The Hedge Fund Chickens of 2004

Coming home to roost in 2005

Christopher Tinker, ICAP Equities

To begin an article on hedge funds into 2005 in the dying days of 2004 runs the risk of simply repeating much that has been written by the marketplace on this "hedge fund phenomenon" over the last 12 months. Indeed, the very concept of a hedge fund "industry" has now become so commonplace that it's taken for granted that such a collective grouping exists. Commentators have written with seeming authority (and increasing frequency) on the dangers of a hedge fund bubble. Hedge fund conferences have proliferated and a new army of hedge fund consultants, outsourced hedge fund services, legal advisors, systems providers and technological support has sprung up. If one were to measure column inches, dedicated publications and conference schedules over the past 12 months, then this would appear to be a high profile "industry" indeed.

So before discussing the prospects for hedge funds in 2005 I will begin by asking the question: does a hedge fund industry – as opposed to an amorphous collection of individual investment strategies – really exist? Such a question may seem heretical in a magazine whose very existence presupposes that a hedge fund industry does exist, but for my own part I remain to be convinced that from an analytical and operational perspective we have evolved to the point of commonality of purpose and an established industry.

Outside of the media, and those who have a vested interest in perpetuating the concept of an "industry" (see below), I have met relatively few hedge fund managers who consider themselves part of any such grouping. If they consider themselves as anything, it is as outsiders to the established norm – "Alternative Investment Manager" may lack the headline attraction (and assumed descriptive nature) of "Hedge Fund Manager" – but is perhaps more aligned to how managers actually see themselves.

Yet as with "alternative comedians" when the alternative becomes the norm, a broader, collective term is perhaps required and whether one likes it or not, the hedge fund moniker sticks.

Although this may appear to be little more than semantics, it is actually a key part of understanding the prospects for funds in the year ahead. The fact that hedge funds are not (in my opinion) an autonomous grouping of investment managers is relevant here because as the savings industry as a whole tries to find a means to make its returns match its liabilities, it has a very strong interest in shaping these alternative funds into just such a collective asset class, able to absorb its liquidity and enhance its returns.

Pension funds, college endowment funds, fund of funds groups and financial savings companies all need there to be a measurable, quantifiable investment group that their own risk profile and redemption process can operate with. This has been going on for some time, but as any recent start-up hedge fund manager will tell you, the structure of their offering memorandum is now largely dictated by the need to attract this kind of capital and the provision of a track record showing a risk profile that suits the investor, rather than a reflection of the manager's particular non-conformist manner of making a return, is paramount. Despite this pressure to conform to the needs of the savings industry, a quick look at the listings of hedge funds available confirms that there is still no significant degree of homogeneity of process, return profile or risk management across this group of funds. Indeed, a long short equity fund has far more in common with a long only equity fund on all these counts than it does with a fixed income relative arbitrage fund – yet the latter are categorised as "hedge funds" whilst the former is not.

The non-conformist origins of these funds has meant that their commonality is to have evolved out of a particular set of market conditions or investment circumstances that have provided opportunities to either arbitrage a set of market anomalies, or have arisen from being able to operate on a timescale or in a manner not normally available to other investors. Furthermore, in doing so they have also been able to avoid some of themore constraining regulatory and tax requirements affecting their institutionalised brethren, and this has certainly added to the attraction for both managers and investors alike. Thus if the concept of an industry exists in the minds of its operators, it is in the areas of attitude, consistent low regulation, tax opportunity and freedom to set fees, bonuses and lock-ins that homogeneity of purpose exists.

Those who perceive there to be a hedge fund industry already in existence will argue that the reality of institutional capital – estimated to account for 50% of all invested capital in hedge funds by 2006 – has already led to an industry being formed and is one that (potentially) needs closer regulation. Much is made of the numbers concerned. Thousands of funds now exist worldwide – 2750 is the number currently cited although figures as high as 7000 are sometimes bandied about – running nearly $900bn in assets. With over $200bn flowing into hedge funds over the last three years, the extrapolation towards a $2,000bn or even a $3,000bn industry is an easy headline-grabber.

