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While speed and transparency are driving non-traditional sources of value in global financial markets, demand is spiking for new forms of money management – chief among them hedge fund and hedge fund “lite” products increasingly sought by institutional investors looking for better returns. But as the hedge fund story unfolds, investors are bound to discover that not all the reviews are good. Some will be bad, and others downright ugly.
A significant piece of the plot revolves around the growing demand for alpha, or above-market investment returns, in a global economic environment that over the last five years just hasn’t delivered the financial horsepower institutional investors in particular have been searching for. Demand for potentially higher-paying hedge fund opportunities has been accelerated by a combination of factors ranging from underperformance of traditional asset classes to the pressing need to fill the coffers of under-funded pension plans.
A recent study by the IBM Institute for Business Value, for instance, shows that only 29 percent of traditional long-only active fund managers in the United States actually outperformed the market over a 10-year historic period1, highlighting the challenge many institutional investors face in meeting future investment goals and liabilities weighing heavily on their balance sheets.
Beyond the quest for alpha, the rationale behind the hype is simple – hedge funds present a unique opportunity to diversify highly correlated portfolios and to replace underperforming traditional long-only mandates with uncorrelated programs. For example, portable alpha strategies combine the use of hedge funds to lower volatility with the use of derivatives to replicate beta returns and port risk across the industry.
The good
One of the decidedly good things about the rise of hedge funds is the disruptive role they play in the financial markets ecosystem. In today’s marketplace, fees are paid to traditional asset managers to invest client funds in accordance with a declared style – growth or income funds, for instance. Often, however, such funds are constrained in terms of risk-versus-reward exposure, and impose limitations on the use of alternative strategies such as shorting and use of derivatives.
In part because of those constraints, traditional funds have demonstrated a historical underperformance, and that is causing investors to look elsewhere for alpha in less-constrained investment vehicles. Increasingly, hedge funds are creating investment pools and liquidity by offering a new unconstrained money management model. In fact, hedge funds are becoming a preferred weapon in the hunt for alpha – not necessarily because they can’t miss, but because there’s nothing else out there that offers the potential.
In the words of one large endowment plan sponsor: “We are investing in hedge funds because there simply is no better alternative. We recognize that the returns may very well prove to be elusive.”
Despite that very real drawback, as pension funds across the globe look for new investment approaches to bridge the gap between funding requirements and investment returns, institutional investors in particular are hitching themselves to hedge funds. Demand for hedge funds by institutional investors is predicted to grow nine-fold between 2005 and 20152, with corporate and public pension plans expected to lead the way. That equates to a 10-year compound annual growth rate of 24 percent, which is projected to take the total worldwide market for hedge funds from $281 billion to a projected $2.5 trillion.3
As the divisional head of one Wall Street firm aptly stated, “the world is moving toward an absolute return model, one in which a new breed of alternative money manager operates under the presumption that transacting in more opaque, less-liquid markets offers unique pricing opportunities.” Hedging is intrinsic to that type of business model, and may help managers fine-tune the risk they bear via tailored use of derivatives, shorting, leverage and investments in less-liquid assets.
Seeing the writing on the wall, traditional money managers are jumping on the bandwagon and beginning to offer multiple hedge fund “lite” options, including instruments such as equity long-short funds (130/30 funds), funds of hedge funds and market-neutral funds, which typically represent first-phase involvement in the hedge fund arena. But as always, success is predicated on a firm having the skills, risk-management capabilities and technology to capitalize on the opportunities.
The bad
Arguably, the bad side of hedge funds is that, while they almost certainly will transform the financial landscape, the process of educating investors about their upsides and downsides is not going to happen overnight. Today, 78 percent of worldwide assets reside in long-only traditional active management funds, while only 17 percent reside in alternative investments such as private equity and hedge funds, and the remainder resides in passive investments.4 It will take time –decades – before the money-management industry is urged into maturity regarding the potential of hedge funds.
