The New Age of Hedge Funds

Are hedge funds evolving into a 2-tier industry?

PHILIPPE CARREL, REUTERS TRADE AND RISK MANAGEMENT

We are witnessing a deep remodeling of the asset management industry, much more than a paradigm shift – this is a ‘New Age’. In this New Age, hedge funds have become major forces in the capitalist economy and maybe even a political force – or at least a key influencer of economic policie

Hedge funds came into the limelight in 20023 for significantly outperforming other investments. Since then there has been much talk about whether this success is sustainable, replicable and especially scalable – we now see this speculation was irrelevant. The hedge fund industry has split into two clear tiers.

Firstly there has emerged an ‘Institutionalised Hedge Funds’ category operating under very strictly defined risk profiles. In addition we still see the ‘Alpha Crusaders’ alternative investment funds who continue the quest for alpha into new territories such as private equity and emerging markets. This group operates under different legal frameworks, using its own risk management methodologies.

The inexorable growth of hedge funds

So how important is the alternative investment industry to the functioning of world finance and economy? The answer is that hedge funds are as fundamental to the buy-side and the sell-side of the finance industry as predators are necessary to an ecosystem.

Their continuous quest for market inefficiencies, mispricing, exuberance, cross-market arbitrage opportunities and the sharpness this requires is no match for any market regulatory and surveillance authority. In Alan Greenspan’s own words, “hedge funds have grown into a major market force, fundamental to the markets’ liquidity and efficiency”.


Another aspect of their positioning in the world of finance is the benchmark they provide to asset managers and investors in terms of volatility of expected returns. Markets weren’t safer in the past, but risk was a figure relegated to audit reports and investors were (wrongly) comforted by the belief that time would repair all glitches. The main stock market indices may be near their all-time high, the last 5 to 6 years have demonstrated that long term pension payments were at risk anyway. High or low, financial returns can be negative as much as positive. So asset managers have to consider risk management as a key vector of their investment strategies. Similarly, investors have to accept downside risks and stop pretending they don’t exist – or else move into structured investments with some form of capital protection.

Last but not least, alternative investments have become a major part in the life of investment banks – through their asset management divisions but also prime brokerage, and obviously their own proprietary trading desks. Targeted revenues are accounted for and already factored in capitalisations in some cases. Alternative investments provide them with strategic access to market liquidity, insights, ways into private wealth management and many other goodies. Certainly Bear Stearns’s US$ 3.2bn investment to bail out funds is an illustration of how willing major players are to protect this industry.

Towards a 2-tiered industry

Fear, reward and regulation are the 3 engines that continue to drive alternative investment firms. So we have established that hedge funds as a species will survive – but how will they evolve?

The hedge funds’ market size is generally estimated to be close to 9,000 funds with some US$ 1.5tn in assets under management. These figures hide a remarkable concentration as the largest 300 managers represent more than 75% of all transactions. One of the reasons of this concentration is that the cash inflow has been driven by institutional investors and funds of funds since 2003. The search for best performing managers has become harder, leading to new approaches such as portable alpha, open architectures with multiple investment strategies offered by a single provider, exchange traded funds, structures replicating fund exposure and so on. After outsourcing their alternative investments to hedge funds in the first place, large institutional investors began spinning off their own ‘hedge fund type’ companies that they aggressively market throughout the buy-side, from insurance companies, mutual funds, pension funds and now private wealth management. As they are encouraged by a new regulatory framework, such as UCITS III which allows collective investment schemes to use derivatives as investment vehicles, there is little doubt that absolute return strategies will continue thriving in the medium term.


One main implication on trading strategies is that the traditional top down approach whereby strategic allocations precede the tactical stock pick is being replaced by a dynamic selection of hedge fund strategies or even by a ‘manager pick’. This usually shortens the investors timeframe horizon from years to quarters or even months, and leads to monitoring risk factors (dollar, energy, rates, CPI, etc) instead of macroeconomic data or industrial sector reviews. The tactical allocation turns to a risk allocation, to be decomposed by risk factors. For example, allocating an amount or a percentage of P/L to overall vega or to FTSE index changes, short rates, basis risk or even credit indices.

Those techniques are well known in the sell-side, by option traders for example, who would typically receive delta, gamma and vega targets and limits. But the practice would not be as common to asset managers who are generally not equipped with appropriate systems for this type of approach. Moreover these dynamics are not compatible with some of the usual characteristics of the hedge fund industry such as long lock-ups, closed-ends and less transparent valuations; so we can expect intermediate structures like funds of funds or open architectures to keep flourishing in order to convey alternative investment returns to mutual funds and pension funds. As they have to be MiFID and UCITS compatible, these intermediates will operate under allocation strategies defined in terms of risk profiles – for example, investing in credit derivatives from a short list of issuers, in hedge funds long/short only, avoiding concentrations, dealing with managers with an established track record in risk management. They will therefore have to base their go-to-market strategies and communication around these new elements.

