Is this a tipping point for the industry – or a turning point?

Thu Sep 22, 2011

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Investor institutionalisation has created a much more stable and stickier capital base

By Nick Evans

Once again hedge funds seem to be at a turning point, not to say a possible tipping point.It has been a grisly summer and start to autumn, with acute alarm about Europe’s financial (and political) crisis and mounting worries about global economic growth prospects triggering wildly volatile and often chaotic market conditions over the past few weeks.

Performance has not been good for the most part – and very bad in many individual cases. But it has also been very good in a few select cases – with a smattering of funds, notably in the macro and CTA space, doing exactly what hedge funds are supposed to do in terms of generating de-correlated returns when investors need them most.

And, for the industry overall, a 2% loss in August when markets were down around 15% at one point (although they ended the month down around 7%) does represent respectable, if by no means perfect or universal, protection of investor capital in an abysmal environment.

So talk in some quarters about hedge funds facing a re-run of the autumn 2008 debacle seems to be wide of the mark, for a few key reasons.

First and foremost, the increasing institutionalisation of the investor base has created a much more stable and stickier capital base for the industry – and the influence of private investors is very much less than it was.

Unlike the private investors, who ran for the hills in 2008 and will always be vulnerable to further outbreaks of panic, institutional investors have to be invested in something and hedge funds look to be a much better bet than most other things.

For institutions like pension funds, hedge funds are not the problem part of their portfolios – and, by and large, managers are doing the job that these investors need them to do in terms of providing downside risk protection and portfolio diversification.

Second, there is far less leverage in the industry – and, as a result, less risk of the forced deleveraging and fire-selling that compounded hedge funds’ problems in 2008, in the absence of another full-blown banking crisis at least.

And third, most of the liquidity mismatches that caused such grief three years ago have been eradicated or substantially mitigated – although a few remain, it has to be said.

All the anecdotal evidence points to very limited redemptions at an industry-wide level. Quite the opposite in fact – with several reports pointing to continued inflows rather than outflows from institutions and other investors, who are deeply worried about other parts of their portfolios and want to have more of their money invested in hedge funds rather than less.

But this is no time for complacency, as all managers are aware. There are some areas – notably long/short equity – where there seem to be deep-rooted and fundamental problems.

Investors are starting to question the increasingly high correlation of so many long/short equity funds with the markets themselves, the fairness of the fee structure for what appears to be increasingly rare and random alpha generation and, to a growing degree, the whole long/short model at a time when stock-picking – on both sides of the book – simply seems not to be working.

Furthermore, while redemptions generally may be low, those funds that have had particular disasters over the last few weeks – of which there are more than a few – must now be very close to the brink, with big drawdowns in August threatening to tip several over the edge.

In economic, market and investment terms this is certainly a very dangerous time. Things could get a whole lot worse – just as easily, and quickly, as they could get a whole lot better. That is largely in the hands of the policy-makers.

But this does not feel like a tipping point – or anything akin to 2008. On the contrary it could very well be a turning point towards the emergence of a more stable, sustainable and grown-up business – where the institutions that are becoming the drivers of the industry prove their value as sticky investors with long-term horizons and the willingness and ability to stay the course.

In return, these increasingly confident and powerful investors may start to demand better recognition from their managers of what they bring to the party – in terms of reduced or modified fees, more investor-friendly structures and other compensations.

In the current climate, and in the interests of a more mature and robust industry where investors and managers are properly and strongly aligned as partners, their managers – and those who wish to manage their money in the future – would be wise to listen to what they are saying.

ISSN: 2151-1845 / CDC10004H

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