More Evidence That Big Hedge Funds Rule
New studies confirm rising institutional investor interest in big hedge funds and shift away from funds-of-funds.
At a time when many small hedge funds are struggling to survive, some big funds are attracting a steady flow of assets. According to Hedge Fund Research, the largest funds — which each have more than $5 billion in assets — reported total inflows of $18 billion in the first quarter of this year, while smaller funds had outflows of $2 billion. Funds-of-funds also fared poorly, losing $5 billion in assets. These and other recent findings confirm research Institutional Investor has conducted as well.
With most new money going to the biggest managers, a limited number of funds have come to dominate the field. Of the 7,600 funds tracked by Hedge Fund Research, 66.9 percent have less than $250 million in assets. Only 5.3 percent have more than $5 billion. In recent years the big funds have grown, as institutions have increasingly gravitated toward established managers with sophisticated back-office operations. “Most big institutional investors are only willing to invest in hedge funds that have at least $500 million in assets,” says Amy Bensted, head of hedge fund research for Preqin, which tracks alternative investments.
The dominance of a few big funds represents a shift in the industry. A decade ago most hedge funds were small operations that focused on serving wealthy individuals. Then the field changed as institutions began moving more assets to hedge funds. According to a survey by Preqin, public pension funds now have 7 percent of their assets in hedge funds, up from 4 percent in 2007. At the same time that institutions increased their allocations, many wealthy individuals backed away. Angered by the Madoff scandal and big losses during the financial crisis, individuals dumped their funds-of-funds. As a result, institutions now account for 65 percent of the assets in hedge funds, up from 45 percent in 2008, according to Preqin.
To accommodate their increasingly important institutional clients, hedge funds have been forced to grow and change their businesses, says Mikael Johnson, lead partner for alternative investment at KPMG. In the past, a typical hedge fund was an entrepreneurial operation with a few traders and a couple of noninvestment employees. But now institutions demand to be served by substantial operations. That has forced hedge funds to hire staff. “You have to have compliance staff and an appropriate information technology environment,” says Johnson. “The bigger managers are putting in human resource staffs and procurement departments.”
In the past, many hedge funds disclosed little about their investing strategy. But lately funds have begun hiring investor relations staff to make sure that institutions understand current strategies. Maintaining all the personnel is expensive. Because of the extra costs, smaller hedge funds have a hard time competing for business from big institutions.
Winning institutional clients has proved particularly challenging for funds-of-funds. Many institutions have been reluctant to invest because they consider the fees excessive. In a traditional fund-of-funds, an investor would pay 1 percent annual management fees and performance fees that were 10 percent of profits. On top of those costs, clients also faced fees for the underlying hedge funds. To attract big clients, some funds-of-funds have been reducing management fees or waiving performance fees altogether, says Preqin. In some cases, funds-of-funds have agreed to not take any performance fees until returns pass a threshold, such as 8 percent.
Funds-of-funds have also been changing their investing strategies. In the past, a typical fund-of-funds would recruit 20 managers that followed different styles. The idea was to offer individuals and small institutions a diversified portfolio of hedge funds. Now many funds-of-funds are aiming to reach larger institutions by offering specialized lineups, such as managers that focus on Asian stocks or managed futures. By focusing on distinctive offerings, the funds-of-funds hope to provide investments that giant institutions could not easily assemble by themselves.