By Marianne Scordel, founder, Bougeville Consulting – Recent alternative investment surveys have sought to answer the following question: “Investors: Who are they?” Overall, the data shows how hedge funds have become more institutionalised. It also documents how the largest hedge funds are attracting a relatively unchanged level of interest, while investor searches for smaller and mid-sized managers is continuing.
As consultants, Bougeville assists hedge fund managers with their business strategies. This touches upon their decision making and processes as well as how they operate and structure their offering to enhance opportunities with investors. The ultimate objective is always to meet current and future investors’ legitimate expectations or alleviate potential concerns.
The recent surveys prompted us further to explore the split between larger and smaller managers from an investor’s standpoint, and to question the more qualitative aspects of hedge fund investing which will have an impact on allocation in coming quarters. The investors surveyed manage or advise on asset allocation. Sizes at firm level range from USD50 million to over USD600 billion, and hedge fund investments of between USD5 million and USD14 billion. The average size is USD40 billion with hedge fund investments ranging from 2% to 100% of total AUM. Eight investors have worldwide operations, 13 are primarily UK-based or focused, five have their main operations in the EU (outside the UK), while the remaining eight are spread across the Americas, Switzerland and the Middle East (four, three and one respectively).
- Of those surveyed, 70% remain favourable to emerging managers, either increasing their allocation to them or expecting to do so in the near future, while two respondents (7.7%) pronounced themselves “agnostic to size”, with the remaining 22.3% continuing to invest exclusively in larger managers;
- While 60% of the respondents indicated that they had not formally changed their processes or the time spent on due diligence, the same 60% admit to subtle adjustments, for instance in resource allocation. So even though emerging managers are in demand, the number of those able to meet the costs of enhanced qualitative requirements is low;
- Predictably, the pool of strategies preferred is heavily skewed towards liquidity and transparency, with CTAs and Macro trading attracting the highest potential net inflows, while credit and equity long/short also remain attractive
Large and mid-size managers: Growing interest
With respect to hedge fund investing, three trends are apparent:
- Investors are still allocating to larger funds to an extent which has remained relatively unchanged over the past two years, but which increased last year in dollar terms, especially at the larger end of the spectrum (hedge funds with assets greater than USD5 billion);
- A majority of respondents continue to plan to allocate to firms with less than USD1 billion. What’s more, investors’ cash holdings are expected to halve, potentially adding substantial sums to the industry;
- The most common size bracket for new allocations is firms with AUM between USD500 million and USD1 billion. Firms below this threshold face an uphill battle
Increased demand for emerging managers…
Since the beginning of the financial crisis the banking sector, including the employment market for those involved, has been highly distressed. New managers have flooded in to the hedge fund sector looking to prove their skills and develop a track record as a result of little demand for their services elsewhere. With little to lose, the danger could be that this new breed of managers somehow “pollutes” the pool of investable assets in the alternative space, and raises investors’ suspicion towards all emerging managers – the good and the bad ones. In such a market where there is asymmetric information judging quality is virtually impossible and it is likely that bad managers will drive out the good (viz. the classic “market for lemons” problem found in economics textbooks).
Indeed, one respondent noted that information on past performance is difficult to find, notably due to survivorship bias: “No one quantifies how many start up hedge funds were out there and closed down in the first six months of their existence.” Besides, 22.3% of the respondents reiterated, essentially, that “nobody was ever fired for buying IBM”, highlighting the incentives investors have to “play safe” and avoid emerging managers altogether. Thus, they select big hedge fund brands, knowing that a less than outstanding performance from these managers would not result in them being blamed. Such attitudes are typical in times of fear, uncertainty and doubt, all of which characterise the current environment.
The vast majority of respondents (70%), however, say they have remained favourable to emerging managers. They are either increasing allocations or will do so in the near future. Their thinking incorporates several considerations:
- Investors tend broadly to agree that the average quality of the funds presented to them has remained unchanged. Some even say that they see more outstanding candidates now that capital has become scarcer and competition between start-ups is fiercer.
- There is inherent commercial appeal for managers who display entrepreneurial characteristics. In order to survive the crucial pioneering stage, emerging managers must remain focused. What’s more, they are also incentivised to take a healthy dose of risk (and hence are more likely to generate rewards commensurate with this appetite). Moreover, staff own the business, something which ensures that the right motivation is in place. “The sign that this situation has ended is often when a firm moves into smart new offices”, says one respondent.
