The changing nature of its investor base to pension funds and other large investors is transforming the hedge fund industry. Institutionalisation creates new barriers of entry and puts a strain on the vast majority of managers that are small. Large hedge funds meanwhile struggle to maintain their entrepreneurial nature that is often the source of alpha. The Cayman Alternative Investment Summit discussed how the industry can maintain its X factor.
Institutionalisation, which has brought more capital and professionalism, is potentially a threat to the innovation and entrepreneurial nature of hedge funds. In the 1980s and 90s high net worth individuals invested into the absolute return model of hedge funds with a willingness to tolerate higher risk and higher volatility in return for potentially higher returns.
Today pension funds and endowments are less willing to accept that volatility, said Todd Groome of Dalkeith Management Group. “They talk about higher quality returns and when they define that, it is about lower volatility and greater loss protection.”
These investors are looking for outperformance over an economic cycle, where during the downturn of the cycle, they will lose less or ideally no money. This requires institutional infrastructure on behalf of managers and results in a barrier of entry, Groome said.
The X factor in hedge funds is about the people, who are capable of both delivering performance and building a good business model. But the risk-return profile is changing and may mute some of the innovation aspect and entrepreneurial nature, he said. “Institutional investors say they want X factor but the manager often still has to fit neatly into a bucket.”
Silvercreek Management’s Louise Morwick added that specialised strategies, the ones that do not fit into a box or a bucket, are the ones that often have better performance and also offer the benefits of lower correlation. She noted when it comes to fund performance, bigger is not better. Statistics show that smaller, newer managers outperform larger managers, but the vast majority of funds is invested with large managers, she said. “The general perception is that this is safer but this is actually not true from an investment perspective.”
In terms of tenure, younger funds definitely have the edge. It seems that there is a tendency for managers to attempt to reduce risk for older and larger funds which hurts returns, she added.
To uncover the X factor that really leads to success, size, tenure and specialisation are therefore important factors that quite frequently point to emerging managers.
Institutionalisation as a double edged sword means that the industry needs to find ways to preserve its craft nature, summarised Amin Rajan, CEO of Create Research, the debate.
What is absolute return?
In addition to institutionalisation, performance during the 2008 crisis is another reason the industry may have lost its X factor in the eyes of some investors. The often touted absolute return appeared elusive in 2008 and became one of the industry’s core perception problems.
However, Peter Clarke, CEO of MAN Group, said he does not define absolute return as positive return in perpetuity, a statement that sparked much discussion about what absolute return really means.
The realisation that absolute return does not mean positive, uncorrelated return in any market environment stands in contrast to how hedge funds were sold in the past, noted Simon Osborne and investors interpreted it in this way.
Larry Powell of Utah Retirement Systems, in turn, said investors should not have bought into the marketing jargon because it did not make sense. “Of course hedge funds are going to lose money in a crisis. One should not have believed it, but it was the message that was being sold,” he conceded and Liam Kennedy, editor at Investment and Pensions Europe, agreed that “perhaps the promise was oversold”.
Given that there are no absolute returns in all markets, the concept is a little bit deceptive, noted KPMG’s Gordon Rajamohan, but he added that alternatives have done better over the last five years than all other asset classes. “This has created a phenomenon where people are forced to increase their asset allocations to alternatives.”
Another perception problem of funds was debated with regard to the sluggish performance of global macro funds. In response to the question whether it should not be an ideal time for global macro, Powell said today’s macro managers are different than the ones in the 1990s; they utilise options heavily and employ capped risk type strategies. With so many things happening in the global markets at the same time, macro managers are struggling even though the equity markets have recovered, he said. Macro managers are essentially trend followers and when there are no consistent trends, it is difficult for them to make money, he argued.
Restoring trust through engagement and alignment
Perhaps as a consequence of these communication or perception issues the onus is on managers to build trust. According to Jay Feuerstein, CEO at 2100 Xenon, especially for small firms it is key to educate, “not only on what you do but also on what the worst situation could be and how you can handle that”.
Ultimately once a client does invest with a fund there will be speed bumps and the manager will have to remain as accessible and communicative as possible. “It is educating about how you manage your risk, how do look at the distribution of expected returns, how do you expect to make those returns and finally what the environment will be when things become difficult and how to handle that. It is really about communication and education,” he said.
Panellists identified engagement as another important factor in the relationship between managers and investors. “Investment products have a shelf life and much depends on how clients use those products,” said Rajan, calling for a “solutions alpha” rather than a “product alpha”.
PIMCO’s David Flattum agreed, saying hedge funds have to deliver investment solutions on the basis of a detailed understanding of the client’s needs. “We want to understand the client as best as we can and then based on that bring them something that they really need”. This includes giving investment information to clients, when it is right for them and considering client facing professionals as advocates for their clients.
Mark Rosenberg agreed that engagement on a personal level is very important because it can provide investment managers with a second chance. “If they know me, if they have built a relationship with me, and I say we are going to do better next year, they give me that second chance and that’s a big difference.” Moreover to follow the culture and customs of investors through a global network is important, he said.
In addition panellists noted conflicts between the interests of managers and investors must be avoided through the right incentive structures.
The Financial Times editor Pauline Skypala claimed there is a perception that “managers make money whatever the weather” and a “us and them” mentality. But Tom Hirschfeld, COO at Halcyon, responded it is a tendency of the financial press to talk up the zero sum relationship, which in his opinion is only a small part of the dynamic. “We view ourselves as partners of large institutional investors,” he said.
Parag Saxena, CEO of New Silk Route Partners, noted that fees always are and should only be a problem in the sense that investors need to do their homework and understand what they are investing in.
Large institutional investors like URS or USS however said since 2008 they have paid no manager the typical management and performance fees of 2 and 20 per cent. Where are these mystical managers who earn 2 and 20? asked Powell.
But Kennedy said organisations like URS and USS have considerable negotiating power. Despite the pervasive cost pressure on investors he had not seen any anecdotal or direct evidence from research and surveys that investors are not prepared to pay a decent well-structured fee. “There is a strong acknowledgement that people want to access the skill in the hedge fund world.”
With regard to the question whether economies of scale should not kick in and management fees should decrease for larger funds, PAAMCO’s Maarten Nederlof, said when investing with young managers, it is not unheard of that the fees are higher until they reach a critical mass.
“You might look at a large fund and say you don’t need that much of a management fee but there are a lot of hidden costs and expenses in fees,” for example from managed accounts or investments in other hedge funds, he said. “There is a lot to know other than just the headline number.”
KPMG partner and conference chair Anthony Cowell summarised the purpose of the Cayman AI Summit, saying despite the market turmoil there was never a better time for the hedge fund industry to innovate and reinvent itself. He believes it is imperative to understand the challenges the industry faces as a secular change. To understand its future one would have to invent it rather than predict it, he said.