Infovest21 Investor Focus

ANALYSIS: Institutions continue to transform the hedge fund industry
“Hedge funds are no longer mysterious. They aren’t a rare product. Institutions are becoming more comfortable with hedge funds and they are becoming smarter on which managers they’ll pay for,” said Jon Lukomnik, managing director of Sinclair Capital, at Infovest21’s morning seminar last Thursday.

Jordan Foster, who is responsible for marketing and client relationship management for North America and South America at Marshall Wace Asset Management, says that hedge funds have generally become more transparent, often provide holdings (in some form, usually with a lag) to investors, and are now more clear regarding expected return/risk characteristics and value added in terms of alpha and beta.

What institutions want
Institutions are looking for a strategic partnership where they can get your [consultant/fund of funds’] thoughts on financial markets as well as due diligence information, Lukomnik adds.
Both hedge fund managers and funds of funds say institutions are looking for more customization.

“Institutions, recognizing the robust, unique intellectual capital at many hedge funds, are increasingly asking larger hedge fund managers to ‘co-construct’ long-only solutions for them,” says Foster. “These solutions often provide a complement to traditional long-only managers, with the expected effect of improving information ratios of their total portfolio.”

Lukomnik emphasized that manager’s terms and conditions need to line up with the strategy. For example, with a long/short equity fund, there is no need for a three-year lock-up. By contrast, if you’re running an activist strategy, people want a lock-up.
Institutions are also now scrutinizing the manager’s back office as a condition to allocate assets.

Large managers vs small managers…issue of crowded trades
Recent HFR statistics indicate that two-thirds of Q2 2011 asset flow went to hedge fund managers with assets over $5 billion. Speakers at the seminar generally thought that trend would continue as larger managers provide more comfort and less career risk to the institutional investment staff. Lukomnik also pointed out that more extensive operational due diligence must be done on smaller managers than larger managers.

However, institutional investors are trying to find creative ways to gain access to emerging managers as studies show that young, smaller managers outperform.

“This is an area that our institutional clients continue to be very interested in. Definitions of emerging manager vary – size could range from $500 million to $2 billion,” says Rock Creek Group’s Sherri Rossoff.

Furthermore, as the very large hedge funds reach capacity, investors need to look at the next level of hedge fund manager, said Mihir Meswani, chief portfolio strategist/risk management director at Sandalwood Securities.

One of the implications from relying heavily on larger managers is crowded trades as many managers are investing in the same holdings, says Meswani.
One problem is exiting those trades. “With liquidity only a sometimes thing for the past few years, it’s the exit from crowded trades that has mattered,” says Lukomnik. “If there is liquidity at quarter-end in a trade that has worked, look out. Everyone heads for that exit at the same time, because they’re selling what they can.”
Rossoff points out that smaller managers tend to find investment opportunities that are different from larger managers, which among other characteristics, helps differentiate them.

Evolving role of fund of funds as solution provider
The general consensus was there will always be a role for funds of funds particularly for smaller institutions and family offices that can’t make $50 million allocations.
“The role [of Rock Creek] is more than simply picking managers from a database,” says Rossoff. Funds of funds proactively manage portfolios in terms of top-down positioning to avoid systemic risks and quickly take advantage of new investment opportunities with an experienced team that understands underlying positions as well as the markets generally.

“Funds of funds will increasingly be a solutions provider. Some family offices want to use us as their research arm. Some institutions may ask us to provide a tail risk solution,” adds Meswani.

Differentiated fees, not lower fees
Small institutions are increasingly using hedge fund style mutual funds. Lukomnik points to their strong growth. In 2009, there were 104 hedge fund style mutual funds. Today, there are about 198 – almost double. That represents $163 billion in assets – they are not charging 2/20 fee.
Rossoff points out that while a goal may be to negotiate the best possible fees, she would be cautious about managers dropping their fees too fast and sacrificing their ability to maintain a solid business operation.

Some fee structures that look too good to be true are. For example, a manager who says it has no management fee, just a success fee and “expenses,” could actually be exceptionally expensive if those expenses include salaries and bonuses, says Lukomnik.
There will be pressure for differentiated fees, not necessarily lower fees, says Lukomnik. “The few managers who are good, who are willing to close their funds, will be able to get high fees. Others will not.”

Jordan says, “We (Marshall Wace) have not seen significant fee pressure. I believe that is true for other managers who do not have unlimited capacity. That said, many seem to believe the institutional fee structure will settle somewhere near 1.5%/20 – closer to pre-2000 levels. Some investors have asked for an option to soft-lock assets for two or three years in exchange for a modest fee reduction. I believe this alignment of interests makes sense.”

Foster expects we will see more creative fee proposals, ones that reflect a strategic partnership (more explicit sharing of alpha). “Hedge funds seem to be migrating from a ‘DDQ culture’ (one where hedge funds are more resistant to fluid information exchange with prospective investors) to the ‘RFP culture’ prevalent in the long-only world (where managers are more responsive to detailed questions regarding their investment and operations processes).”