Hedge funds: what should you believe? Read certain press articles and you will hear about the imminent demise of the industry – apparently beset by a lack of transparency, excessive capital chasing the same trades in limited opportunities, broken black box models, exorbitant pay for undeserving managers, activist bullying and even fraud. How could they survive? Latest reports on asset flows to hedge funds evidence growing inflows in terms of allocation size and range of investor type. Hedge funds are growing up and, like any industry, maturing as they do so.

Certainly, the increase in assets managed by the industry suggests the continued popularity of hedge funds among the world’s largest and most sophisticated investors. A recent poll of US endowments, which were perhaps the first institutions to disaggregate portfolios into passive and active risk1, revealed that their hedge fund portfolios had become a larger share of their overall risk budget. The average hedge fund portfolio allocation currently comprises 20% of their overall asset allocation, with some of these institutions investing more than 40% of their portfolio directly in hedge funds2.

How can the disparity between generally negative public sentiment and sound investment rationale prevail in the hedge fund industry? We believe that misconceptions about hedge fund investing, coupled with sensationalised stories of select hedge fund collapses, are predominantly to blame. When considered as part of an investor’s overall portfolio, hedge funds continue to perform an important function. The benefits of diversification and asymmetric returns, the elusive ‘alpha’, achieved through active risk management, form the primary investment rationale of hedge fund investing.

Prospects for new capital

Much of the evolution of individual hedge fund strategies has been driven by the supply/demand characteristics of the industry. Large inflows from institutional investors have been both positive and negative for the industry. Today, the spectrum of the hedge fund investor base ranges from sophisticated institutions such as insurance companies, pension funds, central banks, endowments, family offices, high net worth individuals, private banks and corporations to the smaller retail client. Both the retail and small to mid-size private individual channels are recent additions to the market, as lower entry minimums allow access to hedge funds through structured products and listed hedge funds. Thus, new capital is likely to continue to grow, as a wider investor base has easier access and large institutions increase their allocations.

According to research conducted by Hedge Fund Research, the second and third quarters of 2006 each saw over $40bn of inflows to the industry, the two largest recorded quarters ever (HFR, January 2007). The increase in the size of assets has led managers to look for new sources of return as certain strategies have been compressed in their return potential. New strategies have been made possible by developments such as the emergence of new financial instruments (including emerging market credit default swaps) as well as the increased liquidity in some markets such as credit derivatives, many commodity markets, and emerging market equity, fixed income and foreign exchange.

The changing hedge fund landscape

While some hedge fund managers will continue to rely upon fundamental security selection skills and thoughtful risk management – where in-depth due diligence and hard work should be rewarded – many others will continue to innovate their approach to investing, identifying new strategies or variants on existing investment styles. As markets and their participants evolve, certain strategies may become less profitable, causing them to fall out of favour. Whether this process is cyclical or permanent, it highlights the need for investors’ hedge fund exposure to be diversified by manager and strategy. Furthermore, investors need to continuously seek out new and innovative strategies.

The chart below sets out the universe of hedge fund strategies as we see it today. Hedge funds are classified across four sectors and the underlying strategies are grouped into core and newly emerging opportunities. Each sector is distinguished by its unique risk and return characteristics and approach to investing. Whilst some of the sub-strategies fall neatly into one particular sector, there are many that operate across more than one sector. For example, quantitative macro trading strategies can be categorised as both tactical trading and relative value or hybrid private equity/hedge fund investing could be classified as both equity long/short and event-driven.

Opportunistic/evolving strategies

• Event-driven – hybrid public and private investing

Hedge fund managers’ relentless pursuit of alpha and the compression of returns in some areas of the hedge fund landscape have broadened the spectrum of liquidity to which investors have become accustomed. An evolving theme in hedge fund investing is the propensity of some managers, typically those with an established track record and reasonable scale, to adopt strategies that aim to unlock value over a longer time horizon than traditional hedge funds would.

Two emerging strategies that have gained attention, particularly in the press, are 1) activist investing and 2) ‘hybrid’ public and private investing – both of which are sub-components of the equity long/short and event-driven sectors.

