Investing in the future: Power shifts away from hedge fund managers and towards investors

The financial crisis has resulted in a changed relationship between hedge fund managers and investors. Transparency, liquidity and fee structures are dictated increasingly by investors.

A few years ago hedge fund managers were powerful beings. They were able to command hefty fees in return for sizeable allocations from rich individuals wanting to grow their wealth through investments in a diversified, non-correlated asset class.

Investors who wanted more transparency or better liquidity were forced to shop around as managers, flush with capital, dismissed their demands.

Times have changed. Hedge fund investing is no longer seen as the preserve of the family offices and high net worth individuals (HNWIs) and the make-up of the asset class has also altered thanks to the fallout from the financial crisis.

Funds of hedge funds (FoHFs) were disproportionately hit during the crisis, losing a greater proportion of assets than single manager funds and recording poorer performance. That has also led to a move towards direct investing by some investors.

At the start of the millennium, hedge funds were still relatively new and the industry was less than half the size it is today in terms of the number of funds. Investors allocated less than $70 billion to hedge funds in 2000-01. Total assets under management (AUM) stood at $539 billion by the start of 2002 but rocketed over the next six years to a peak of $1.9 trillion in January 2008. In January 2010 industry AUM was estimated at $1.6 trillion.

Chris Manser, global FoHF activities head at AXA Investment Managers, says the industry was depicted as a “cottage industry” 10 years ago with investors and managers focused on fund performance. If a fund were making returns, investors would happily allocate to it.

Matteo Dante Perruccio, chief executive of FoHF Hermes BPK, agrees many FoHF investors allocated money to managers that had the necessary characteristics like liquidity and capacity but in many cases without performing deep enough due diligence.

For a while everything was great. The stock market downturn of 2002 barely made a dent in the growth of hedge funds and their popularity. Institutional investors, including pension schemes, university endowments and charitable foundations, increasingly became involved in the industry. The number of single funds and FoHFs available to investors rocketed.

Ian Morley, chairman of Allenbridge Hedge Info, says institutions were on the hunt for non-correlated, diversified low-risk instruments. “I don’t think that was completely deliverable in the way they wanted it, but they were sold what they wanted,” he says.

Some managers knew there was a risk of a mismatch between assets and liquidity, Morley says. This was not communicated to investors. The sheer number of FoHFs in particular meant there was crowding in larger managers, and FoHFs were unable to provide the diversification they promised, he concludes.

The FoHF industry grew over the decade as a response to demand for hedge fund products from investors new to the industry. Small and large investors were seeking to benefit from the perceived advantages of hedge funds and thought FoHFs would be a simple way to tap into the market.

Even as the bull market continued some investors were becoming concerned about risky hedge fund investments as well as the dangers of not carrying out thorough due diligence.

This was thrown into sharp relief in 2008 when the collapse of Lehman Brothers followed by the Bernie Madoff fraud coupled with the ensuing financial crisis demonstrated that hedge funds were not immune from the troubles affecting the wider financial services industry, particularly counterparty risks.

“That definitely shook up peoples’ expectations,” believes Chris Wyllie, head of portfolio management at family office Iveagh. Wyllie adds that suddenly investors became aware that hedge funds could, in a deep downturn, be correlated to equity markets and their portfolios were not as diversified as they thought.

Adam Wethered, co-founder of private investment office Lord North Street agrees. He says the crisis reinforced some “home truths” to investors. One issue suddenly brought into the limelight included a mismatch between the underlying investments in hedge funds and redemption terms as investors all rushed for the exits.

Counterparty risk was also suddenly at the forefront of the minds of investors (as well as hedge funds) as banking collapses shocked the industry and huge amounts of capital were tied up in the Lehman collapse.

AXA’s Manser says it can take a crisis like 2008 to make investors realise that “maybe performance is not the only aspect that they should be focusing on”.

The effects of 2008 on the industry have been well publicised. The demand for liquidity from investors hit by the market downturn led to net outflows of $155 billion over 2008 and $131 billion in 2009. Coupled with poor performance, this wiped out a large chunk of the growth in AUM and the number of funds declined sharply.

The economic strife also had a considerable effect on the interaction between investor and manager, resulting in an acceleration of the shift in power that some believe began during the bull market.

Investors are demanding increased transparency of portfolio holdings, better corporate governance and independent service providers. Negotiations over fees are more common although achieving reductions is difficult. Managers are more open to other demands, say investors.

Managers who resist the trend are likely to lose out on asset allocation, no matter how strong or long the relationship with investors.

“I think the really large investors do have a lot more power now,” says Virginia Parker, chief executive of US FoHF company Parker Global Strategies.

“We think investor opinion of hedge funds has improved over the past decade with the adoption of more directed institutional quality due diligence for large investors. Those firms who were unfortunately struck by bad experiences during this time have targeted improved analysis efforts in an effort to stay positive and not ‘throw the baby out with the bath water’,” says Matt Strube, senior investment manager for hedge funds at the Teacher Retirement System of Texas (TRS).

