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All in pursuit of short supply alpha

Date: Monday, February 11, 2008
Author: Pauline Skypala, FT.com

The people who run funds of hedge funds routinely comment that there may be 15,000 hedge funds on the market, but only 150 or so make the grade. Presumably they are not the same 150 across the board, or the performance of funds of funds would be within a small range. Presumably, also, the qualifying 150 change over time, given that another standard observation is that hedge fund performance deteriorates after about three years.

But that still leaves only a relatively small proportion of the available hedge fund universe judged to be of sufficient quality by those in the know. Who judges the fund of fund managers? Is the ratio of quality to quantity a similar one? These are important questions judging by the opinions expressed in a survey by Watson Wyatt, in association with the Financial Times.

The survey (the results of which can be viewed at www.watsonwyatt.com/2020Vision ) revealed a strong expectation that institutional investors will favour absolute return products over the next decade or so, with nearly 75 per cent of that opinion. The same proportion takes the view that institutions will show an increasing appetite for products that can produce alpha, or skill-based outperformance, due to the need for higher returns. The two are strongly related, of course, as absolute return funds are largely in the hedge fund sector, and although hedge funds do not have a monopoly on alpha production, they are often seen as a key source.

But if there is one thing about alpha that most managers agree on, it is that it is in short supply. That supply is unlikely to increase in response to rising demand. Instead, as with anything in short supply, the price will rise. Survey respondents acknowledge this, with nearly 70 per cent agreeing the talent shortage will continue, and a similar proportion forecasting rising compensation for the best fund managers.

If the respondents (485 asset managers, institutional funds and other financial services practitioners) are correct, the outlook is for an expanding absolute return sector, a deterioration in aggregate returns from that sector, higher prices for top alpha producers, and a lot of disappointed investors.

It is the herd instinct at work again in the pension fund industry.

It is understandable that pension funds should turn to the absolute return sector, perhaps wearied of the volatile returns from the relative return industry. But will they be buying a reliable source of return or a myth? Well-resourced funds may be able to chase down the elusive alpha, with help from their advisers. Smaller funds might do better to focus on using cheap beta, or market return, strategies to meet their return needs. Survey respondents appear to take on board the need for better governance to pursue alpha. Nearly 80 per cent say institutional funds should spend more on internal governance resources over the next 10 to 15 years.

This should be music to the ears of Roger Urwin, global head of investment consulting at Watson Wyatt, who maintains that pension funds would get more bang for their buck if they spent it on internal expertise rather than expensive external fund managers.

But it appears another development he is pushing, for pension funds to use their collective clout to push down investment management costs, is less likely. Over half (55 per cent) of survey respondents think this should happen, but only 40 per cent think it will.

Turkeys do not vote for Christmas, of course, and as 57 per cent of respondents were asset managers, perhaps it is not surprising they prefer to believe they can continue to charge high fees.

There is no sign that more difficult market conditions or poor sector performance will put pressure on fees. Indeed, the move seems to be in the opposite direction, if a fund launched last week is any indicator. Alternative asset manager Managing Partners Limited is charging a 50 per cent performance fee on gains above 10 per cent on its British Property Opportunities Fund, which aims to take advantage of discounts appearing in the UK commercial property market due to forced sales.

The managers will use up to 70 per cent leverage and say the fund "could produce high returns in a very short time". They will do very nicely if it does.

At the opposite end of the spectrum, State Street Global Advisors has launched a diversified beta strategy expected to return about 7 per cent a year, net of the 35 basis point annual charge.

It provides passive exposure to hedge funds (via a replication strategy), property, commodities, equities, infrastructure and other asset classes.

The choice and sophistication of beta products is increasing fast. It is an area investment banks are keen on as well as the big quant houses such as SSgA and BGI. Pension funds should take a close look at whether such products fit their needs.

One step the survey is pretty sure pension funds will not be taking is to hand over their assets and liabilities to a buy-out or run-off vehicle. Only 18 per cent think most defined benefit funds will go that way. However, nearly a third do not express an opinion, so the jury may still be out on this.

The survey was done before the UK's Accounting Standards Board came out in January with proposals to discount DB scheme liabilities at the risk-free rate, rather than an AA corporate bond rate. If the idea is adopted, scheme sponsors may view buy-out as a better option than the pursuit of uncertain alpha.