ANALYSIS

Inside job: institutions shape the new hedge fund model

The institutional foray into hedge fund strategies is changing the way these managers invest. In turn, the hedge fund industry is being shaped by this now dominant investor base.

Just two years ago, scathing accusations were hurled at hedge funds. Many of the strategies are correlated with public markets, investors complained. They use too much leverage, impose lock-ups that don’t match the liquidity of underlying assets and are unresponsive to investors’ requests for greater transparency.

For all of this, too, investors pay fortunes in fees.

As about $600 billion drained from the industry, underperforming managers or those with insufficient scale went out of business. Stronger managers endured tough times, such as the final quarter of 2008, when about $150 billion in redemptions requests were made.

Cambridge Associates, an asset consultant, describes this as the “emotional nadir” for the hedge fund industry during the crisis, in which its aggregate funds under management (FUM) fell 30 per cent to $1.3 trillion, and the number of managers dropped 11 per cent to 8,923.

But two years later, in the final quarter of 2010, hedge funds netted $150 billion in new commitments, according to Hedge Fund Research, and many of the managers who survived 2008 and 2009 have regained or grown their market share. Cambridge says the industry’s total FUM has returned to its pre-crisis peak of $1.9 trillion. Its poor fortunes have clearly reversed.

The industry is, however, in the grip of fundamental change. Its funding base is now dominated by institutional investors, whose demands for more nuanced strategies, greater transparency and risk controls, and better fee and liquidity terms make the traditional hedge fund investor, high-net-worth individuals, seem low-maintenance.

Since the crisis, it’s become apparent that institutions are using hedge fund strategies in smarter ways. David Saunders, co-founder of K2 Advisors, the hedge fund-of-funds (hedge FoF) based in Connecticut, says these investors “have a clear picture in their mind of what they want their portfolio of hedge funds to do in their asset mix”.

Increasingly, the concept of an alternatives ‘bucket’ is becoming passé, Saunders says: “Hedge funds invest in everything within the typical capital structure and across asset allocation bands”.

As a result, the strategies are becoming “ingrained” in asset allocation modelling. Some investors ask for long-volatility programs to hedge their exposures to the equity risk premium, he says. Others want active overlays to protect their portfolios or to exploit short-term inefficiencies in particular sectors.

These are far cries from the role that hedge FoFs still performed a decade ago: providing access to portfolios of selected hedge funds.

When K2 Advisors launched in 1994, it served as a guide for primarily high-net-worth investors seeking access to its portfolio of chosen hedge funds. But in 2001, as its client base became increasingly institutionalised, it reached a turning point for its business: a client asked the firm to build a customised hedge fund program from environmental, sustainability and governance strategies.

Similar requests came, and the trend to customisation among K2’s clients began. These days, the manager’s flagship hedge FoF accounts for an ever-smaller component of its business: most of the time, it researches the universe of hedge funds and advises institutions on the strategies, often undertaking due diligence and tailoring hedge fund programs for investors. Less a manager, K2 is more the “strategic advisor,” Saunders says.

This is one aspect of the ongoing “institutionalisation” of hedge funds, which began at the turn of the century when US pension funds bought the strategies to diversify away from long public-equity biases, and then was accelerated by the financial crisis as many of the traditional hedge fund backers, high-net-worth investors, redeemed their commitments to gain liquidity.

As a whole, institutions were less flighty. They now represent a more stable asset base for hedge funds as they invest in the strategies to achieve specific, long-term investment outcomes. “Crisis or no crisis, this institutionalisation has been happening since 2000,” Saunders says. Of the $9.7 billion-plus managed by K2, 94 per cent of these assets are institutional.

Now that institutions are more attuned to hedge funds, they are also asserting themselves more forcefully. They are, rightfully, a demanding investor base. “They’re fiduciaries. They’re fee-conscious. They want transparency and benchmarking to know how the strategies apply to their overall portfolio,” Saunders says.

“The traditional hedge fund deal is: you give me the money, and I send you the net asset value and perhaps a nice little letter. It’s changed. These investors not only want to know, but need to know because they’re fiduciaries.”

These demands have, in many cases, provided investors with a better understanding of hedge funds and led to a more sophisticated deployment of them. Long/short equity strategies, for instance, shouldn’t necessarily sit in the alternatives bucket, Saunders says. “With the transparency available today, they should be captured in the equity allocation. You can’t ignore this exposure to equities because it sits in your alternatives bucket.

“Institutional thinking about hedge funds is evolving, which is forcing us to evolve. Sometimes we change, sometimes they ask us to. That’s a partnership.”

Each time a customised solution is developed through such a partnership, new intellectual property is created, says Samuel Mann, managing director of K2 Advisors’ Australia office. Sometimes this can be transferred to other clients confronted with similar challenges.

As K2’s investor base has become more institutionalised, its client service headcount has swelled. Not only do investors need transparency and data about their market exposures, liquidity and returns, but also they want dialogue, Saunders says.

“What they want to know is if the manager has still got that edge.”

He says receiving data without commentary can be an unfulfilling experience. “You’re not getting into the investment process and idea generation – the alpha – just a bunch of data-gathering.”

Investors want an explanation of the recent performance of strategies and some idea of how it will perform in current market conditions. For this reason, managers should send information about holdings, exposures and risk levels ahead of conference calls.