Over time, investors eventually will become unwilling to pay alpha fees for less-than-market, or beta, returns. Financial markets firms can expect investment products to continue to separate to the extremes, with alternative investment classes such as hedge funds and private equity investments on one end of the spectrum and more passive styles involving index and exchange-traded funds on the other
The less-than-attractive
In the meantime, investor irrationality involving hedge funds is building. Ironically, at a time when overall returns to the asset class are falling, hedge fund fees are becoming increasingly hard to justify, and a concentration of the industry likely will prompt a shake-out. Over the past two years, the average hedge fund has failed to beat the S&P 500. A bubble is forming, and as physicists are quick to point out, bubbles tend to burst. That’s when things could turn ugly.
Today’s investor is paying a high price for inventive but costly financial engineering. The standard 2 percent management fee coupled with a 20 percent performance fee is plenty of incentive to attract new investment firms into the market, but it’s also setting the stage for institutional investor backlash over the long term. For now, institutions feel justified in paying excess fees because, as mentioned earlier, there is no other alternative.
While the hedge fund industry is here to stay, a shake-out is inevitable. With 9,000 funds and more than $1.7 trillion in assets as of March 2007, the industry has gained critical mass. Between 1981 and June 2006, assets grew at an average annual rate of 47 percent and the average size of a fund grew by more than 2,000 percent, from $7 million to $150 million.5 At the same time, though, 3,100 funds with $257 billion in total assets also exited the industry.6 In addition, funds with more than $1 billion in total assets accounted for a whopping 35 percent of total hedge fund assets in 2006 vs. 10 percent a decade ago. 7 Together, those trends suggest increasing levels of concentration among hedge funds and point to hyper-competition in the industry.
So what does it all mean? While the precise impact of hedge funds on global financial markets remains fuzzy at the edges, there most likely will be a core set of outcomes.
To begin with, governmental pressure might help to slow or suppress the process, but right now regulators seem to have put hedge fund decisions on hold. While they have succeeded in tightening the leash on traditional investment firms whose products are aimed at individual investors, regulatory agencies generally are veering away from the hedge fund market, perceiving it as a venue dominated by a narrow range of institutional and high-net-worth individual investors.
Though some experts suggest the impact of hedge funds on global financial stability might turn out to be considerable, past attempts to address the issue have been less than successful, and for now regulators apparently have decided not to intervene until the potential systemic risk is better understood. In fact, there seems to be a trend toward more flexibility when it comes to regulatory structures on unconstrained financial instruments. Changes being considered in the U.S. Employee Retirement Income Security Act and the European Union’s Undertakings for Collective Investments in Transferable Securities legislation, for instance, are aimed at providing greater flexibility for mutual funds to invest in alternative financial instruments.8
Smart money vs. smart money
In addition, financial markets firms should expect the battleground to converge. As demand for hedge funds grows and traditional asset managers increasingly adopt newer approaches to investment, ‘smart’ money – investment capital deliberately directed towards generating higher-than-average returns – will begin to fight with other smart money as the competition for alpha heats up. That confrontation already is beginning to have ripple effects in today’s markets. Insurers facing the challenge of generating superior returns on invested assets, for example, are evaluating the worth of outsourcing the function to asset managers. At the same time, asset managers are edging into less-traditional vehicles and beginning to compete head-on with hedge fund managers.
You don’t have to be a best-selling author to figure out how at least one part of the hedge fund story will end: alpha will become increasingly difficult to generate. Heightened competition and saturation will undoubtedly shrink the overall pie, and only those firms focused on innovation, superior risk management, market insight, talent and technology will be positioned to generate superior returns.
Actions to consider
Clearly, there is no clever twist that will resolve the growing pressures affecting today’s cast of hedge fund characters. An executive at one leading investment banking firm summed up the challenge for many of today's hedge funds this way: "Given increases in transparency, today's alpha is very quickly becoming tomorrow’s beta, making it difficult for hedge funds to consistently add value."
Avoiding the commoditization trap could be the single biggest challenge. Ultimately, hedge funds will have to differentiate their services by delivering on the alpha promise. Funds are responding to challenging market conditions by expanding into multiple asset classes, new investment styles and even into private equity and investment banking activities.
