As institutional demand for hedge funds grows, not all providers will be able to meet the emerging standards for the industry, according to a recent report. Those firms that want to thrive in the maturing market will have to adopt new ways of doing business.
Last year’s report, ‘Institutional Demand for Hedge Funds: new opportunities and new standards’, was produced by the Bank of New York and Casey, Quirk & Acito, the Connecticut-based management consulting firm. It was based on interviews with more than 50 senior professionals, a poll at a June 2004 hedge fund conference, and intensive research. And although the report focuses on the US, it offers important pointers to all geographical markets.
According to the authors, the hedge fund industry “is midway through an important transition in its source of capital,” as institutional investors are beginning to take over from wealthy individuals as the major source of capital.
And at the same time, we may be seeing “the morphing of hedge funds into firms that have been prisoners of style boxes, and a breakdown of the ways in which funds look at themselves,” said John Casey, chairman of Casey, Quirk & Acito, speaking to IPE about the report .
Up to now, endowments and foundations have been at the vanguard of institutional investment in hedge funds in the US: nearly 40% of all endowments and foundations with more than $100m (e77.4m)under management have invested substantially in hedge funds, with average allocations nearing 12%. And the sector in general accounted for 53% of total institutional capital allocations at the end of 2003.
In the US market, however, defined benefit plans are the sector to watch. The report points out that, “despite representing nearly five times as much in assets as endowments and foundations, defined benefit plans currently account for just 40% of institutional hedge fund capital”. The report maintains that defined benefit plans will be the drivers of increased capital flow into hedge funds, estimating that pensions’ proportion of institutional capital will move from 40% to more than 65% by 2008.
About half of all institutional investors get into hedge funds through a fund of funds structure, and the report contends that funds of funds will maintain this market share. However, at the present time, 10% of investors in funds of funds employ a dual investment model, investing both directly and also through funds of funds. In fact, dual investors account for 25% of the total number of institutional investors, and 30% of total institutional capital. These dual investors have a firm commitment to hedge funds, as the report notes: “As they move into their ‘second stage’ of investing, current dual investors have on average greater capital allocated to hedge funds than investors following the direct only or funds of funds only models.”
Although the moves are in the right direction, it remains true that most US institutions have not yet invested in hedge funds - and European institutional investors even less - so the report’s authors turned their attention to an investigation of what is stopping them.
Headline risk, defined as ‘the (not irrational) view that poor performance (let alone malfeasance) among hedge fund investments will bring outsized criticism relative to the same performance from more traditional managers’, remains the main reason for avoiding hedge funds. In a June 2004 poll as part of the research for the report, 34% of respondents named this as their main reason for steering clear of the sector. In other words, for many institutional investment managers, the risk is not worth it.
The second reason given in the pool was capacity – the idea that returns will come down (and correlation go up) as more money enters the market.
It seems inevitable that increased funds will enter the market. The authors expect that, by 2008, US institutions will have more than $300bn invested in hedge funds. And investors - actual and potential - agree that this will demand a resetting of return expectations.
Currently institutions have an average net-of-fee return expectation from hedge funds of around 8%. The report highlights this, saying: “This result is interesting to us, given that similar research done three years ago indicated that expectations were about 400 basis points higher.” This resetting is attributable not just to analysing the effect that increased capacity will have, but also to the idea that many new entrants are choosing a lower-volatility route into the market, and selecting investment based on a hedge fund’s ability to diversify a portfolio, not just to provide outsize returns.
“We may be in a secular transition period, where the high returns of 1970s - 2000 have ended,” suggested Casey. “ We are now looking for different ways to capture good real returns.”
Based on its research, the report defines seven requirements for institutional success, the keys for hedge fund managers to attract this growing pool of capital. “These attributes define a much more mature business model than has heretofore been required in the hedge fund industry. It is more resource-intensive and will require overall higher professional standards.”
q Business management: The attention to business management is rational. Institutions want to be assured that their hedge fund adviser is a viable long-term business and that investment professionals are not distracted from making good decisions about their portfolios. They want to minimise potential disruption due to overdependence on any one individual for the effective operation of the firm;
q Culture of integrity: Hedge fund managers must instill in their firms unimpeachable ethical standards with little to no tolerance for infractions. Adequate resources must be dedicated to compliance;
q Operational excellence: Meeting the increased standards for operational excellence will be a significant challenge for many firms. As a result we are likely to see the continued growth of outsourcing options for hedge fund firms. In addition we believe that institutions will also expect hedge fund managers to systematically address Embedded Alpha or the less apparent ‘frictional’ costs of managing an investment portfolio;
q Disciplined investment process: Hedge funds must have investment processes that are understandable (even if complex), consistent, risk-aware, and perceived to be repeatable… hedge funds must also be able to articulate in a clear and concise manner the true competitive advantage that they possess – ie, how they will deliver alpha in a manner that is unique and compelling;
q Investment strategy innovation: Many institutions…expect that hedge fund firms will dedicate resources to constantly evaluating the effectiveness of their investment process…in some ways, institutions seem much more tolerant of such investment process reinvigoration among hedge funds than among traditional mangers (where it is perceived as ‘style drift’);
q Comprehensive risk oversight: Hedge fund managers should also have a compelling approach to operational, regulatory, and counterparty risks…Institutions perceive risk oversight best practices to include having senior risk professionals who are independent of the investment team;
q Sophisticated client interface: To be fully successful in the institutional market segments, hedge fund firms will require a broader set of distributions skills, among them: dedicated client service; quality communications; solutions resources; and willingness to provide transparency.
Finally, the report broadcasts a clear warning to unprepared hedge fund managers. “Though many hedge funds are making the appropriate adjustments, the great majority of today’s hedge fund managers are unlikely to meet the new stringent requirements. Likely, the next great generation of hedge fund firms are only beginning to be built today.”
But as hedge funds are trying to become a little more like traditional managers, so those traditional managers are going to have to start thinking a little more like hedge funds, according to Casey. As hedge funds mature, we are also seeing the ways in which they have influenced the overall industry. “Hedge funds have contributed to institutional investors’ way of thinking. They are now looking at different tools and techniques. Hedge funds have brought about a certain boldness in getting new tools and techniques into a portfolio. And these will embed into the long-only, or old-school, firms.”

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