Pension plan sponsors are not so much afraid to invest as afraid to commit -it's a "summer of love" with alternatives. How much more flirt, fondle and flee before pensions grow up? We think the next five years will be a period of rapid maturation. By 2010 we expect the hedge industry to find its long term shape and economics.
Institutions wanting hedge exposure have yielded to "take it or leave it" trader-managers. Will a natural order arise with pensions dominant? Is CalPERS at the top of the food chain or the bottom? We foresee a bifurcated industry wherein – as with most other financial services – family needs and institutional needs are handled by different means at different fees.
In a low return low volatility world, can the lucrative, ludicrous business of fund of hedge funds thrive by serving rich families and a few gamine (or trepid) institutions? Yes, if needs must, but very hard years are ahead for the largest and the smallest. Those grown fat on institutional experimentation must shrink back to their natural market, while those who have not grown into their "big boy pants" may not be viable. There is room in the middle for specialized offerings and proprietary distribution, but few will be independent.
"Survival of the fittest" echoes of high school, but think on it: Darwin's mechanism needs an environment of escalating challenge; it has no grip when everything is rosy. In an environment of peace and plenty, survival is everyone's bounty. Such were the 1990s; halcyon days of robust markets ripe with volatility.
The current decade is proving to be abundantly Darwinian. A capital markets ice age, in which entropy is the rule of the day: in this barren landscape survival should not be taken for granted. The wreckage at the end of the halcyon era, we now realize, may have marked a most important turning point. Perhaps we were overly concerned with the apparent rotation out of growth into value and not enough concerned with the permanent effects of increases in market efficiency and liquidity.
This article considers some consequences for hedge fund managers if recent trends – lower returns, low volatility, escalating pension liabilities – continue for a time. We consider pensionfunds a powerfully disruptive influence on the hedge fund business. Pensions face an unforgiving combination of underfunding and anemic returns. Adding insult to injury, more vigilant accountants are humorlessly measuring pension liabilities using grim assumptions, including upward revisions to employee longevity.
For 30 years pension assets have been managed with beta exposure, bought dear. In doing so, the pension community has been perpetually reacting to the past instead of anticipating the future. This is true in both market and business terms. In market terms, overdiversification has been a plague on every house. In business terms, pensions have been slow to reconsider roles and fees – they have remained essentially unchanged since first established in the aftermath of ERISA in 1974.
We believe the next five years will be an unusual time – a period of "fast forward" evolution through aggressive adaptation. While some of the evolution will be voluntary – pensions are rethinking how to more effectively manage assets (and leverage) – much of it will be bloody. It will be a time of false starts, good ideas badly executed, and banditry – as are all transitional eras.
The transition will be most evident in the untamed territory that is hedge funds and the wagon-trains that traverse the wilderness: funds of hedge funds.
The transition will be most evident in the untamed territory that is hedge funds and the wagon-trains that traverse the wilderness: funds of hedge funds.
With a Hobbsian world-view, these new gladiators soon sought independence. They discovered they could replace bank equity with old family money, and that the banks and brokers would lend against it many-fold. The independent hedge fund was born.
Thus success led to riches, riches bred hubris, hubris bred discord, and discord begat fragmentation. The ultra-wealthy – as when they financed the Colonies, the silk trade, the quest for nutmeg, gold or poppies – held their noses and accepted any demand as long as the trader could bring the coin. "Opacity" was a familiar concept – after all, the methods of prior quests were also unscrutinized (and deniable in polite company).
By the early 1990s, courtiers to the ultra-wealthy created a permanent role for themselves as purveyors of diversification and access. Their creation, the fund of hedge funds, soon became a key organizing force in an unregulated, fragmented and secretive market.
Such a Rube Goldberg thing: double fees, double-dip draw-downs, rear-view decisions, and perverse incentives. Surely if designed (intelligently) for anything, FoHFs must be designed to be superseded: a speed bump in the evolutionary roadway. But where plenty is the norm, any oddity can thrive.
The rise of this oddity had two important consequences: first was the acceleration in the number of hedge funds. By 2000, there were 3,000 hedge funds where 15 years before there were perhaps 300. Second was a focus on allocation among "styles". In the 1990s this worked for clients, despite the fact that the styles were not enduring classifications, because diversification was important in a volatile world.