Hedge funds already are competing with private equity firms to source new and innovative investments that will generate excess returns and differentiate them from the ‘long/short equity’ pack. For example, given supply constraints and the expected demand for new and slightly used aircraft, hedge funds have begun trading Boeings and Airbuses and are now launching aircraft investment funds.9
For equity long/short funds in particular, they will have to tap into increasingly sophisticated algorithms and potentially build the type of low-latency, smart-order routing infrastructure that will allow them to compete for speed and ensure the lowest implementation shortfall.
On the flip side of the equation, prime brokers will feel the pinch on margins as the increasingly saturated hedge fund industry demands further unbundling of services and greater integration and transparency across providers. Experts recognize the fact that prime brokers are continually struggling to expand functionality to their clients at little to no marginal cost.
The first question could become one of technology impact on industry roles. To what degree will emergence of automated solutions, and their providers, drive the unbundling of basic services such as trade and settlement data versus enable firms to act as true consolidators of improved services to clients? Ultimately, firms who can deliver a greater degree of flexibility combined with superior execution will claim the advantage at a time when the highest value activities will revolve around financing, structured products and complex trades. Technology will play a lead role. Recently, for example, providers have begun to examine the use of functional programming languages such as Haskel to build an environment capable of capturing the most exotic trades, which are generating the most revenue for both buy- and sell-side desks.
The second top-of-mind question facing prime brokers revolves around the degree to which providers are willing to sleep with their enemies to satiate client demands for improved integration and reconciliation across competing brokers. Far and away, the answer will have more to do with cultural change than it does with pure technology.
Traditional asset managers may be the most hard-pressed to face mounting industry pressures. Traditional asset managers must revisit the way in which they manage and price money management services. This will have to do with fundamental questions about the business model, risk appetite and the associated learning curve. Will firms opt to remain traditional managers, shift toward passive offerings or transition to a more unconstrained model?
On a more tactical note, while many firms have begun to address the challenge of process duplication in their front offices, few have tackled the more daunting task of integrating their front- and middle-office operations. As more sophisticated trading strategies take hold, they’ll have to do just that. The risks inherent in fragmented operations demand a clear vision of how new processing requirements will integrate into an organization’s existing systems and end-to-end processes. Pricing of illiquid securities, cross-asset risk management, derivatives processing, and consolidated financial, risk and compliance reporting will all require more efficient, integrated platforms that can optimize the acquisition, processing and delivery of data across today’s organization and geographic boundaries.10
Institutional demand for hedge funds is expected to continue to grow at a rapid clip, surpassing the retail market. While this is likely to have a dramatic effect on the competitive landscape, there’s a question about whether the capabilities and products required to support such a transition will be in place.
Clearly, the ability to differentiate product offerings away from the pack, the strategic utilization of advanced technology enabling speed and transparency, and a strong focus on business process efficiency will be necessary to reap the rewards.
References:
1 Dence, Suzanne, Latimore, Daniel, White, John. “The trader is dead, long live the trader!” IBM Institute for Business Value. 2006.
2 IBM Institute for Business Value analysis. 2006.
3 Ibid.
4 Dence, Suzanne, Latimore, Daniel, White, John. “The trader is dead, long live the trader!” IBM Institute for Business Value. 2006.
5 Barth, James R., Li, Tong, Phumiwasana , Triphon, Yago, Glenn. “Hedge Funds: Risks and Returns in Global Capital Markets”. 2006 Capital Access Index; Best Markets for Business Finance. Milken Institute. December, 2006.
6 Ibid.
7 Ibid.
8 “Hedge-fund envy.” The Economist. March 17, 2007.
9 Gimbel, Barney. “Stocks, bonds…or jets.” Fortune Magazine. May 31, 2007.
10 “Fund Managers: The challenge of hedge funds.” IBM. 2006.
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Suzanne Dence is responsible for research and thought leadership for the financial markets industry within the IBM Institute for Business Value. Suzanne can be reached at sdence@us.ibm.com.
Wendy Feller leads the Financial Services Sector practice across the financial markets, banking and insurance industries for the IBM Institute for Business Value. Wendy can be reached at wefeller@us.ibm.com.
Zohar Hod co-leads IBM’s Trading Solutions Group. Zohar can be reached at zoharhod@us.ibm.com.
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