCITS in Europe and 40 Act funds in the US hedge funds are increasingly attracting retail investors. That is another trend which is a major positive for the future of the industry, particularly if markets get choppier in the coming years. Retail investors will increasingly look for absolute return solutions which provide downside protection rather than more traditional long-only products.

What do these mega-trends mean for the manager? I would suggest there are five broad conclusions.

Firstly, those hedge funds that will be successful will be those that prioritise how they are perceived by investors and the market. CIOs of institutions need to be able to win over their colleagues on investment committees and boards of trustees, so reputation is paramount.

Secondly, firms must clearly differentiate their investment edge relative to their peers. Investors don’t want to pay hedge fund fees for vanilla managers. If they are paying those fees they need their manager to be doing something special and different.

Thirdly, managers need to demonstrate not only their investment expertise but also communicate the culture and values of their organisation and explain the robustness of their operational infrastructure. Investors need to be reassured that the organisation has both the right culture and infrastructure in place, they face significant career risk in their allocation decisions.

Fourthly, brand is increasingly important for hedge funds. Firms should take brand-building seriously and ensure that their brand is aligned with their corporate narrative and business goals. In hedge funds too often the principal is the brand.

Finally, hedge funds must follow larger firms and clearly define their own corporate responsibility, social and environmental awareness, and commitment to transparency. That would not only draw praise from investors but many other stakeholders too.

Written by Christen Thomson, Senior Director and Global Head of Hedge Funds

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