Still, FoHFs grew in power and scope for 10 years straight – conveying on their young "research" analysts the impression that they add value. Recent quantitative research makes a persuasive case that sources of return in that period were mis-measured and that risk levels were higher than understood at the time. Other work suggests that the cycle of optimal asset reallocation is shortening. We believe these are among many manifestations of increased competition among sophisticated investors.
Consider the Great Death of Convert Arb: perhaps half the practitioners are sidelined or retooled irretrievably. The other half havesimply moved a few feet around the trading floor – working in a distressed, credit or some other team. However unlikely it might seem,if spreads were to widen, themodels, modelers and traders could re-form in a flash. Partly for that reason, spreads may never widen in/among the primary markets.
This is not to comment on prices, only volatility. What we call "trading" is converging with "investing". Investing imposes a judgment of reality (value) on price, and relies on truth to emerge over time. Trading imposes a judgment about a sequence of prices (market) on position, relies on agent relationships to persist, and structural financial relationships to hold fast. In this paradigm, prices are an expression of both longer-wave perceived value and shorter-wave trading effects. If the dynamics discussed above are indeed taking hold the relative importance of trading fades persistently.
The solutions of yesteryear, preserved in silicon and experience, create a state of dynamic tension enforced through real-time monitoring of "old" data pairs. Because technology does not falter or forget in the same way humans do, market cycles may be expected to better and better embody the volatility of non-capital-market phenomena. Not only is there no turning back, but the relative importance of asset allocation, reallocation cycles andimplementation techniques must be reconsidered.
For the few non-traditional managers who can sharpen their competitive edge there are huge spoils. A harsh competition for allocations from pensions is in the offing. Darwin would be proud: survival is the impetus to evolution; necessity the mother of invention. We may hardly recognize the result in 2010.
2010.Some aspects of the future are of the Past Is Prelude variety: segregation of beta and alpha and the marginalization of conventional long-only styles. There is little new in this – it is mainly a matter of giving new labels to old ways, encouraging new tactics and lower, better structured fees. Such herd movements in the vast pension veldt are for another time; here we focus on how pensions will force changes on a young hedge industry.
Our hypothesis is that in five years the alternatives world will not merely be bigger because of pension, it will be different: it will split in two:
The Old Market will grow only 10% CAGR through 2010, to $1.4 trillion. However, it will change quite a bit despite the placid pace of growth.
The bulk of the AUM growth will be toward multi-strategy offerings which intermediate the FoHFs, who will not be able to reduce price fast enough to compete. The effect of this in overall revenues is modest, but five years of no growth means compressing margins for old market FoHFs.
Over the same period, in the pension market, overall growth is much faster. The composition of AUM deployments is more heavily skewed and the evolution of revenue composition is much faster.
In addition to the "old" and "new" markets, growing Global Retail and Other Institutional segments figure in our detailed forecasts but are not represented above.
We expect the two groups that dominate the hedge industry – fund of hedge funds and "trader" hedge firms – to be challenged during the next five years. Both the mission and the methods of both types of competitors are under attack, as further described below.
FoHFs in the "old" business (more on their other choices later) will differentiate based on product management and marketing – product niche, fees and affiliation – rather than return. Note the pattern of hedge exposure in endowments and foundations, where investors committed 14% (vs. 1.5% by pensions) of assets at the end of 2004.
This data suggests that the FoHF is part training wheels, part TV dinner. For large funds it is a format to be abandoned as soon as the learning curve levels off, while for smaller funds it is a well-rounded meal, easier and cheaper (risk-wise) than cooking. We expect continuing allocation away from FoHF by foundations and endowments, all of which will be taken up by pensions "just starting to learn".
The same thing happened when private equity was first the rage for pensions, but by 2004 the situation had stabilized: funds of private equity funds (FoPEFs) flows were 10% of new pension allocations to private equity and represented about the same proportion of all pension private equity. Concentration? The largest quartile of firms control 80% of the FoPEF assets, with a product that has friendlier features than FoHF (no performance fees, for one thing). Our conclusion: once everyone discards the training wheels, some institutional consumers (say 10%?) will still buy TV dinners, but they will pay less and less.