1. With activist investing, hedge fund managers take significant positions in public companies in order to effect change to maximise shareholder value. Managers may try to encourage a company to sell off non-core assets, engage in share buybacks, pay a special dividend, or sell itself outright, typically without assuming control, which is characteristic of private equity. Although activist investing has gained prominence recently, it is not a new strategy, as notable investors such as Warren Buffet and Carl Icahn have employed it effectively for years.
2. Hybrid investing focuses on opportunities across both the public and private markets. A number of multi-strategy and event-driven hedge funds currently invest in hybrid opportunities, including: those in Fig. 2. The time horizon for this type of strategy typically falls between a traditional hedge fund and a traditional private equity investment. This is known as ‘intermediate duration’ time horizon investing, and falls between two and five years as outlined in Fig. 3.

Hybrid investing is less liquid than most hedge fund strategies due to the longer-term investment horizon and in some cases, the private equity component of the portfolio. This poses a challenge from a portfolio construction standpoint and has, in some cases, led certain investors to create dedicated vehicles for these types of strategy, with a liquidity structure more similar to private equity. The ability of managers to generate premium returns in hybrid investment strategies is likely to vary over time, based on both supply/demand characteristics as well as the number of participants in this space. The relative success of managers is also determined by their expertise, ability to source deals and risk management skills. This form of investing is unique as the scale or capital base required to implement the strategy effectively eliminates smaller hedge fund managers. Additionally, the expertise to operate across different asset classes provides another barrier to entry. Consequently, there are only a handful of players who are well positioned to capture the opportunity set effectively. Investors looking to allocate to this type of strategy should be aware that capacity with the best managers is scarce and many of the managers in this space are closed.

• Equity long/short – Asia/Emerging Markets

With Asia’s prominence in the global economy on the rise, investors’ appetite for Asian hedge funds has increased. In the last couple of years, a higher number of hedge funds with exposure to emerging markets and Asia has been launched than in any other area of the hedge fund landscape. Large multi-strategy US and European-based hedge funds are now devoting considerable resources to Asia and are opening offices and building investment teams in the region. Hong Kong and Singapore have become major hedge fund centres and Sydney is also gaining scale. Equity long/short is by far the predominate strategy in Asia and, whilst relative value, event-driven and macro managers are still numbered, we expect these strategies to grow in popularity as Asian markets evolve, corporate governance is more closely defined and new instruments are created.

Developments in many of the underlying markets such as the ability to short sell have improved risk management and, as a result, the prospects for hedge fund strategies in the region. Greater China, which includes Hong Kong and Taiwan, is the most ‘shortable’ with several hundred shortable stocks. In Taiwan, investors are also able to short through swaps. In India, investors can short through single stock futures available on over 100 securities including options and futures on indices. Given these developments, it is estimated that there are now over 950 hedge funds operating in Asia, most of which adopt long/short strategies5.

Asian and Emerging Markets hedge funds are not without their own set of challenges. The vast majority of managers have short track records, which make analysing performance difficult. Corporate governance is a facet of the markets that should be considered given new regulations and the absence of relevant precedent records. In addition, liquidity and limited shorting are also factors that pose challenges in building hedge fund portfolios in this particular segment of the industry. That said, on the whole, Asian hedge funds continue to perform well in comparison to the traditional equity markets and we expect that opportunities will continue to persist in these markets for hedge fund managers. As the markets become more liquid with increased research coverage, market participants, and availability of data, we believe hedge fund talent will be easier to identify quantitatively. As with emerging market debt, we do expect underlying emerging equity markets to become more efficient, which could influence the opportunity set going forward. From an underlying investor’s standpoint, these types of hedge funds will offer diversification to traditional long only exposure in Asia, since the short component offers potential protection from adverse market moves. These strategies have also been used as an ‘equity implementation’ tool, by substituting traditional equity exposure in the region. They also present geographic diversification to global long/short programmes and improved risk adjusted returns over local equity markets.

The region as a whole offers investors the prospect of growth and exciting opportunities. Last month, Standard & Poor’s raised India’s Sovereign and local currency credit rating to investment grade. Vietnam joined the WTO and China dropped its peg to the US Dollar and as a consequence, its currency has begun appreciating. India and China are the world’s two fastest growing economies. Certain hedge funds can offer the ability to capitalise on this growth story through a prudent, risk managed approach.

The future

Demand for hedge fund investments continues to prevail among sophisticated investors globally. The case forcertain hedge funds remains powerful given their ability to provide stable, asymmetric returns that demonstrate attractive diversification benefits to an overall asset allocation over time, as well as capital preservation.

However, as returns in some segments of the hedge fund landscape become less compelling, innovation of existing strategies and venturing into new markets becomes an essential component of surviving in this business and accessing the best managers in the industry remains key.