The funds involved in these strategies need to demonstrate compliance. In other words they need to concentrate on generating ‘pure alpha’ (if such a thing exists) out of a predefined selection of risk factors. For example, a fund could offer an FX-neutral exposure to energy, or a beta neutral exposure to a selection of small caps. Institutions typically keep their beta management in-house and avoid funds whose beta exposure may distort or complicate their own operations. In the long run, we may see an evolution from single strategy funds toward ‘single risk’ funds. Arguably these funds would no longer be hedge funds as we know them, but would have evolved into ‘Institutionalised Hedge Funds’ or targeted risk exposure supermarkets.

At the other end of the spectrum, there will still be a market for ‘pure’ hedge funds, which, by definition, are unregulated generators of beta and alpha returns, essentially guided by market opportunities and their own assertiveness – the ‘Alpha Crusaders’ of the financial markets. The drive by institutions and regulators toward more specialisation, transparency, controls, allocation restrictions and the mounting costs associated, should logically drive these natural hunters out to green field territories. Of course the traditional unregulated long/shorts, converts and event driven will remain but we may see a new opportunity to use opacity as an asset, a valuable tool for arbitrage. It can be found in private equity and all other types of emerging markets, such as distressed debt in China, art and natural resources. The hunters will not only clean up some of the market inefficiencies, but will also reveal those markets to the media and to the world, generate new opportunities and, to a degree, become a global macroeconomic factor of wealth generation and repartition. The economic impact could be very significant.

Takeovers through private equity funds are thought to represent 25% of all corporate acquisitions so far in 2007 – this is a global phenomenon. Private equity funds now reach out to all business sectors, including exchanges and have taken over most leveraged buy-out business. The impact on the economy is easy to measure, as tens of billions of dollars and euros have been directly injected into the economy and instantly put to work for industrial purposes last year. Here again the macroeconomic impact is significant enough for regulators to encourage the trend while establishing boundaries, and for large banks to join the bandwagon.

We have heard the term ‘new economy’ before. It looks like ‘new capitalism’ this time or at least a ‘New Age of the Hedge Fund Industry’.

Old age vs new age industry workflow

The alternative investment specialists tightly supervised by regulators and by their large institutional clients are an essential engine for generating returns required to fund populations retiring younger and living longer. Their secondary role is to spread exposure of the asset management industry to a broader range of risk factors – currently concentrated on a very small number of stock indices. In the New Age, ‘Alpha Crusaders’ continue to explore unknown territories and opportunities. 50% of them have specialised in private equity, raising trillions of dollars, funding small and large companies, exchanges and utilities and in some countries, influencing local fiscal policies.

The alternative investment specialists tightly supervised by regulators and by their large institutional clients are an essential engine for generating returns required to fund populations retiring younger and living longer. Their secondary role is to spread exposure of the asset management industry to a broader range of risk factors – currently concentrated on a very small number of stock indices. In the New Age, ‘Alpha Crusaders’ continue to explore unknown territories and opportunities. 50% of them have specialised in private equity, raising trillions of dollars, funding small and large companies, exchanges and utilities and in some countries, influencing local fiscal policies. Bulge bracket asset managers on the other hand, take control of marketing and distributions through funds of funds and their own alternative investment specialist firms. The consolidation process is happening – this is becoming a game for the big boys.

Old age workflow and new age workflow

Figure 1 overleaf shows traditional industry workflow characterised by a concentration of prime brokerage on just a handful of key players. Hedge funds rely on prime brokers for much more than financing and a broad range of services are offered to them. A dozen fund administrators share the market. Execution venues remain totally outside the workflow. Independent order routing services link both worlds. The main difference shown on Figure 1 is the presence of bulge bracket financial institutions at all levels. The prime brokerage market is now shared by the top tier banks. Services have been vertically integrated, from prime brokerage to fund administration, back office services, risk and portfolio management, compliance reports and portfolio modeling. Following the acquisition of Bysis, the industry is widely expected to continue its consolidation.

Meanwhile, MiFID and Reg NMS have deeply influenced the trade execution industry. Their best execution and transparency requirements, in particular, have made market liquidity a virtual feature, no longer linked to a geographic concentration of market players. It gives a historic opportunity to leading investment bank powerhouses to further integrate and get their share of the execution business. The loop is now complete and a single house can offer an end-to-end integrated workflow to hedge funds, provided it has the right liquidity, connectivity, data, risk and portfolio management tools. The leading asset management powerhouses have also achieved control of asset allocation and their go-to-market strategies can now hinge on a catalogue of risk profiles they engineer through the ‘Institutionalised Hedge Funds’ or directly via their own alternative investment vehicles.

The second type of hedge funds either stick to traditional strategies but remain unregulated or specialise in opaque investments such as private equity, emerging and even exotic markets such as art, tourism and natural resources. Some hedge fund managers may operate funds of both types. A new breed among this tightly integrated and concentrated population of large players is the independent valuation and risk aggregation service providers.

Philippe Carrel is Global Head of Business Development, Reuters Trade & Risk Management