Within the world of hedge portfolio managers we also see bifurcation:
As dramatic as some of our hedge predictions are, we foresee more profound changes in the institutional world. Because the force of pensions will be so great, we will begin with a closer look at the motives of this ungentle giant, new to the playground.
Why is this so important to pension plans? The answer is part science and part history.
The science part is an unwelcome correlation between conventional asset allocation and shoddy results. This unwelcome test of the advice of pension consultants against the real world is bringing disdain upon the consultants and their corporate stewards. Both groups labor under adverse selection and inadequate incentives.
Then there is the cost: pension plans have paid a huge price to buy beta – paid in fees, risk and market impact. We now know beta is cheap and abundant while alpha is rarer than we thought. Clearly, a new way of thinking about and acting on asset allocation is needed if pensions are to serve long-living employees. These are relativelynew realities – it has taken a long time for the capital markets to deliver the efficiency and liquidity that was first imagined by scholars over twenty years ago.
The history includes the interesting demographics of those who guide foundation and endowment funds: successful contrarian and outcome-oriented investors picked from the best based on whispered references. Many move on to shepherd the funds of the super-rich, enjoying a much greater economic interest in success. By contrast, the alpha-seeking truffle-pigs who guide pension funds are doomed by their constraints to find only beta instead.
The history part also includes five years of scandal, publicity and litigation. Some corporatemasters new to the board room are trying to rethink asset allocation top to bottom. Will this result in a wholesale remake of allocations? Not yet. However, we do expect moves to the edges – passive and hedge – within the next five years.
Prodded by pension underfunding, pensions will reward the accelerating capabilities of quantitative hedge firms. To pay for this, they will utilize sophisticated hybrid solutions for execution of beta exposure and take full advantage of the willingness of banks to provide leverage for hedge exposure. Thus, when pension committees act on their new imperative to "get it fixed" they will be aided by much more science than ever before. That being said, they are no more trusting thanever before and they absolutely will not give up their belief in transparency.
Leave aside the relevance of the information, what pensions want is simple: real-time risk management metrics and daily audit trail of positions and flows. In the mid-1970's it took five years for master trust banks to deliver this for US equity portfolios. It was required because new upstart firms – non-bank independents started by young, smart and bloody-minded portfolio managers – were running money without having custody. (The hedge fund managers of yesteryear? The parallels are eerie.)
This time around, we expect full real-time transparency for all portfolio types by the end of 2007. After that, brace an escalation of tensions between pension clients and hedge managers. This is what happened in the late 1970's: first, portfolio management (call it talent) segregated from custody (call it work) and the profits went to the talent. Then a price/technology/service war erupted among providers of work. That war ended 20 years later with a marketplace dominated by five banks, after which all portfolio managers had to provide full transparency. It was a matter of only a few years before AIMR-compliant portfolio measurement and attribution – built on the same infrastructure – was the de facto law of the land.
This time around, for hedge, the dealers – never inclined to conflate work with value – have compressed the cycle into a 10-year shakeout of prime brokers. A prime broker is a custodian on steroids, with lendingand trading powers – in other words, just what banks thought they were in 1980, before 20 years of self-doubt and mergers.
So if pensions cannot give up transparency and the most successful managers will not provide it, they will part ways. After all, there are very few hedge managers who have more than a minority of their capacity earmarked for pension.
Pensions prefer to operate on a pension cycle and use pension metrics. They favor fees based on three year rolling alpha generation while hedge managers prefer high-water-mark gain-sharing. Pensions favor static, standard fee schedules across providers, while hedge firms use fees to auction capacity. These differences, too, will provoke the migration of hedge firms toward or away from the new paradigm.
Another reason some hedge managers will eschew pension mandates will be the scope of the assignment. For pensions, the perfect solution has three parts: unconstrained search for alpha, ultra-cheap exposure to beta, and drawdown avoidance. The alpha/beta divorce does not mean that alpha gets to go bingeing while beta stays home. Pensions will gravitate to managers who will "throw in" beta exposure for free. Drawdown moderation techniques, fully in the public domain since the Grossman/Zhou article in 1993, are most efficiently applied to the overall portfolio. This, too, is within the capabilities of the "new age alternative quant manager".