More worryingly, there are now frequent suggestions being aired in the media and in government that hedge funds are major employers of risk in the form of leveraged borrowing and provide half or more of all brokerage commission – inferring, perhaps, that there may be an unhealthy relationship developing between banks and hedge funds in a manner not dissimilar to that between stockbrokers' analysts and their corporate finance colleagues.

Against this backdrop it is perhaps no surprise that the regulators want to get involved. With such a significant amount of money potentially outside of the controlling influence of the SEC, issues such as the late trading scandal have provided the excuse for claims of potential corruption and bias and the need to protect investors' money under the auspices of the SEC. Plans by the SEC to require registration and regulation for not only funds that are US based but for any fund outside of the US that has 15 or more US investors from February 2006 onward are already the subject of legal challenge. The idea of a full-blown "industry" investing billions of dollars of institutional money and private investor money outside of the established regulatory environment is seen as an anathema to the legion of lawyers, accountants, legislators and politicians who regard it as their responsibility to supervise on behalf of the general public. This in turn means that it is in the interests of these groups to categorise and identify hedge funds as an industry where common regulation and reporting requirements should apply.

All this means that rather than being driven by the cyclical vagaries of the investment cycle or shifts in exchange rates or volatility, prospects for hedge funds going into 2005 will be dominated by the structural shifts occurring in the savings and investment industry as a whole and growing pressures for regulation. As funds increasingly move towards an institutionalised capital environment, the role of asset gathering will continue to increase in terms of management priority and the need to target the returns and risk profiles required by the fund of fund allocators will grow. Risk positions will continue to become more focused towards shorter term time horizons that, for many strategies, may be inappropriate, but for capital providers are deemed necessary. Fund profiles are also likely to change. Although not the only reason, the average lifespan of a hedge fund (5 years) frequently reflects the fact that many of these early phase opportunities have tended to have a lifespan beyond which the risk return trade off was no longer attractive and the managers – rather than fight the change in market conditions – have quietly wound up their funds and returned the capital to investors. Such an approach makes eminent sense for the type and style of both the investor and manager of even the relatively recent past. However, as institutional capital exerts an ever growing influence, there has been a growing tendency for such funds to seek to re-invent themselves, build a more disparate return base within the fund concerned, and provide and then sustain the ever more important "track record" of monthly performance returns by which capital is allocated.

Whether we like it or not, regulation is now going to be an increasing burden on funds – the plethora of conferences focused upon giving advice in this area over the next few months is testimony to that. I am not for one moment suggesting that regulation is only a negative process, but as red tape increases, operating costs and legal contingencies are raising the barriers to entry of new funds whilst, at the same time, pushing existing groups towards consolidation and merger. This, of course, may be no bad thing, but for those who looked for hedge funds to provide diversification in terms of return, this drive towards homogeneity is actually a negative development.

As for the funds themselves, many of the reasons for establishing themselves in the first place will go as their role as asset managers becomes secondary to one of administrator and asset gatherer and their styles become compromised by the demands of the capital providers. Many hedge funds are becoming little more than an outsourcing process for large financial groups who often own equity within the fund and allocate capital on the basis of risk assessments across a range of such vehicles.

If all this sounds overly gloomy, then it is not meant to be. My focus upon the structural changes facing hedge funds is aimed at recognising that past performance cannot be regarded as any real benchmark for investing in the future if the style, manner and approach of the funds concerned is changed by these elements.

I happen to be of the view that market conditions are likely to be good for most forms of hedge fund investment in 2005 as global growth drives-on, interest rates remain low by historical standards, and liquidity remains ample. Volatility may even return to help those whose investment returns depend upon it. Provided that their fund style suits such conditions then it should be a better year for many managers. However, the number of funds who decide that they can no longer invest in the style and manner that they wish and therefore close down is likely to increase as time goes on. 2005 may thus see the hedge fund industry emerge as an entity of outsourced investment vehicles, heavily regulated by government and driven by the risk and return needs of institutional capital providers. It may be an industry, but the phrase hedge fund or alternative asset manager will no longer apply in the manner that it once did.

Chris Tinker works for ICAP Equities advising hedge fund clients on long/short European equity strategies and stock selection