- Several respondents said smaller managers often have access to niche products and are not forced into crowded strategies. This means that they are better able to take advantage of arbitrage opportunities. When they do operate in more liquid markets, they still retain some advantage over larger competitors as the sizes of their trades tend not to move the market, thus avoiding slippage costs.
- Last but not least, it is easier to obtain lower fees from emerging funds. We referred earlier to the “market for lemons” problem, observing that, typically, the lack of transparency, coupled with a potential inflow of new comers into the market, could result in investors being less inclined to take the chance of allocating to a small, relatively unknown manager. While emerging managers have become more, not less, popular, the lemon theory has nevertheless had the anticipated impact as far as costs are concerned: investors have been trading off lack of transparency for cost savings and have increased their presence in the market partly because it allowed them to spend less money, thus increasing the potential for yield.
Overall, the 70% of those supportive of emerging funds make for a diverse group. On the other hand, the 22.3% of those who have been rather averse to investing in emerging funds are relatively small in terms of AUM and lack the operational expertise/experience needed for hedge fund investing. This is also the case of those who dedicate only a small part of their otherwise substantial pool of investable assets to this activity.
…but with conditions attached
In spite of this positive picture of the emerging fund space, most of the respondents supportive of smaller hedge funds were quick to nuance their initial endorsement. Yes, they are keen to invest in emerging managers – and, in the case of two respondents, have made a business out of it – but they also point out the following:
- While 60% of the respondents indicated that they had not changed their processes or the time spent on due diligence, they equally admit to subtle adjustments, for instance in resource allocation. The quality of funds managing to meet investors’ expectations has gone up, due to additional checks being performed on prime brokers and an increased emphasis on corporate governance. This also means that fewer managers end up in that pool of investable start-ups, thus somewhat correcting the information asymmetry highlighted above.
- “No one trading out of their garage ever hits our inbox,” said a respondent, when asked what types of start-ups he would be more willing to invest in. Indeed, among the respondents very favourable to emerging managers, six said that they only ever invest in funds if they have known the manager for a long time, usually dating back to when the manager, or the investor, was in a previous job.
- Also, it is possible that the increased level of interest comes from a base that had dwindled over the years since the start of the financial crisis. Indeed, a quarter of those supportive of smaller managers said they had moved away from the space in the past few years and were now coming back. Included in this category are private banks and one family office.
- Finally, several investors supportive of smaller funds say that they were now prepared to lower the minimum size of the funds into which they would invest. While this may sound like good news, the numbers provided (USD100 and USD200 million, both by private wealth managers) still seem rather high for a manager starting up.
Liquid strategies, with CTA and global macro favourite
The respondents who referred to specific strategies pronounced themselves unanimously in favour of Global Macro, with 23% of the overall sample wanting more of this. This is followed by CTAs, as, again, 23% of the overall sample said they wanted to invest more in this strategy in the near future, while only one respondent (4%) wanted to hold relatively less of it.
Reasons for the rebalancing of portfolios in favour of those two strategies had to do essentially with the liquidity offered, and, in the case of macro strategies, the lack of such existing funds available through managed accounts, especially for those focusing on emerging markets.
Credit and fixed income strategies are more evenly split, with 27% of the respondents wanting more and 19% wanting less. While comments mostly referred to product liquidity (or the lack thereof) respondents were equally split among those willing to invest and those reluctant to invest in more controversial products, such as mortgaged-backed securities. Here opinions diverge about the price/value of those products and their current positions in the economic cycle.
Finally, equity long/short strategies triggered the most diverse responses, with 19% of respondents being ‘in favour’ and the exact same number being ‘against’. This result masks a size discrepancy, as the bigger and more institutional investors wanted to invest more, partly because they have recently been underweight or were late comers to investing in hedge funds (e.g. European pension funds).
For an emerging manager, the conclusion to draw from all this is probably to choose your niche carefully and be flawless from a business and operational perspective, knowing that if you are part of the happy few to make the cut, then there are opportunities out there.
Investors want more of…
…and less of
Marianne Scordel founded Bougeville Consulting in 2009 to assist alternative fund managers with their business strategy. This includes providing assistance to hedge fund managers in finding cost effective solutions to compulsory changes (e.g. those pertaining to the regulatory environment) and in enhancing commercial opportunities -- adapting products, structures, or the marketing thereof. Prior to this, she worked for Nomura and for Barclays Capital. She is an Alumna of St. Antony's College, Oxford.