The Institutionalization of the Hedge Fund Industry

The perception has long been that those who invest in hedge funds are high net-worth individuals – the very wealthy. That was largely true when hedge funds first began many years ago, but it is no longer the case. Today, investors in hedge funds are more likely to be institutions such as university endowments, charitable foundations, public and private sector pension funds and sovereign wealth funds.

This investor transformation has been a gradual process that reached a material milestone last year when, according to research by AIMA, institutions for the first time accounted for an absolute majority of hedge fund assets under management. Research has also shown that during much of the past 10 years, institutional investors represented the majority of net new investment capital in the industry. Such institutional interest is also evident among smaller hedge fund managers and many institutional investors are early stage investors with smaller funds, even start-ups, believing they offer the opportunity for attractive returns.

Of capital from institutions, AIMA’s research suggests that about one-third comes from pensions. Pension managers describe their interest in hedge funds as higher quality returns as well as additional risk management expertise and trading or market nimbleness - attributes which are particularly valued in recent volatile markets. From a macro perspective, advanced economies across the world are facing demographic pressures, and the funding positions of many pensions are challenged. Hedge funds are viewed as offering better risk-adjusted returns than other asset classes.

Pension funds globally typically allocated less than 5 percent of their portfolio to hedge funds or funds of hedge funds (while typically targeting 6 percent-10 percent), and while this share has increased over the last few years, many expect it to double or triple in the years ahead. This is a global trend. In the US, private sector pension funds look to allocate on average up to 10 percent of their assets to hedge funds, a little ahead of America’s public sector pensions, which target about 8 percent on average. In the UK, some of the biggest schemes allocate up to 15 percent of their portfolio to hedge funds. In continental Europe, the take-up of hedge funds by pensions has been more mixed, but pension funds in some markets, such as the Netherlands, have enthusiastically embraced hedge funds and other alternative investment strategies.

The global economic crisis provided only a temporary interruption in the growth of institutional investments. Investors pulled about $300 billion (£199 billion) out of hedge funds between October 2008 and June 2009, but inflows returned to healthy levels in the second half of 2009. Recent surveys by Credit Suisse and Deutsche Bank suggest that the industry may attract $200-$300 billion of new capital this year. It appears that a large part of the redemptions that followed the 2008 crunch were from high net worth individuals rather than institutions, and that institutions continued contributing new capital throughout most of 2009.

As part of its own growth and maturation, and in response to greater institutional investor demand, hedge fund managers and firms of all sizes have become more institutionalised in terms of their internal systems, structures and general operational infrastructure. This can be seen in the use of risk management practices and systems, compliance procedures, performance and risk reporting, governance structures and overall operational sophistication. Institutional investors demand the highest quality of operational and risk management systems from the funds they invest in, and both to attract and in response to investor feedback, hedge fund managers have developed the most sophisticated asset management and trading infrastructures in the financial services sector.

These demands have required significant investments by managers in systems, technology and people. However, the benefits to investors and managers far outweigh the costs. The growing emphasis by investors and policymakers on transparency and systemic-risk analysis will serve to reinforce and continue this infrastructure build.

In a chicken-and-egg sort of way, institutions’ increasing allocations to hedge funds and sophistication reflect the hedge fund industry’s growing maturity. At the same time, hedge funds are no longer viewed as a distinct asset and increasingly as somehow separate from the broader asset management industry. Today, more accurately, hedge fund managers are increasingly viewed as providing more active portfolio management – utilising a variety of hedging practices to reduce volatility and protect capital.

The institutionalization of the hedge fund industry has been a developing theme for the past 10 plus years, and is likely to continue. As participants in a maturing industry, hedge fund managers of all sizes and from all regions are equipped today to attract and professionally service the growing institutional investor base. The infrastructure evident among asset managers and firms today will also assist them to meet new regulatory demands, and to offer a growing variety of products to the expanding institutional and individual investor base.

Todd Groome is the Chairman of the Alternative Investment Management Association