Increased inflows of institutional money into hedge funds are having a major impact on the way the industry operates. Competition among managers and the very specific requirements of pension funds and other institutions has resulted in more pressure on transparency, risk control and fees.
The image of hedge funds as small, independent boutiques run by escapees from investment banks has changed dramatically over the last few years. Today, not only have some of those smaller boutiques become bigger, but the large asset management houses have also expanded their business into the alternative territory, introducing long/short strategies to avoid missing out on institutional mandates.
Institutional demand means size is becoming everything in the industry. Speaking at the Gaim conference in Cannes earlier this summer, Jon Hitchon, head of global prime services at Deutsche Bank said that only a few years ago $1bn (€790m) was considered to be a large fund. Today, he said, the main strategic concern for those managing between $1bn to $2bn is how to grow further. “It is rapidly becoming a game of the haves and the have-nots,” he said.
New environment
Many hedge funds firms - that were originally set up to serve the needs of the high-net-worth sector - are now facing the challenges of adapting themselves to the new and more demanding environment.
In 2003, only one in five European institutional investors invested in hedge funds or fund of hedge funds. In 2005, that number increased to one in three. According to a recent survey conducted by IFI Research for Northern Trust’s Global Fund Services, failure to address institutional investors concerns could slow the growth in the sector.
The study - based on responses from investors, hedge funds and fund of hedge funds collecting, investing or managing over €132bn in hedge fund assets – highlights that increased regulatory supervision will be inevitable, suggesting a two or three-tier regulatory environment should be considered depending on the size of the managers and the type of investors they are targeting.
Increased regulation could also result in the industry splitting into two different segments – those focused on wealth management and those with the capabilities to serve the institutional arena.
Graham Martin, managing director at Optima Fund Management says that even though his firm’s original focus was the wealth management sector, today 70 per cent of its business is institutional. He adds that this shift of direction has not altered considerably the way the business is run.
Solid process
“From our point of view, we have always tried to provide a more institutional service,” he says. This would include providing as much transparency as possible, being close to the client and maintaining a solid process. “These are the things that are very important for institutions.
“Having said that, I agree that in the wider marketplace there are a lot of hedge fund and fund of fund managers that have set up a business that is more high-net-worth oriented and have to make changes [to their business] to be able to market it to institutional investors.” Founded at the end of the 1980s, Optima manages around $6bn in fund of funds portfolios, for clients across the US, Europe and Japan.
Firms like Optima now have to compete with some of the very large asset management houses, but Mr Martin says that institutions generally prefer to work with independent players because of their lack of conflicts of interest. “It is great to be independent but you also have to enable institutions to tick all the boxes in their due diligence process,” he adds. “We meet a lot of those requirements but if investors look at some of the larger institutions they might be quicker at doing the due diligence because they are bigger firms, though they should take the same time on all firms.”
 | William Glass, partner and business development at EIM – a funds of hedge funds manager that currently allocates around $8bn to their party managers - also believes in the competitive advantages of independent firms. |
“There is no doubt that the demand from institutional investors is increasing and there is no doubt that the larger houses are interested in providing this type of service,” he notes. “I think one of the advantages that we have is being traditionally an independent boutique. We do only one thing and one thing only and that’s providing tailor-made funds of hedge funds portfolios.”
Mr Glass explains that the term ‘tailor-made’ is essential to their strategy since the company does not sell off-the-shelf products. He explains that in the early days this position was sometimes a hindrance since pension funds were starting to invest in hedge funds for the first time and were looking for existing products with a track record. “We were excluded from a number of earlier mandates because we didn’t have products, but now the world is shifting and that’s where our competitive advantage still lies.”
This shift has meant that the larger and most sophisticated pension funds have gone beyond the standardised products and are looking for suppliers who can provide solutions specifically designed to fit their asset-liability needs “Every portfolio we build is in line with the specific asset liability requirements of each pension fund and that seems to us something that the larger houses have perhaps more difficulty producing, to that degree of transparency and dialogue,” Mr Glass says.
Time and money
But some recent mandates and more significantly, the fact that large asset management houses are investing time and a lot of money in improving their hedge fund offering, means these players are likely to continue gaining market share. This could result not only in fewer opportunities for independent boutiques but also some pressure on fees, an issue that is still keeping some institutional investors away from hedge fund investments.
Mr Glass says that even though they see some fee pressure this is actually very slight. “For us [fee pressure] has resulted primarily from the fact the average size of the accounts has risen very substantially, so obviously there are size rebates to some extent.” Although pension schemes moving into hedge funds might be shocked at the high fees, he thinks if managers can demonstrate they can deliver the kind of the returns being sought, they will be well compensated for doing so.
“They are also disappointed with the fees they have to pay for much active management and not actually achieving active management results,” he adds.
“A pension fund which is going to entrust a large amount of money to a manager is going to look beyond price and I think you can still make some very good arguments to justify our price.”
At Optima, Mr Martin says that the pressure is not on reducing fees but more on changing their structure. “I think what we are seeing is not a downward pressure on fees, more restructuring, moving towards fee structures that institutions like to see.”
Despite their double layers of fees, fund of funds remain the vehicle of choice for most institutions making a first foray into hedge funds. However, as Northern Trust’s survey points out, the growth of multi-strategy managers is threatening this status quo. Single manager multi-strategy funds aim to give investors diversification without the additional fees, which could definitely put extra pressure on fund of funds managers. However, Mr Glass comments that single manager multi-strategy funds cannot achieve the same level of diversification as funds of funds, “where you have 30 to 40 managers that you can work with. So for the time being we haven’t seen that as a direct threat to us”.
The report also questions whether the growth of multi-strategy operations could in part explain the slowdown of new start-up operations this year, as star managers are being attracted to boutiques offering multi-strategy products.
New ideas and talent
On top of this, investors are showing concerns regarding capacity issues. They see technological advances, systematic trading and new managers chasing similar inefficiencies as reasons for potentially reduced returns. If returns are not as good as expected, surely fees could become unsustainable, but the sector is confident that there is enough talent out there ready to come up with new ideas to exploit anomalies.
The institutionalisation of the business is not only driving traditional asset management houses into hedge funds. Last month the Financial Times reported that DE Shaw – one of the world’s largest hedge funds with some $23bn under management – has plans to expand their traditional asset management capabilities to satisfy demands from investors who want to combine conventional investment strategies with the ability to sell short up to a certain level.
This moves shows that the line separating traditional and alternative investment strategies is getting thinner. Large houses are trying to emulate the flexibility and entrepreneurial culture of boutiques, while boutiques are trying to offer the robustness and transparency that institutions want.
There is no doubt that further regulations will be introduced and further standardisation of the industry is likely to follow. For those with institutional clients as their main target further changes to the way they operate will be inevitable.
