Hedge fund industry could become the investment banks of the future

Date: Tuesday, January 20, 2009
Author: Carol Lewis, Times Online.co.uk

Mark Twain said that visiting a fortune-teller “was just as good as going to the opera, and the cost scarcely a trifle more — ergo, I will disguise myself and go again”. But he was visiting a clairvoyant at the height of 19th-century America; today in Britain, he'd be as likely to find himself talking to a hedge fund manager if he was seeking enlightenment about the future — and it might not be as much fun, either.

Hedge fund managers have made a healthy living in the past from predicting trends, but it is a precarious business at the best of times, and now is not the best of times. Few are willing to put money on what will happen to their industry in the future. True, despite 2008 being the worst year on record for the industry, they are bullish, claiming that it will survive and, in the long term, flourish, but after that things get complicated. There are almost as many opinions on how the industry will need to change to achieve this as there are investment strategies.

Most commentators agree that there will be changes. Many believe that there will be more large multi-strategy funds as hedge funds consolidate. Stuart McLaren, partner in the investment management group at Deloitte, believes that hedge funds will merge to cut costs and reduce exposures associated with single- market strategies. “We will probably see hedge funds becoming more like the investment banks of old, having a number of different trading strategies probably set up in such a way that there are effectively many funds or trading desks within the hedge fund,” he said.

Rob Mellor, head of financial services markets for tax at PricewaterhouseCoopers, also suspects that hedge funds might be the investment banks of the future: “Those that are going to survive are the large institutions - there appears to be a flight to capital and the bigger institutions and the bigger funds because they are already perceived as having the bigger infrastructure in place that is going to help them to manage this market.”

Most people expect the industry to come under more scrutiny. Mr McLaren said: “I'd expect to see a lot more visits from the FSA to hedge funds and [a need for it] to understand their trading strategies in a lot more detail. If the FSA thinks there is a particular risk, it could make [the funds] hold more capital and put in place better governance arrangements.

“Your typical hedge fund has one, maybe two, domineering individuals who are running it. We will probably see the FSA start asking: what independent oversight do you have? Do you have non-executive directors? Do you have an internal audit function? Do you have a really strong risk and compliance function? And I think they will start pushing some of those things to cover themselves but also to add that element of supervision within the business that may not have been there in the past.”

Julian Young, partner and leader of the European hedge fund practice at Ernst & Young, thinks that investors are starting to look for “depth of talent” in hedge fund organisations - they no longer want their funds to be managed by only one or two star traders; they want the safety of knowing that if one fund manager isn't performing, their money will still give them returns.

Yet this does not spell the end of the hedge fund boutique. According to Andrew Baker, chief executive of the Alternative Investment Management Association (AIMA): “The industry will split [between large funds appealing primarily to institutional investors and boutique funds appealing mainly to high-net-worth individuals]. The squeeze will come in the middle area - someone who is not quite a boutique but not quite big enough to be able to appeal to an institutional investor.”

Almost all commentators expect to see a number of small boutiques set up when the markets begin to calm, possibly as early as the end of this year. Mr Mellor said that bailed-out banks were likely to abandon some fund activity as they become more conservative, which could lead to some proprietary or structured trading desk staff leaving to set up their own boutique funds.

Mr Baker also predicts that the hedge fund market will split by investment strategy - those that will follow highly liquid strategies and those that prefer semi-closed funds or funds with much stricter redemption policies. “It might be difficult to do both under one roof,” he said. This would be accentuated if, as some expect, regulation is introduced to prevent “strategy drift” - funds will have to stick to the strategy agreed at the outset with an investor.

Another trend that is emerging is the need for segregated accounts. In the past, Mr Young said, institutional investors may have invested via funds of funds “a model, which if not broken, will need a significant overhaul”. They may now go directly to the hedge funds but ask for their funds to be managed in the same way, but separately, from the main fund - giving them greater transparency and control over their money.

He adds that another trend is for hedge fee structures to change from traditional management and performance fees, based on the unrealised value of the investment, to performance fees charged on realised profits or where private equity-style hurdle rates are introduced.

Despite news of growing redemptions and shrinking funds, the hedge fund industry is alive and kicking - and adapting. To paraphrase a certain Mr Twain, reports of its death have been grossly exaggerated.

Case Study: Survivors will be small, nimble niche players

Adrian Paine, founder, and Guy Wolf and Jonathan Chamberlain, principal partners of Oxburgh Partners, the hedge fund, believe that the industry's losses this year will lead to “smaller, more nimble funds chasing returns that beat the market”.

“Those surviving hedge funds will go back to how hedge funds were 20 years ago: small, niche players who have their own capital invested with clients and are very focused on making money rather than management fees,” Mr Paine said. “Almost a small private bank, not obsessed with growing the asset base but obsessed with performance and making sure that clients make money.”

Mr Wolf said: “The larger you become as a fund, the harder it is mathematically to diverge away from benchmark performance. Hedge funds were traditionally niche operators trying to beat the mainstream, but if you are the mainstream, it is very, very difficult to beat it.”

The partners attribute the success of their flagship Dowgate fund, a European equity long-short fund, which is up 26.16 per cent since its inception

in November 2007, to their high-liquidity strategy of trading in assets such as futures. Mr Paine said: “We invest only in liquid assets, things we can sell relatively quickly, should we need to, which means we can make a decision and actually follow through with it rather than making a decision and then spending the next month trying to put it into action.”