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Maturing hedge fund industry must shift gears to grow institutional business, says SEI

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As hedge funds increasingly look to the institutional market for asset growth, they must equip themselves to fit the high expectations and conservative attitudes that characterise institut

As hedge funds increasingly look to the institutional market for asset growth, they must equip themselves to fit the high expectations and conservative attitudes that characterise institutional investors, according to a white paper published by SEI entitled Five Critical Challenges for Hedge Funds Taking Aim at the Institutional Market.

Hedge fund assets under management have been growing at a compound annual rate of 26 per cent since 1990, the paper’s authors note, with much of that growth coming from the institutional market.

‘To maintain that growth trajectory, the hedge fund industry will need to branch out from its traditional high net worth, foundation, and endowment clientele to serve the broader institutional market,’ says Paul Schaeffer, managing director of strategy and innovation for SEI’s investment manager services division.

‘But to compete for those assets, the industry must recognise that large institutions have a distinct set of demands concerning issues such as the quality of infrastructure, transparency and risk.’

Based partly on a survey of more than 100 institutional investors by SEI and research firm Infovest21, the SEI analysis details growing institutional acceptance of hedge fund investing. Forty-seven percent of the institutions surveyed said they already invest in hedge funds.

Within that group, 73 per cent of pension plans and 55 per cent of institutions overall said they had increased hedge fund allocations over the last few years. Portfolio allocations to hedge funds averaged 30 per cent for endowments, 13 per cent for pension funds, and 24 per cent for other institutions.

At the same time, institutions expressed continued concerns with hedge fund investing. Headline risk was named by 37 per cent of survey respondents as their biggest worry, followed by lack of transparency (19 per cent) and poor performance (15 per cent). Institutions also remain cautious in selecting hedge funds, the survey found, devoting an average of seven months to due diligence and 12 additional weeks to approval.

The paper identifies five challenges hedge funds should address in order to attract more institutional assets, starting with the need to demonstrate institutional-quality infrastructure and operations.

Infrastructure was ranked the top criterion in hedge fund selection, named as most important by 46 per cent of survey respondents, while 54 per cent of these said it was because ‘better managed firms produce better returns’.

The quality of fund administration is a prime concern. Of those respondents most concerned with infrastructure, two-thirds described it as unacceptable for funds to handle their own administration internally, while half demanded a ‘big-name’ administrator; 81 per cent said they took steps to verify that hedge fund investments were valued independently.

The second challenge for hedge fund managers is to meet investor demands for reporting and transparency. Lack of transparency was the second most commonly cited concern with hedge fund investing, with 19 per cent of institutions ranking it as most important.

This concern was greatest at strategy level, with 85 per cent of respondents saying they would not invest in a strategy they did not fully understand. More than half said they sought portfolio transparency at the industry or sector level, while one third were most concerned with the transparency of the investment process. However, only 11 per cent said they sought transparency regarding specific investment positions.

The third challenge identified by the paper is to build stable management teams with a full range of skill sets. Interviewees ranked ‘people at the firm’ as the third most important factor in hedge fund selection, surpassed only by firm infrastructure and performance.

Other survey responses revealed that investor concerns with hedge funds’ organisational stability and staffing are not confined to those making investment decisions, but cut across all key management and support positions.

The fourth challenge is to shift focus from performance to investment disciplines. Institutions are as concerned with investment process and risk profile as they are with the level of absolute returns, the survey revealed.

Interviewees ranked ‘consistent, stable return’, ‘uncorrelated returns’ and ‘high risk-adjusted returns’ as more important objectives than high absolute returns. Seventy-two percent of interviewees said the investment strategy, rather than performance, is their starting point for hedge fund selection.

The final challenge, SEI says, is to keep abreast of public policy and regulatory trends. Citing ongoing deliberations over hedge fund-related regulation, tax policies and accounting rules, and investor concerns with headline risk, the paper urges the industry to ‘commit whatever resources are needed to ensure that hedge fund managers meet the highest possible standards for their overall compliance and general business practices.’

‘The take-away message is that institutions clearly prefer to do business with institutional-style organisations,’ Schaeffer says. ‘For hedge funds, the challenge will be to fit the profile of an institutional-quality fund while preserving the performance attributes that attracted major investors in the first place.’

The white paper is published by the SEI Knowledge Partnership, which provides ongoing business intelligence to the firm’s investment manager clients. The investment manager services division provides operations outsourcing solutions to managers of mutual funds, hedge and private equity funds, separately managed accounts and institutional client services.

Based in Oaks, Pennsylvania, SEI is a global provider of outsourced asset management, investment processing and investment operations solutions to corporations, financial institutions, financial advisors, and affluent families. At the end of last year, SEI administered USD426bn in mutual fund and pooled assets and had USD197bn in assets under management.

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