The emergence of hedge funds as a widely accepted component of investors’ portfolios is among the most significant developments in the asset management universe over the last decade. Even though hedge funds have been in existence since the late 1940s, recent growth in assets, managers, funds and strategies has been astounding. From 2000 to 2005, hedge fund assets more than doubled to over $1.1 trillion.

This substantial growth has raised capacity concerns. As hedge funds move through the natural maturation process – the so-called ‘industry life cycle’ – have they reached an inflection point where returns decline? Can hedge funds absorb these inflows while continuing to deliver on their central value proposition – alpha generation?

A maturing hedge fund ‘industry’ may evolve to be less attractive. When a manufacturing industry reaches maturity, it often implies commoditisation, consolidation and low margins. This is not necessarily a bad thing for consumers – who may benefit from lower prices (although innovation and investment tend to be limited). In contrast, if hedge funds collectively become mature, there may be no value for either managers or investors since active management, at least according to conventional wisdom, is zero-sum.

But are hedge funds reaching maturity? In this paper, we argue that the question surrounding hedge fund capacity requires a fresh look. In a previous paper examining competitive dynamics at the manager level, we argued that hedge funds are innovation businesses with the ability to evolve and adapt to changing circumstances.2 Truly innovative managers with sustainable advantages should continue to generate alpha, despite the entry of new participants and the increases in overall asset levels.

In this article, we take on the overcrowding issue from the ‘industry’ level and derive insights regarding recent growth and implications for the future. From this perspective, we reach three important conclusions:

1. The hedge fund ‘industry’ is not really an industry at all. Discussions about the future of the ‘hedge fund industry’ are misguided because we do not believe that hedge funds alone constitute an industry. Hedge funds, rather, represent a particular business model and governance structure within the broader active management industry. Questions regarding capacity and the ability of managers to continue to generate alpha, therefore, must be examined in this larger context.
2. Asset management is experiencing an unbundling of value-producing services and is creating more choices for investors. The active management industry, like all industries, undergoes phases of change. The current phase is characterised by the unbundling of services and the expansion of consumer choice – specifically, the emergence of separate delivery mechanisms for alpha and beta. Hedge funds, unlike traditional long only funds, are more focused on the delivery of alpha.
3. In the broader active management industry, hedge funds represent an alternative governance structure to traditional active management. Within the active management industry, a competition among governance structures has emerged. Do hedge funds or traditional long only active management formats – given eachhas distinct systems of incentives and controls – offer the better structure to support active management activities? We examine some of the challenges involved in governance of alpha generation activities and consider the tensions that emerge in the establishment of a governance system. We conclude that the hedge fund structure, although imperfect, ultimately is better suited for managing the separate production and delivery of alpha than the traditional long only fund structures.

What is the ‘industry’ and how overcrowded is it?

What defines an industry? In general, industries are defined by what they produce and not how they produce it. The business model of Dell Inc. historically was much different to that of Hewlett-Packard, but because both offer personal computers, they are categorised in the same industry. In this context, traditional active managers and hedge fund managers also are attempting to deliver the same product for their customers: alpha. Alpha is the portion of return (and risk) that an active manager generates independent of the market. In the absence of alpha, investors are better off obtaining market exposure passively through cheaper vehicles – such as exchange traded funds (ETFs), index funds, or derivatives such as futures or swaps. Seen in this way, hedge funds are not an industry – they are a business model within the broader active management or alpha industry.

The way hedge funds deliver alpha is distinctive. Perhaps the most salient aspect of this is that hedge funds typically deliver alpha with less exposure to markets. As Figure 1 indicates, where traditional managers maintain beta exposure explicitly as part of their value proposition, beta historically has been approximately 23% of hedge funds’ excess returns to cash.

While hedge funds have been growing substantially, they still represent a small part of the active management industry. As shown in Figure 2, hedge funds are only one-sixteenth the size of the US traditional long only active management industry and represent less than one-eighth of the active risk taken by investors.