We predict the ascendancy of hedge fund firms operating on a "new" business model; new yet oddly familiar fee structures, more than a whiff of quantitative techniques, buttoned-down sales and service, and the entrepreneurial drive needed to compete.
The "old" game continues to attract pension money despite weak hedge returns. Old paradigm managers have feasted on the flows: hedge assetsgrew at a 22% CAGR over the three years through 2004, with a majority coming from institutions. Perhaps half of those mandates were shoehorned into a "retail" format, while the savvier half was awarded to institutional-grade firms like AQR, BGI, GMO, Numeric and Symphony.
We expect hedge assets to reach $2.5 trillion by 2010, a 15% CAGR of which 8% will come from returns and 7% from net new flows. High net worth individuals account for a large majority of the industry's asset base but their contribution to growth will slow materially. Worse yet for FoHFs, large family fortunes will shift to direct ownership of multistrategy products while small institutions fill in with the diversified FoHFs.
Research from Greenwich Associates shows that FoHFs with more than $1 billion have a virtual lock on exploratory mandates from institutional investors. If we are right about the new paradigm managers, this is very bad news for the largest FoHFs, who will lose their early-adopter pension clients rapidly in the face of a more compelling proposition for direct and multistrategy offerings. The biggest FoHFs have built up a sizable cost base building databases, inventing pseudo-science tools and overpaying inexperienced staff. Darwin's curse is that today's predator is tomorrow's prey.
How big is the opportunity? Our forecast is premised on "old" flows moderating in the face of lower returns and saturated HNW sales. When pensions mandates hit stride in 2007 and rise aggressively thereafter, the spotlight will have shifted to multi-strategy.
As a directional matter, we believe our forecast is more likely to be overly optimistic than to be overly pessimistic. The forces we identify all point toward bifurcation of the market with concomitant loss of revenue, disintermediation of FoHFs and the evolution of a new paradigm competitor. Faint of heart, we hesitate to call a sharp downward turn. Thirty years of history militates for the familiar over the rational, the old over the new. That said, we find a few heartening signs.
The mix of invested assets has begun to shift. Equity long/short has been the loser as beta-surfers have been unmasked, and the hunt for alpha has teased investors away from mainstream strategies toward unconstrained multi-strategy.
The fragmented industry of today is in contrast to the relative concentration of the early 1990s, when a few global macro funds controlled much of a smaller pool – $30 billion. The spores cast off from the center took root and grew well: global macro today is $100 billion AUM, only 9.7% of hedge AUM.
Multi-strategy can be Revenge of the Nerds Part II, in which the Nerds bet on the game instead of playing it, dress up snappy and quote poetry to win the cheerleaders, and then buy the team and run it with new discipline. Has this happened before? There are numerous firms powered by an "Intel Inside" that is sold as "part but only part" of the investment culture.
Implosions of single strategy managers have driven clients to established multi strategy firms, and pierced the pretensions of FoHF manager research. Clients who are interested in the unconstrained search for alpha resonate with the idea that speed and ease matters in asset allocation and alpha-chasing. As the Bard wrote "if 'twere done, 'tis best 'twere done quickly!". As important, the nimble multi-strategy format also ameliorates or eliminates the double-dip draw-down.
Today, a substantial proportion of multistrategy AUM is charged at a flat management fee of 100 to 125bps. We expect management fees to drop to 75bps across the board, but we also expect institutional clients to accept a performance fee of 20% of returns in excess of a hurdle rate (cash, adjusted for leverage) on a three-year rolling basis. For FoHFs we add 0.75% to the underlying management fee of 2% – training wheels can be costly – to estimate total management fees for the hedge business.
Despite trending toward lower fee rates over the next five years, the business opportunity is substantial: in 2010, management fees will be $40 billion, up nicely from $25 billion this year.
|of which FoHF fees||1.9||2||1.9||1.9||1.8||1.7||-1.90%|
|of which underlying direct fees||4.1||5.3||5.5||5.5||5.4||5||4.10%|
|HNW, F&E FoHF||$13.7||$15.3||$15.6||$15.7||$15.9||$16.2||3.40%|
|of which FoHF fees||4.3||4.5||4.4||4.2||4.2||4.3||0.20%|
|of which underlying direct fees||9.4||10.8||11.2||11.5||11.7||11.8||4.70%|
|HNW, F&E direct||15.1||16.2||17.6||18.9||20.1||20.8||6.70%|
|HNW, F&E multi-strategy||2.3||3.3||4.1||4.8||5.5||6||21.40%|
|Total HNW, F&E||$31||$34.8||$37.3||$39.4||$41.5||$42.9||6.70%|
Our forecast of performance fees assumes alpha generation of 5% for direct hedge investments, including the effects of leverage (net after management fees above an expected return for cash of 3.5%).
