Future Directions for International Hedge Funds

Michael Streatfield, CFA, strategist at Investec Asset Management, outlines major trends in the hedge-fund industry and discusses why the rise of the multi-strategy fund could be particularly relevant for trustees.

The explosion in the international hedge-fund space has seen a mushrooming in number to over 8 000 hedge funds, while over the past five years their assets have doubled to $1,2 trillion. From such heady growth, four trends are emerging to shape the industry:

• Pressures of professionalisation;
• The drag of commoditisation;
• Rising indigestion, and
• Inevitable consolidation.

At present, retirement-fund trustees are making modest allocations to hedge funds. Going forward, fresh investment ways – multi-strategy hedge funds and ‘new balanced’ funds – are gaining ground. In 2002, when global equity and fixed income markets were weak simultaneously, international hedge funds gathered momentum (see graph).

This weakness reinforced the need for portfolio diversification and hedge funds were seen as a must-have component. Retirement funds have entered into this area, albeit cautiously, with holdings up to three percent on average.

Allow me to elaborate on the trends:

• Professionalisation

  Although allocations by institutional investors have been modest, their entry to this market (traditionally dominated by high net worth individuals) has encouraged professionalism. Institutions do more due diligence and have demanded more transparency, more information and more control over adherence to the defined investment style.

  This is a double-edged sword. It has seen more money flow into the space, but some hedge fund managers believe it is accompanied by handcuffs. As Donald Putnam, now of Grail Partners, remarked in Hedge Fund Journal: “We consider pension funds a powerful disruptive influence on the hedge fund business.”

• Commoditisation

  In particularly short supply, invariably, are people with investment talent. The explosion in the number and size of funds means that finding them is now like searching for a needle in a field of haystacks. Outsourcing and prime-broking services means the barriers to entry, for setting up hedge funds, have fallen. Traditional managers get up and running in a way well described by The Economist: “Unable to get into established winners, investors are pouring money into managers with no track record but good pedigrees.”

  Growth cannot continue exponentially. Not all hedge fund managers will perform satisfactorily or attract sufficient assets for economies of scale. Retirement funds should be discerning to select talent. Amongst the morass of wannabees, the cost of great managers is rising.

• Indigestion

  Because they pay high fees for hedge fund managers, investors have high expectations. The glut of untested funds has begun to show. Over the past few years, five percent of hedge funds do not made an impact and fail each year. In the same way that star-like profiles are given to hedge fund industry performers, equal prominence will be given those who inevitably will fail. Investors in hedge funds should steel themselves, but take comfort that some bad apples do not necessarily reflect the health of an orchard.

• Consolidation

  Inevitably, the next stage of this rapid growth is consolidation. The best managers, who are doing spectacularly well, will gain a lion’s share of assets at higher fees. Mediocre managers will need to consolidate to get to scale. This will not be an easy process. KPMG Create’s hedge fund research team reckons that, given the independence of hedge fund managers, this consolidation will be more ‘Darwinian’ in nature. The result will be a stronger hedge fund industry emerging to service investors.

What else can retirement fund trustees expect? Already, we’re seeing a number of product responses:

• Traditional managers are adopting hedge fund thinking into their processes. There is a large drive for ‘new balanced’, bringing hedge funds and other alternatives into multi-asset funds so that investors gain exposure and maximise diversification;
• With total costs under a spotlight, large hedge fund managers are offering multi-strategy funds. These are a cost-effective cluster of hedge funds overseen by hedge fund managers close to their markets. Circumventing hedge fund of fund offerings, their entry point is proving popular. Over the past three years they have seen a remarkable 254 percent annualised growth, and are certainly worth watching.

In a low-inflation, lower-interest rate environment, retirement fund trustees should be realistic about the performance targets that hedge funds can achieve. On average, when compared with the 1990s, returns have fallen. But as we see more volatility in global markets, hedge funds will prove to be an important component in investment strategy for retirement funds.