The implication for investors is that while hedge funds may operate in an industry that theoretically is zero-sum over the long run, the imposition of the zero-sum constraint on the industry as a whole may not be a meaningful predictor of hedge fund returns. Within a segment, alpha is not necessarily zero-sum, even over the long run. There are many hedge funds and traditional active managers seeking alpha but also individual and institutional investors who are trading, either for return or hedging. Given varying investment goals, market inefficiencies will exist. It is only in this broader frame that issues of capacity can be examined. Fears of ‘too much money chasing too few opportunities’ may be overstated.

Expanding choices: “Would you like some alpha with that beta?”

There are lessons from other industries that provide clues regarding how the active management industry is likely to evolve. Greater use of technology and market integration has led several industries to unbundle consumers’ choices. A prime example is the cable television industry. At its outset, cable TV provided customers with very little choice. There was only one channel lineup, and customers faced a take-it-or-leave-it option. Implicitly, cable prices reflected the cost of the full suite a subscriber was forced to buy. The result was a great deal of inefficiency: Some consumers wanted parts of the offering but were not willing to pay the price for the full range; others were willing to pay the higher price but received a number of services they did not want or need.

Progressively, as complementary technology and substitutes emerged, the cable TV industry increasingly has moved from a prix fixe to an à la carte service offering. Cable TV subscribers now can choose between variouschannel packages that fit their viewing interests and can select a variety of value-added services: digital video recording, hundreds of individually subscribable premium channels, digital cable and even Internet service. This pattern has been followed in other industries. Technology and innovation have enabled producers to tailor pricing and product offerings for users on an individual basis.

The emergence of hedge funds represents a similar phenomenon. Thirty years ago, when financial markets were not as developed, investors had little choice. If investors wanted broad market exposure, they had to get it from an active manager; and if they wanted alpha, they had no choice but to take the beta that came along with it. As the asset management industry has evolved, investors increasingly have been able to access beta exposure inexpensively and easily – through the development of low-cost index tracking funds, ETFs and derivatives. It is not surprising that hedge funds – which provide investors with a purer form of alpha – have rapidly expanded at the same time. Investors now can choose alpha and beta separately and can mix and match to their precise specifications. The result is an improved ability to manage portfolio exposures.

A clash of governance structures

When viewed as part of the active management industry, hedge funds represent an alternative form of governance with unique incentives, processes and constraints. In this context, questions about industry capacity and the future evolution of the industry really are questions about a competition between governance structures. In other words, the key ‘crystal ball’ question is which of the active management governance models is likely to prevail? (see Figure 3)

It is not surprising that new forms of governance have emerged as alpha and beta began to be managed separately. While the combination of the two embedded in traditional active management structures may have justified one method, when alpha and beta are delivered separately, the old forms of governance may not be the most appropriate for each of the pieces.

A solution to what? Challenges in governing alpha generation

The appropriate governance structure for alpha generation has to address a number of the issues that are embedded in the production of alpha. Interestingly, these issues are not unique to active management. The governance issues that apply in active management are typical of many businesses in which human capital (eg talent and skill) and intellectual capital (eg technology, innovation and knowledge) are a primary basis for value creation. When considering which governance structure is appropriate, important issues to consider are:

