How has the era of institutionalisation impacted the hedge fund industry? Patrick Ghali, managing partner and co-founder of alternatives-focused investment consultant Sussex Partners – which marks its 20th anniversary in 2023 – offers his insight.
- The institutionalisation of hedge funds has had pros and cons for allocators
- Investors today benefit from far greater protection and better transparency
- But managers have less appetite for risk, often leading to mediocre returns
By Patrick Ghali
Managing Partner, Sussex Partners
While much has changed over the past 20 years in hedge funds, it is clear that the industry is here to stay and that it has established a firm place for itself in investors’ portfolios.
The much-anticipated melding of the alternative and traditional asset management worlds has perhaps not progressed to the extent imagined 20 years ago, however the advent of UCITS funds in Europe and the popularity of 40Act funds in the US has certainly helped to broaden the investor base for hedge funds over the past two decades.
For better or for worse the industry has become a lot more institutionalised compared to what it looked like before the Global Financial Crisis (GFC).
For better because investors today benefit from far greater protection than was the case back then and are generally treated much better by managers than they used to be. Gone are the days when all that investors could hope for was an annual account statement with scarcely any explanation of how performance was achieved. Instead, investors today benefit from greater transparency improved liquidity and a more robust operational infrastructure to manage and look after their assets.
For worse because as the industry has become much more institutional in character, this has led to some managers growing beyond their ability to generate consistent alpha, and to diminishing the risk-taking ability of managers catering to institutional asset pools, thereby “clipping their wings” and resulting in generally lower volatility and mediocre returns as a result.
The maverick investors of old have been replaced in many instances by investment committees, and while that has led to more predictable returns, it has arguably removed one of the reasons that hedge funds were originally attractive.
A profound shift
The drive towards a more institutionalised industry has equally led to some well-known and previously high performing managers deciding to return outside capital once they had reached a certain size, converting to become family offices and running capital free of external constraints to the ultimate detriment of allocators which have lost out as a result on attractive investment opportunities.
This is by no means to say that the whole industry has become bland and unattractive to investors, but rather that there has been a profound shift, and it has become more challenging to find the return profiles of the “old” hedge fund industry. Investors are having to work harder in many ways due to this shift, to look outside the well-trodden paths and invest a lot more time and effort if they want to generate outperformance rather than just low/safe/uninspiring returns.
The rise of Asia as an alpha market for hedge funds is one such area where returns reminiscent of the “good old days” can still be found. Once considered exotic markets with operationally inferior managers, where it was almost possible to count the number of Asian managers on one hand (Morgan Stanley only held its first Asian Hedge fund conference in Shanghai in 2004), Asia today is a firmly established part of the hedge fund universe with a vibrant industry and ecosystem. Allocators now understand and appreciate the alpha opportunities presented by Asian markets compared to the US and Europe and ignoring Asia’s returns potential can be a mistake.
One of the biggest ironies of the last 20 years, again a result of institutionalisation of the industry, is the demise of funds of hedge funds (FoHFs) and the seemingly unstoppable rise of multi-strategy hedge funds in their wake. Perhaps this is the logical evolution of the FoHF model, though looking at their typical set up, liquidity terms and fees, it seems odd that investors have embraced these to the extent that they have while at the same time criticising FoHFs for many of the same features.
The liquidity spectrum
Another perhaps inevitable development of two decades of hedge fund evolution has been the bifurcation of liquidity requirements (very liquid UCITS at one end and private equity type structures at the other end of the spectrum), although the jury remains out on whether this makes as much sense as investors seem currently to believe it does.
Whether hedge fund strategies should ever be run in a daily liquidity format, and whether locking up capital in strategies which have performed dismally in low liquidity periods, such as during the GFC, is the best course of action has yet to be seen.
Investors perhaps put too much value on the benefits of Instant liquidity, allowing them to “add value” by trading managers. Perhaps even worse though is the allure of reporting seemingly steady returns through “volatility washing” which is particularly evidenced by asset flows into the more illiquid part of the spectrum.
It will be interesting to see what the next 20 years will bring. Inevitably AI will play a significant part within the industry. Whether human traders will be able to outcompete machines in the future will be intriguing to know.
Asia will continue to grow its share of the pie and become an even more entrenched part of the industry, and we may see a further merger of traditional and alternative asset managers and approaches. It never made much sense that some investors had the benefit of an extended tool kit whereas others were constrained to using nothing but the bluntest of instruments.
The industry will certainly continue its push into retail channels, though whether the current trend for illiquidity can continue unabated remains to be seen. What is unlikely ever to change is the dynamic nature of the global hedge fund industry, that there is something new to be learnt every day, and that it never dulls.
Patrick Ghali is Managing Partner at Sussex Partners, an alternatives-focused investment consultant. He co-founded Sussex Partners in 2003.