TRS is one of many pension schemes around the world to have increased its allocation to hedge funds in recent years. It now allocates 4% ($3.5 billion) of its assets of around $88 billion to hedge funds.

In the UK the Universities Superannuation Scheme (USS) moved into hedge funds following the crisis. Michael Powell, head of alternative investments for USS, explains the scheme’s trustees were heading towards allocating to hedge funds and other alternatives earlier but had some concerns around issues like illiquid assets and a mismatch between assets and liabilities.

“We felt that the financial crisis cured a number of these issues for us,” explains Powell.

USS started investing directly in hedge funds from day one. In this it was ahead of the curve. Recent research by a number of organisations shows institutions are increasingly allocating to single-manager funds directly rather than going through FoHFs.

Perruccio at Hermes BPK thinks this is potentially a dangerous trend. “I think one of the biggest mistakes institutional investors are making right now is making the assumption that these investors are resourced appropriately and have the necessary knowledge to invest directly in hedge funds,” he says.

Direct investment requires significant resources and skill from the investor. FoHFs argue they can supply this whereas even some large institutional investors lack the in-house expertise to monitor a diversified investment into single managers.

This lack of expertise is also cited as the reason for the majority of current inflows going to the largest managers who offer the comfort of a recognised name and institutional strength infrastructure. “The problem is that you’re creating a vicious cycle because you will inevitably have capacity constraints,” warns Perruccio. “I believe what people are missing is that the real opportunity in the hedge fund space is the mid-sized guys.”

Understanding the industry is set to become more important for high net worth and institutional investors alike. Parker from Parker Global Strategies says there is a lot of pressure now for investors to become more sophisticated. She thinks this will help ensure the survival of FoHFs and consultants.

Smaller institutions in particular continue to invest through FoHFs rather than directly, notes William Jarvis, a managing director at the Commonfund Institute, an investment management company serving US endowments and foundations with a FoHF programme. However, he says institutions with over $500 million in assets tend to allocate a majority of capital directly.

Lord North Street’s Wethered says the fees paid to good FoHFs are worth the money and allow investment companies like Lord North Street to spend time educating clients. “Some people have a natural curiosity about hedge funds. We spend a lot of time explaining the characteristics of hedge funds and making very sure that we understand the extent to which our clients understand that hedge funds are difficult to understand,” he says.

Investors see the institutionalisation of the industry as a positive sign for the future. They also think 2008 merely accelerated an existing trend.

“I think the trend towards more institutional-type investors has been a secular one and would have occurred anyway even if 2008 hadn’t happened,” notes Manser at AXA.

“I still think the long-term trend is certainly going to be for large pension funds to continually be switching their exposure away from quoted equities where they’re still heavily exposed. I think the hedge fund industry will be a natural beneficiary of that now,” comments USS’s Powell.

There is also an acknowledgement that more players within the industry could have a negative impact on performance.

“As assets grow within the industry, mathematically it must become more difficult to generate the returns that we want and the alpha that we want,” says Powell.

Boutique managers will continue to have a place in the portfolios of smaller investors and HNWIs as well as in institutional portfolios. Wyllie says Iveagh will always be interested in managers with a track record setting up a new fund. Powell says although USS’s hedge fund portfolio is currently skewed towards larger funds, it plans to look at smaller managers in the future.

Allenbridge Hedge Info’s Morley believes boutique hedge fund companies will always exist. “If you look at the history of financial markets when operations get too big and too bureaucratic often the founders want to get out and get back to where they started from. If you think hedge funds are classically Darwinian then they should be the most adaptable to the changed circumstances,” he says.

However, investors and FoHFs believe the demands for transparency and risk management generated by the financial crisis are here to stay and will continue to encourage institutions in particular to allocate capital to hedge funds.

“As more hedge funds adopt best practices and increased transparency of their processes, institutional investors will gain comfort in managers’ abilities to create alpha,” says Strube at TRS.

Investors of all types are also institutionalising their practices in response to the industry’s development, whether they are single family offices or large pension schemes.

“Like any young industry you have change that takes place. I think we’re seeing the evolution of an industry becoming more sophisticated and more regulated and with that managers who are investing in hedge funds need to get more sophisticated and this will inevitable mean that funds of hedge funds with the necessary skills and knowledge will be in demand,” notes Perruccio at Hermes BPK.

Despite the crisis investors believe the pendulum is swinging back in favour of hedge funds. Continued equity market upheaval has shown over the long term hedge funds will outperform stock markets as well as competing alternative asset classes like private equity.

Investors predict this will accelerate allocations to hedge funds away from ‘traditional’ asset classes. But they will ensure that investors, not the managers, control the reins in the search for the diversification benefits from an asset class that has finally grown up.

 

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