• Beta is a commodity; alpha is not. Through futures, swaps, index funds and ETFs, beta replication largely is an undifferentiated, fixed cost business. In contrast, alpha generation is rare and unique, with skill being difficult to replicate. Beta, therefore, is a commoditised business, where scale is the main basis for competition, and price pressure is substantial. Alpha requires dynamically developing and protecting one’s intellectual property, informational advantages and human capital.
• Returns are volatile and uncertain. A manager’s historical performance-even with a long, consistent track record-could be the product of luck (good or bad) or skill.
• Investors cannot perfectly tell who is skillful and who is not. If alpha is hard to generate, it is even harder to observe. This means there is an information asymmetry between manager and investor – what is called a problem of hidden information in organisational economics – about the type of manager with whom an investor is doing business.5 For example, managers themselves generally have a better idea of whether they possess true competitive advantages that may lead to sustainable out performance. Similarly, managers may have a better idea of whether the future conditions for their strategy will be more or less favourable for alpha generation.
• Investors cannot perfectly tell what actions the manager is taking. In addition to the hidden information problem, active management possesses another potential informational asymmetry – commonly termed hidden action. What managers are doing also may be imperfectly observable to investors. This can take many forms. Whether managers are adapting their approach to improve their performance generally is difficult to observe. In other words, are they motivated to make changes to improve performance?
  Similarly, the way managers generate their returns may be imperfectly observable: Are they taking undue but unobservable risks that will be obvious to investors only after the fact? As an example, some managers may take on downside risk-which will generate attractive returns but also expose investors to downside events.
• Investors are less exposed to the performance of a fund than the fund manager. This may seem counterintuitive, but it stems from practical considerations. Investors (usually) have a portfolio of investments so their tolerance to assume risk on any single investment or manager is made in the portfolio context. Managers, however – especially if they have their own capital largely invested in their fund – are personally less able to diversify the risk they take in their fund.
• Investment constraints lead to inefficiency.There is a general principle in optimisation that, all else being equal, an unconstrained solution to any problem generally is as good as, if not better than, a constrained one. In the context of active management, an analogous principle has been posited as “The Fundamental Law of Active Management.” As Grinold and Khan explain in their seminal book, Active Portfolio Management, the value added of active managers is equal to their degree of skill in predicting future values, the number of independent opportunities they identify and the degree to which they can act on those opportunities. Investment constraints limit the second and third of these.

Implications of managing alpha production

There is a need to develop governance models more appropriate for an ‘unbundled’ world. This has the following implications:

Implication 1: There is no ‘silver bullet’-governance is about tensions

As illustrated in Figure 4, certain features of active management we outlined create a tension in the establishment of a system of governance. The resolution of issues may reduce one problem but, at the same time, will compromise the objective of management – alpha generation.

• Transparency Hidden information and hidden action require greater transparency to mitigate. However, the fact that active management is an intellectual property business implies that the ability to generate alpha will decline if information about how it is generated is made public.
• Incentive strength Good managers may be discouraged from entering the active management industry if they are overly exposed to risk that they cannot easily diversify. An investor – with a broadly diversified portfolio – can and will assume the risk of a single investment or manager. It is much more difficult for managers to diversify since their income and their own capital are much more tied to the performance of the fund. Strong incentives only magnify this problem. In the extreme, we may have adverse selection problems where only excessively risk-seeking managers would be willing to participate in active management, shrinking the pool of skill. This suggests a weaker incentive system. On the other hand, strong incentives can enhance alpha generation. First, strong incentives help screen out weaker managers. Since those who are more skilled will generate, on average, more attractive economics when incentives are strong, they will be more willing to accept such a structure. Second, strong and explicit incentives should encourage managers to ‘invest’ in intellectual property and human capital to maintain and improve performance, again enhancing alpha generation.
• Incentive symmetry A related problem in the design of incentives for active management is not just the strength but also the shape or symmetry of incentives from gains and losses. Again, the features of active management tend to involve a tradeoff. On the one hand, asymmetric incentives, where managers enjoy the benefits of gains with investors but do not suffer losses alongside them, encourage a particular type of moral hazard: excessive risk taking. Because managers do not internalise the costs of losses under an asymmetric structure, the expected payout of large risks is higher for the manager than the investor, meaning the manager potentially will take more risk. On the other hand, if managers are too exposed to downside risks, only those who are extremely risk-seeking may participate.
• Investment constraints A final example that illustrates the tradeoff between the various features of active management governance is appropriate investment constraints. On the one hand, greater restrictions on the actions of managers may limit problems of moral hazard. On the other hand, the fact that fewer constraints create greater opportunities to add value suggests that constraints should be lower.

