July 7, 2012 3:34 am

Institutions drive changes in hedge fund sector

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Man walking out of Lehman brothers building©Reuters

Hedge funds have seen a radical shift since the collapse of Lehman Brothers in 2008

In the past five years, the hedge fund industry has gone through a radical shift – one which the financial crisis has hastened, rather than precipitated (PDF of this story with graphics).

Once known as the preserve of the high-rolling, risk-friendly super rich, hedge funds are now well on their way to being a mainstay of mainstream asset management.

Indeed, the industry’s prime source of money, since 2008, has not been individuals but institutions, whose criteria for investing are as exacting as the cheques written are large.

Pension funds, endowments and sovereign wealth funds are what rescued many hedge fund managers from the turmoil of 2008, when assets flew out the door and opportunities to make easy money disappeared amid volatile trading conditions.

Such investors, however, are changing the face of the hedge fund industry.

For a start, as a superficial reading of data from Towers Watson’s annual alternatives survey, it appears that with hedge funds size matters, post-2008. The top 50 individual hedge funds manage $187.6bn of pension fund money.

Of that, $120.5bn – some 64 per cent – is managed by the top 10 alone.

Moreover, Bridgewater Associates, the world’s largest hedge fund manager, has $47bn of that.

Assets under management alone are obviously not what institutional investors look for.

The survey also reveals that many large managers have relatively small allocations from pension funds relative to overall assets.

For example, in GLG Partners’ case it is $1.2bn out of a total of $15.5bn.

To attract significant pension fund money, hedge funds have to fulfil a whole list of operational requirements that signify their reliability.

Damien Loveday, head of hedge funds at Towers Watson, says: “The organisation must offer a sufficiently robust operational infrastructure that can meet the needs of institutional investors.”

As smaller and midsize managers identify these criteria too, they are attracting institutional allocations, Mr Loveday says.

He adds: “The larger firms have tended to see more inflows historically, given [investors’] perception of better controls and consequently [of their being] more institutionally friendly, but now more and more hedge funds have created strong controls – and operational infrastructure and investors are increasingly less sensitive to size when considering their allocation.”

While the hedge fund industry itself has enjoyed relatively strong interest from institutional investors, however, funds of hedge funds, the traditional gatekeepers, have not had such an easy ride.

Several high profile fund of funds businesses have merged or – as in the case of Arki Busson’s EIM – are reported to be interested in merging to shore up their cost-heavy business bases and bolster dwindling assets.

Funds of funds are having to reinvent themselves in the face of the hedge fund industry’s newly institutionalised client base and its more exacting needs and demands.

It is no surprise, therefore, that the largest funds of funds – those which have stayed close to the top of the rankings for several years – are also those which already have the largest institutional client bases.

About half of Blackstone’s $39bn in fund of hedge fund assets, for example, is institutional money.

For Grosvenor Capital Management, the second largest, more than half the investment is institutional and likewise for Mesirow, the number three.

Craig Stevenson, head of funds of hedge funds at Towers Watson, says: “The FoHF industry is facing secular pressure on its business model, as witnessed by the redemption levels and industry consolidation, which we expect to continue.

“There will be a trend towards fewer, larger providers and more use of bespoke-advisory type mandates rather than plain commingled, but there will remain successful boutique operators, though these will live and die based even more on delivered investment returns.”

And, in the current environment, such returns are proving elusive.

According to Hedge Fund Research, the average fund of funds has lost 5.3 per cent in the past 12 months.

The benefits the industry is supposed to provide – “Diversification, decorrelation, access to alpha [skill premium],” according to Mr Loveday – are fine in theory, but difficult to achieve in practice.

“Most investors have adopted a healthy scepticism as a starting point,” says Mr Loveday.

He adds: “The evolution has been much more discernment on behalf of allocators as to what they expect from individual managers in terms of alpha delivery, exposure management, transparency and fee structures.”

As investors become more discerning, though, hedge fund managers, who have traditionally enjoyed a relatively unfettered existence, will have to give up a great deal of their independence and their secrecy.

The question remains whether in doing so, they will also give up their ability to deliver the outsized returns that investors expect in the first place?

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