“Then you don’t tie up the manager with a phone call of 40 minutes of data gathering, but drill down into the most important part of the relationship. And the hedge fund manager also benefits from this.”

Hedge fund investors, including K2, did not miss their chance to extract better deals from managers.

“There weren’t many hedge fund investors willing to step back in and invest in the depths of 2008 and early 2009, so hedge fund managers began to review their terms and conditions. We saw a willingness to discount fees, offer transparency into portfolios and provide better liquidity terms that match underlying investments, instead of long lock-ups just because they could,” Saunders says.

This has given investors greater clout in their negotiations with managers, and has led to some positive outcomes, according to Cambridge Associates.

Managers have the opportunity to cultivate long-term, committed investor bases with an understanding of hedge fund strategies, Cambridge says, which could lessen the severity of another redemption cycle if global markets sold off rapidly again, or another fraudster of similar scale as Bernie Madoff was publicly uncovered.

Cambridge has researched and consulted on hedge fund investing for more than 40 years, and its clients’ exposure to the strategies exceeds $26 billion. Of the 10,000 or so hedge funds in existence, about 250 managers have successfully passed through its research and due diligence “funnel,” says Eugene Snyman, managing director of the consultant’s Australia office.

In Cambridge’s experience, investors use hedge funds primarily to achieve diversification. The strategies do not belong in growth portfolios, which are usually dominated by listed and private equities, or in defensive buckets built to hedge inflation and deflation.

They are diversifiers aiming to generate positive compound returns, which are uncorrelated to public markets, over long periods of time. The ultimate goal, to gain equity-like returns with risk levels similar to bonds, still stands.

“This portfolio can stand on its own, but its role is to diversify from the investor’s other assets and strategies,” Snyman says.

He says investors with $30 million or more to allocate to the strategies can “be well diversified over 15 or so manager relationships” and build a direct program. In addition to customised strategy selection, these programs maintain a “liquidity schedule” which monitors the available liquidity among managers.

But the resurgence of hedge funds has once again brought capacity concerns to the fore. Little more than two years since Lehman’s collapse, some top managers have already ‘soft-closed’ their funds to new investors, says Paul Liu, a hedge fund specialist with Cambridge, who is relocating from San Francisco to join the consultant’s Sydney team.

“Capacity is a real concern,” Liu says. “On one hand, we really are believers in hedge funds. On the other hand, we’re quite selective in that there are 10,000 hedge funds out there and we work actively with about 250 of these managers.”

Even though clients’ hedge fund allocations have been filled – one invested $1 billion in the strategies last year – there is potentially the problem of too little capacity, and Cambridge “wouldn’t feel comfortable going to the second best”, Snyman says.

This makes it an imperative to find new talent. While the centre of gravity for the hedge fund universe is still Connecticut and New York, promising managers are emerging in Europe and Asia, particularly in Hong Kong. “It’s still nascent, but we are finding interesting managers, some of which have grown up and gained experience in the US and are now plying their trade in Asia,” Snyman says.

“There is the challenge of capacity, but the opportunity set is starting to broaden globally.”

Liu is upbeat about the hedge fund industry in Asia. “Hong Kong seems to be the new New York. It is no longer considered a hardship outpost – many managers are deploying human capital out there.” Many of these new stars are former proprietary trading teams that have been restructured out of investment banks and reinvented themselves as hedge funds.

The financial crisis, which forced underperforming managers to close, has made way for these newcomers. It has also driven consolidation, in many cases making the surviving managers bigger and stronger. Overall, these changes have been positive for the industry, Snyman says.

“What attracts people to the hedge fund space are the fees they can charge.” Cambridge has seen a lot of managers – who are really long-only with a bit of indexed leverage but charge two-and-20 – leave the space, he says. These managers stood in stark contrast to others which exercised astute risk controls, such as stop-losses and the flexibility to move into cash or gold.

Since the crisis, Cambridge has more than doubled the number of operations-focused staff in its hedge fund team to more than 30 so that it can track managers’ counterparty relationships and processes.

Liu says positive outworkings from the crisis include managers’ diversification of prime broker relationships, in addition to the trends of establishing custodial relationships and providing more transparent reporting to investors.

“They have always been issues and will continue to be, but there have been some drastic improvements on those fronts. What we have seen is the hedge fund industry become a lot more institutionalised.”

Now that redemptions have eased, and managers are not so compelled to accumulate their available cash to meet payouts, they can remain invested and be better positioned to exploit market dislocations.

This “may help lead to a restorative cycle of strong performance and stabilising capital bases”, notes Cambridge in recent research.

“For the survivors, the rewards should be strong as pricing inefficiencies continue even as many markets have rallied well off market lows.”

Indeed, the crisis changed the competitive landscape of the hedge fund industry, says K2’s Saunders.

“The industry, to some degree, bifurcated post-2008. A handful of large players have been receiving inflows and they are institutional managers, because clients require more and more resources.”

These survivors can reinvest in operational systems and pay bonuses to keep talent. Managers that are still beneath their high-water-marks will find this difficult as they endure a dearth of performance fees.

“You will also see fewer partnerships. Investors don’t need two or three hedge FoFs, but one partner.”

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