In sum, the characteristics of active management create governance problems that suggest solutions to mitigate them. The problem is that in almost every case, these solutions destroy the main objective of active management – creating alpha. In the extreme, focusing solely on resolving problems such as hidden information and hidden action can completely eliminate the ability of managers to add value. Taken together, this suggests that the optimal solution that at once limits governance problems but creates a context for alpha generation will be one that balances the tensions.

Implication 2: The hedge fund ‘format’ provides a more appropriate, albeit not perfect, governance structure for active management

What may be readily apparent from Figure 3 is that traditional long only active management formats solve governance tradeoffs in a particular and unbalanced way. Across every dimension, manager incentives are limited, and risk is taken almost exclusively by the investor. This limits the ability to screen out poorly skilled managers and to motivate effort. In the absence of strong incentives, constraints on actions such as regulation and inflexible investment mandates then emerge as additional ways to manage residual moral hazard problems – albeit at the cost of compromising alpha.

While the typical hedge fund incentive structure is not perfect, it strikes more of a balance. Strong incentives are created through performance fees – which may serve to screen out truly unskilled managers and motivate others to generate alpha. Similarly, the alignment of incentives is complemented by a lower degree of constraints – increasing opportunities for alpha generation.

One issue raised by this discussion is: Why do the traditional governance structures exist at all? One answer may be that traditional (long only) active managers care relatively less about alpha generation than hedge fund managers do. Before the emergence of more sophisticated financial instruments, many investors had no choice but to bundle alpha with beta. Tracking passive investments is not about skill – but scale and cost minimisation. Alpha generation requires the exact opposite – performance incentives have the potential to screen and align incentives more appropriately. In the traditional model, where alpha and beta are explicitly bundled, these two governance pressures operate in exactly the opposite direction, and it is possible that the flat-fee, regulated structure was optimal for the bundle. It may not be surprising, therefore, that as alpha and beta have become increasingly unbundled, there has been the potential to create more efficient structures for each of the pieces.

Implication 3: Combining incentive fees and co-investment: Relaxing the governance tradeoffs further

While we believe that the hedge fund governance structure is more appropriately aligned with the needs of active management, it is important to note that the hedge fund model does not eliminate the tradeoffs altogether. There still are a number of incentive problems that are not eliminated – principally potentially excessive risk taking caused by high water marks and asymmetric incentive structures.

One of the central problems that investors encounter is that the ‘standard’ management plus incentive fee structure is too coarse. Perhaps most important, the fundamental incentive distorting behaviour in hedge funds is that managers do not participate on the downside. Here, there are a number of ways that the tradeoffs may be relaxed more effectively.

It may be that the simplest way that manager incentives can be effectively aligned with investors is manager participation in funds. If a manager has significant ‘skin in the game,’ there is potential to solve residual incentive problems. To see this, consider how a manager with $100 in assets under management would be compensated if they are at their high water mark with a standard 2% management fee and 20% incentive fee. In Figure 5, we show the manager’s payment as a function of their return over one year. The blue line shows the manager’s total earnings in the absence of co-investment, and the red line shows the manager’s earnings if they have $10 invested in their own fund in addition to the $100 invested by outside investors. As can be seen, the effect is to create disincentives for losses.

If properly calibrated, a mixture of standard fees and co-investment can reduce sharp governance tradeoffs for the manager. The correct level of optimal co-investment will depend principally on two factors:

• Relative risk aversion between manager and investor. A manager and an investor may have very different risk/return preferences, particularly given the degree of the manager’s exposure to the performance of the fund. The manager’s payoffs, particularly if the manager is averse to downside risk, do not need to be perfectly symmetrical. For example, if a manager is four times as averse to downside risk as upside return, a 5% participation on the downside and 20% participation on the upside may be enough to ensure that the manager and investor are incentive aligned.
• The ‘Goldilocks Principle.’ Establishing an appropriate level of co-investment is a balancing act. At low levels of co-investment, managers may have incentives to take too much risk. Equally important, at very high levels of co-investment, the opposite may occur: Managers, who cannot as easily diversify the downside as investors, may not take enough risk. Only in the middle – in other words, ‘not too hot, not too cold, but just right’ – will managers have risk-taking incentives aligned with those of their investors.

