This content is from: Portfolio

Hedge Funds to Improve the Asset Management Industry

The emergence of a vibrant alternative-investment industry is having an impact on institutional portfolio management.

The mass media’s interest in the hedge fund industry has exploded over the past few years. Invariably, the coverage has focused on the absolute outperformance or underperformance of hedge funds and other alternative investments — as if asset management were a horse race between traditional investments (long-only equities and fixed income) and alternatives (hedge funds, private equity, real estate and commodities).

This black-and-white narrative has broad appeal because it pits the familiar against the unfamiliar — the safety of crowds versus idiosyncratic risk. But asset management is not an either/or proposition. Institutional investors know this and have maintained their allocations to alternative investments in the face of redemptions by retail investors.

The dissonance between institutional and retail investors has its roots in a popular misconception that alternative and traditional investments are somehow mutually exclusive. They are not. Many alternative investments simply deliver a more refined expression of the same risk factors found in traditional actively managed investments. By distilling these risk factors, alternative investments are like technologies that allow investors to construct more-customized and, in many cases, more-optimized portfolios.

This isn’t the first time that new technologies have enabled such a fundamental reorganization of industries. In the mid-1930s a young economist traveled from England to the U.S. to study a seemingly simple question: Why does the corporation exist? After researching some of America’s largest companies, he concluded that corporations exist to manage business processes that are simply too difficult or expensive to coordinate on the open market. That economist was Ronald Coase, and he went on to win the 1991 Nobel Prize for economics.

Coase found that as new technologies reduced search and transaction costs, peripheral business processes could be outsourced. The emergence of a rubber industry, for example, allowed early-20th-century automotive companies to sell their rubber plantations. Similarly, technologies such as the telephone, computers and eventually the Internet effectively eroded the gravity holding the corporation together. The result was what authors Alex Lowy, Don Tapscott and David Ticoll have called the “business web” — a loose federation of companies assembled on an ad hoc basis with a bespoke objective.

The emergence of a vibrant alternative-investment industry has had a similar impact on institutional portfolio management. Investors can now assemble the risk exposures that best match their own liabilities, best reflect their own market views or are delivered by their preferred alpha-creating manager.

As refined sources of beta, exotic beta and alpha, alternative investments essentially deliver the off-the-shelf components that allow investors to create their own value propositions rather than buy what amounts to a prepackaged and somewhat arbitrary combination of risk factors delivered by traditional active management.

Asset managers are responding to this opportunity by broadening their product suites. Traditional asset managers now offer hedge funds and hedge-fund-like products, while alternative managers are complementing their offerings with long-only products.

This has resulted in pressure on hedge fund firms. Just as e-business transformed from a set of stand-alone dot-coms into a ubiquitous business process, so too is the alternative-investment sector changing from a set of pure-play hedge fund companies into just another line of business at generalist asset management firms.

Many agree that this convergence of traditional and alternative will define the coming decade in the asset management industry. Policymakers have added fuel to this trend by taking tentative steps to bring alternative asset regulation in line with traditional asset regulation. Institutional investors have begun to organize themselves around common risk factors instead of superficial labels such as “hedge funds” (witness the ongoing debate at CalPERS about the appropriate classification for hedge funds). Even compensation schemes have begun to converge as institutional investors have put pressure on hedge fund fees.

Despite the mass-media narrative, alternative investments cannot and should not be viewed as either better or worse than traditional investments — regardless of their relative performance. Instead, they should be seen simply as a technology that drives the ongoing evolution of portfolio management by disrupting the status quo. And, as history shows us, that’s always a good thing.

Christopher Holt is director of the CAIA Institute, a research initiative of the Chartered Alternative Investment Analyst Association.

Related Content