Hedge fund assets flow towards biggest players

Having enjoyed strong growth in the years leading up to 2007, in the aftermath of the financial crisis the battered hedge fund industry has gradually changed shape and assets have consolidated around the top funds.

“Brand names matter more today than they have previously. I am not sure this is beneficial for the industry,” observes Charles Stucke, CIO of Guggenheim Investment Advisors in the US.

Increasing regulation will arguably provide more transparency and help develop the industry, but it may also undermine its foundations.

Within the asset management space, the hedge fund industry has been “a bright spot for pure meritocratic entrepreneurialism,” says Mr Stucke, but examples of changes in regulation are against it. For example, Singapore has introduced a $10m (€7.5m) capitalisation requirement to start a new fund business, but “many excellent funds” today could not have put up that sum at the beginning of their partnership.

The retailisation of hedge funds, from the purely private market into the regulated space –with Ucits funds in Europe or 40 Act funds in the US – is also contributing to increase the value of brand and consolidation of assets around the biggest firms.

Hedge funds, traditionally able to raise assets through a handful of high quality institutional marketers, are having to adopt an entirely different business model for large scale distribution, as they need to negotiate with third party distributors or distribution platforms, or build wholesailing  distribution forces.

“As assets flow to Ucits and 40 Act funds, those brands acquire more power, as long as they can maintain acceptable performance,” says Mr Stucke. He expects the opportunity set for the regulated market will broaden, along with the number of funds and assets in this space.

However, scale can be an enemy for many investment strategies. “I believe there will always be a role for small to medium-sized private partnerships, due to capacity constraints of certain strategies and lack of complexity of their business model,”he says.

Concentration of assets has an impact on fees too. While there is very little pressure on fees for managers of large single funds – also as many are closed or closing to new investments – smaller or emerging managers are bearing the brunt, observes Mr Andreas Leukert, senior analyst premium solutions at Bank Julius Baer.

But consolidation also brings new opportunities, according to other investment professionals.

“The hedge fund industry is kind of retrenching back closer to where it was before the boom when there were fewer, high quality managers delivering superior return,” notes Rupert Robinson, head of wealth management at Signia Wealth.

In the second half of the 1990s and 2000s, a plethora of new managers flooded the market, jumping on the 2 and 20 bandwagon but “not making a very good feast of it,” says Mr Robinson. “The more the sector shrinks, the more consolidation there is, the better the quality will be, and the better the returns  generated for clients.”

Data from Hedge Fund Research (HFR) does show evidence of moderate industry consolidation over the past few years: the percentage of capital managed by firms managing more than $5bn in assets has risen to 67 per cent from 60.4 per cent in 2007 (see chart below).

“Generally people tend to overstate the degree to which the industry has become concentrated,” says Ken Heinz, HFR’s president. “I submit it was concentrated in 2007 and today has only become marginally, not significantly, more concentrated.”

Also, he believes, it is difficult to state whether the implications of this concentration  are good or bad for investors. “Most people think concentration is bad because larger funds represent a systemic risk, whereas smaller funds generally do not. I do not necessarily agree with this premise.”

Many also believe that, invariably, performance of a small to mid-sized fund necessarily moderates as the fund becomes large, an impression also unsubstantiated conclusively in fact, adds Mr Heinz.

Anecdotally, larger funds tend to have lower volatility and more infrastructure, hence greater market and operational risk controls. But funds only become and stay large and established because of their ability to attract investors by generating performance through various market cycles. By failing to do so large funds begin to lose investor interest, assets and talented investment management personnel.

“To the extent that funds remain open to new investors and cognisant of their capacity, as measured by the ability to generate performance of the existing base of capital –concentration or marginal changes in industry concentration do not make the hedge fund industry significantly more or less risky, nor do they increase or decrease performance expectations,” adds Mr Heinz.

In effect, both large, established and start-up funds have their own pros and cons. “In the early days, the manager really needs to perform to be successful, whereas managers managing tens of billions don’t have the same incentive, and they may become a little bit more conservative not to damage the franchise,” says Peter Rigg, CEO at HSBC Alternative Investments.

Start-up risk implies assessing “very carefully” these new managers, whereas from large, established groups, with an institutional style of investing or solid infrastructure, investors can take “a lot of comfort”, although sometimes returns are “not as exciting,” he states, explaining the bulk of clients’ allocations remains in big funds.

“If you can find the sweet spot between the manager who has the incentive and the one that has the robust infrastructure, that’s very good as well,” says Mr Rigg.

Whether a fund is too big or not has to be assessed in the portfolio context, says Julius Baer’s Mr Leukert, explaining there is a significant difference between a $10bn macro hedge fund investing in the most liquid futures markets and an Asian small cap manager with, say, $4bn in assets.

He also observes a trend towards the “institutionalisation” of the hedge fund industry. “The investor base of single funds has shifted towards endowments, pension plans and sovereign wealth funds since 2008. This has led managers on average to adjust their risk targets downward, with the effect of somewhat lower returns as well.”