Implication 4: Governance models will converge

Traditional active managers provide investors with both beta and alpha. In that environment, scale and cost are as important as alpha creation – cheaper provision of beta could offset underperformance on the alpha dimension. This, perhaps, is one of the reasons why expense ratios are a critical differentiator among traditional funds.

The introduction of cheap and accessible passive investing has sharpened the basis on which traditional managers compete. Providing beta is a commodity, meaning that both traditional active managers and hedge fund managers increasingly will be selected purely based on the efficiency with which they generate alpha.

It is perhaps not surprising, therefore, that new governance formats have emerged that are hybrids among the standard structures. As one example, some traditional active managers, seeking to unshackle themselves from their constraints, have introduced so-called 13030 funds (or other net 100% long forms). In these structures, managers are allowed to use leverage and go long and short – 130% long and 30% short the total equity capital invested. The result is that they are 100% net long, meaning they target a market exposure of approximately one dollar per dollar invested, seeking to then generate an active return through the specific long and short positions. This structure is designed to allow traditional managers to relax the constraints they typically face when pursuing alpha but maintain their familiar provision of beta. Viewed through the lens of this paper, however, these structures are inefficient in several ways. First, they still bundle alpha and beta together. Second, they still provide constraints on alpha generation. Third, they provide weak incentives.

A second example of a hybrid form comes from the other direction. Some hedge fund managers now are packaging beta explicitly with alpha and offering a structure that effectively is the two independent pieces – and two governance structures – combined. These funds typically have a lower fixed management fee and then an incentive fee based on outperformance to the market. For customers who want packaged solutions, these combined solutions are effectively the same as buying the pieces, with the same economics as if the pieces had been purchased separately. The key point is that the incentive characteristics are aligned to each of the pieces more appropriately.

In sum, since beta and alpha now are easily decomposed, asset managers have the ability to repackage them in much more tailored structures to meet the objectives of particular investors. The key to success of these structures, however, is how well they create opportunities for alpha and how effectively they align their mix of incentives against the challenges of generating alpha.

Conclusion

The rise of hedge funds has garnered substantial attention among observers. In this paper, we have argued that to understand hedge funds, it is fruitful to examine them as part of the broader active management industry rather than as a standalone asset class or even as an industry. In this context, a number of key features stand out:

1. As part of the broader active management industry, hedge funds still represent a relative minority of the risk taken in the hope of generating alpha. Seen this way, concerns about exhausted capacity may be overstated.
2. The real question for investors is which of two models of governance – the traditional active management model or the hedge fund model-is more suited for generating alpha? While structural features of alpha generation do involve tradeoffs, we believe that, on balance, the hedge fund form is more appropriate for alpha generation.
3. While superior to a traditional model, the hedge fund format is imperfect. Therefore, mechanisms to make the manager/investor outcomes more symmetrical (such as an appropriate level of co-investment), when combined with the current hedge fund governance structure, may further align incentives between managers and investors.

In time, the governance tradeoffs should be relaxed through tailored structures (including fees). One could foresee a range of governance structures that vary by fund size and age, managers and investor preferences, and so on. The challenge for both managers and investors is to recognise the tradeoffs and agree on appropriate structures, then execute in an operationally tractable manner. Thiswill mean a further sea change in the active management industry but one that will encourage the goal at the heart of the industry – the pursuit of alpha.

Neil Brown is Managing Director and Global Head of Sales, Marketing and Research for Citigroup Alternative Investments. Rui de Figueiredo is a research consultant to Citigroup Alternative Investments. He also is an Associate Professor at the University of California at Berkeley.