The practice of charging for results above zero instead of above a cash return hurdle will decline as investors demand fairer terms. We expect FoHFs to provide on average a 2% return over cash (again net of their management fee) with the performance fee rate declining from 10% to 5% over the next five years.
The ephemeral nature of arbitrages, new or exotic financial instruments, and opacity: these do not fit nicely within the standards of institutional decision making. Great inroads have been made nonetheless.
Today approximately 200 hedge firms have assets in excess of $1 billion, of which roughly a third are large, familiar institutional managers with deep existing pension relationships. BGI, Bridgewater Associates, Goldman Sachs, GMO, SSGA, Aronson, AXA Rosenberg, Jacobs Levy, and First Quadrant have all successfully recast themselves as part of the new era.
Financial markets and instruments have evolved in the past decade to the point where investors can deconstruct asset positions and associated risks. Managers can in turn tailor portfolio return and risk expectations with unprecedented precision, flexibility, and economy. The hedge fund industry depends upon these new capabilities, so it is important that they are rapidly gaining acceptance. One reason is that the scientific foundation is well-laid.
Quantitative institutional managers were "first responders" to pension client demandfor absolute return. By repurposing their stock-selection technology to construct long/short equity portfolios, they built bespoke portfolios to fit to specific active risk targets. As a fillip, derivatives were used to port the alpha.
Much has been written about the institutionalization of the hedge world, much of it misguided. Three themes continually recur: slick sales, style adherence and systems for transparency and risk aggregation. We beg to differ:
So what does matter in the institutional market for hedge exposure?
What of new entrants? We think the market could be more "wide-open" than is generally believed. Capacity concerns hamper some who are already well-positioned, and there are simply too few credible players today.
Were it not for their conservative incrementalism, we would nominate the "global network banks" – Bank of New York, UBS, State Street, a few others – as contenders. They have the technology, service and sales talent to make clients comfortable. And one of their own has shown the way: Barclays Global is the poster-child for stealthy use of quantitative insights and incentives to create a new business ($15bn in hedge is a lot of market share from a standing start).
BGI is Revenge of the Nerds Part III, in which the Nerds take over a dull business with contracting earnings (a tedious first reel), lock themselves in the garage challenging themselves relentlessly (a long second reel) and invent two types of Flubber to find power and wealth (apologies to Fred MacMurry fans). We foresee $100 billion in hedge mandates to BGI, plus the kick from inventing ETF's (the Silly Putty of index funds: simply press it on and Wow, it copies anything!)
Will the other banks follow? Nope; they will copy products and pluck stragglers from the ranks but never "get it": it is vision, culture and incentives that make BGI possible.
Who else might grab the gold ring? One group likely to succeed are the dealers – they can swiftly assemble trader teams into a "platform" of technology and leadership. Goldman is already there, and Citi has its own Tanya-of-Ark to show the rest of us how it's done, complete with sermons. We expect Morgan Stanley and JPMorgan to carve-out really significant market share once the trail is blazed (give JPMorgan credit for being first to twig to the idea that multi-strat might be the wave of the future).
Performance, per se, is not a prerequisite, credibility is. If Morgan Stanley decides to enter this market aggressively will it face performance concerns? Of course not – it will face questions of staffing, capability, technology and pricing but like other large institutional managers (even those past their sell-by date) they will get a free pass on performance. This is not to say it is easy, merely that the current players are vulnerable to new entrants with just the right combination of advantages.
Obsession with track record is one of the many ways of false-flagging other concerns: mainly related to the personality of the new vendors. Institutions rightly fear that what was once a healthy "alignment of interest" has become lethal at large doses.
