Are institutions ready for the new boys?

Fri Jun 3, 2011

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The search for long-term alpha has never been more confusing or more necessary


By Susan Barreto

The largest hedge funds seem to have weathered the 2008 financial crisis and are in growth mode. Institutional investors though are only now peeking out of their cellars to assess what their real long-term exposure should be to hedge funds.

Before the 2008 storm hit, investors were beginning to implement and discuss emerging manager programmes. Once the crisis hit, most investors, such as US public pensions, simply did not have the assets to put to work in established hedge funds let alone emerging firms.

The fact is that the hedge fund portfolios of pension funds missed out on excess returns that - contrary to widely held beliefs - are attainable with less risk and in sustainable ways. Now groups such as Investcorp, Goldman Sachs, Citigroup and Blackstone are banking on pensions catching on to the out-sized performance of 'emerging' managers.

And, in addition to some allocations to emerging manager funds of funds by large state pensions in California and New York, newer investors are considering platforms. For example, in the last month, the $6.5 billion Arizona Public Safety Personnel Retirement System considered a $60 million allocation to a seeding platform offered by Goldman (page 6). And APG is set to back a second seeding via IMQubator (page 37).

Incubation, seeding and acceleration seems like an obvious shelter in the storm. Investcorp recently estimated that while the 2008 drawdown for large hedge funds was 13.7%, while emerging managers were only down 8%. Investcorp also estimates that large funds have generated 40 basis points of annualised alpha over the last seven years and this is substantially less than 130 basis points it estimates for emerging hedge funds (page 22).

And Neuberger Berman's 2011 Strategy Outlook studied 288 emerging hedge fund managers and found that performance since 2002 showed emerging managers annualised 9.49%, versus the 7.61% achieved by larger, more established managers during the same time. So why is it that a recent conference the emerging managers vastly outnumbered investors? It could just be that pension systems are still leery of their own funding and are wondering whether there is an oncoming storm as quantitative easing winds down in the US.

Funds of hedge funds for now have kept the emerging manager marketplace on life support as it waits for an influx of institutional capital. Pension funds coming back to hedge funds and reorienting their programmes have instead invested in the same large brand name hedge funds without any continued focus in finding the next Paulson, contrary to the growing amount of research that says they should be looking for younger, smaller hedge funds for the survival of the industry.

So why are investors still relying on the same 'safe' collection of firms with in some cases more than $10 billion in assets? The options for institutional investors looking for access to 'emerging' hedge funds are plentiful, ranging from platforms, to customised programmes and funds of hedge funds - each with expertise in finding managers through a disciplined process.

Besides the ensuring of assets for these new allocations, institutions need to be convinced that this is more than a fad. Investors looking to take shelter long term in platforms for instance need to consider whether the platform provider is not really a third party marketer in disguise. For those looking at funds of funds, the question is how emerging managers fit into the multi-manager's business. Is this all the fund of funds invests in like Protégé or part of the assets like Fundama, or are these portfolios just a trendy sideline business model?

More importantly, boards of trustees need to take a macro economic view. For global investors that have been pondering the effectiveness of bank regulation and government policy in preventing future financial instability, the search for long-term alpha has never been more confusing or more necessary.