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:
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.
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.
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.
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:
There is a need to develop governance models more appropriate for an ‘unbundled’ world. This has the following implications:
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.
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.
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.
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.
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:
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.
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.
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:
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.
Hedge Funds and the Active Management Industry
Finding the right model of governance to generate alpha
Neil Brown, Managing Director and Rui de Figueiredo, Research Leader, Citigroup Alternative Investments
Originally published in the March 2007 issue