Still, pensions are getting beyond the basics (gimme a Liquid Market, splash of Risk Control slathered with Low Correlation, barkeep!)Large conventional managers will fire up their product development wonks to gain the comp-etitive advantages of a new age multi-strat firm:
The result should be lower volatility and higher alpha – partly driven by cost aspects (we subscribe to the "risk budget" metaphor) and partly driven by the fact that the kind of firm we are describing makes the best possible use of scale: to amplify the impact of insight.
But the size of the opportunity may be a powerful motivator. Where should we look to find the "next generation" competitors?
To get in the game has been relatively easy – in times of plenty… In challenging times, with competitors focusing more explicitly on the potential spoils, winning will require very specific business strategies, many of which haveyet to be conceived much less battle-tested.
Absolute return strategies are more accessible to pensions; the total hedge market is growing at a hell of a clip while the "old" business settles into its long-term form. Sounds like a situation tailor-made for the rough and tumble of M&A. We think not.
Yes, there will be a few transactions of note in the next few years, but they will focus on a limited number of industrial combinations:
We expect more IPO and reverse merger activity. As odd as it may seem, the public markets are a more congenial home for many of these firms than conglomerate or holding company purchase. Man, RAB, BKF- these companies illustrate that markets will listen and decide optimistically what the right share value is. More important, with the Calamosoffering we have a format for reconciling the needs of the team with the needs of the market. Look for lots of IPO activity in two-tier structure on the horizon.
Pricing will be robust, both on and off-exchange. To-date, a diverse investor base (Public) has shown greater appreciation for volatile revenue streams. Whether expressed as a perpetual growth formula or a multiple of their normalized profitability, performance fees which are not the preserve of the team earning them are worth a second glance. And a nifty tax arbitrage ensures that they will be available for sale.
After the next few years, though, the M&A boomlet will play itself out and M&A activity will be a tool of the failed. What small transactions take place will take place at modest pricing, amounting to little more than employment arrangements for the key talent. Talent in the non-quant hedge world has achieved virtual free-agent status. By 2010, second tier firms will be peopled with second tier talent, and second tier talent cannot command a premium in a transaction.
A few of the largest FoHFs will try to morph into multi-strategy firms with innovative fees and a patina of technology and pseudo-quant processes. Very few will be able to turn the sow's ear of "Fund Manager Research"into the silk purse of "Hedge Portfolio Management".
– Some will add teams and evolve into multi- strategy firms, but with qualified investment talent in "free agency" status it will be hard to hold the teams together. Said the scorpion "It's my nature".
– Some will join banks and brokerage firms, to sip a thin gruel of shared success.
– Some will thrive by abjuring any notion of being a business — or "building franchise value" – and learning to be comfortable as a sole proprietorship.
– Institutional motives for hedge are a hodgepodge: part alpha porting, part reconsidered risk budgeting, part anti- drawdown, part hula-hoop. Still, the appeal of low correlation, low drawdown, high Sharpe Ratio endures.
– Paying up for alpha only makes sense if pensions buy beta in bulk. Although reserved for another paper, the implications for active firms are being felt.
– As early adopters get acclimated, their "reports from the front" will accelerate rationality in fees, selectivity in vendors, and demand for new product.
– "Intuitive" trading hedge firms will be overtaken by "scientific" investing firms. This is a big deal because the business models are very different, although the terms are in quotes because neither is either.
– Performance will be crucial to relationship longevity of course, but secondary to anti- drawdown in selling to institutions.
– In 2005, the hedge industry will generate over $40 billion in fees, roughly equal the fees earned by US stock and bond mutual funds.
– Growth of new money flows will moderate in the near term, as the institutional experimental phase subsides.
– Multistrategy and large direct funds will be preferred to FoHFs and will deliver higher returns, better control, and better risk management.
– Product terms will bifurcate into a "retail model" for HNW clients and an "institutional model" for large pools of long term capital. Hedge firms will pick one or the other – it will be hard to serve two masters from one platform.
– The "I wanna own the team" fad will pass, as it becomes more obvious that GP interests encourage adverse selection and loyalty to failing.
– Quantitative firms will remain the most attractive to buyers. Buyers will be reassured by methodology but rewarded by scalability.
– Those that have clients or technology for sale will find the pricing disappointing – an industry reinventing itself does not pay much for prototypes.