For hedge funds, it’s survival of the biggest

Date: Wednesday, March 25, 2009
Author: Hilary Potkewitz, Crainsnewyork.com

The future of hedge funds may not be as bleak as thought—as long as a hedge fund has at least $1 billion in assets under management.

Deutsche Bank’s annual Alternative Investment Survey, released Tuesday, reveals what can only be called mass optimism among investment professionals in a field that has been pummeled over the past year.

Industry-wide losses averaged 20% last year, yet 40% of the survey’s 1,000 respondents expect their portfolios to post 5% to 10% gains this year. More than 80% believed their fund performance would end the year on a positive note of some kind.

“The key finding here is that the hedge fund industry is more resilient than most articles lead you to believe,” said Barry Bausano, co-head of Global Prime Finance for Deutsche Bank.

But the future won’t prove resilient for everyone. According to the bank, “size is becoming increasingly important” in hedge fund investing, leading to a “premier league” of “fewer funds with higher quality managers,” as smaller fries succumb to investor redemptions.

Indeed, more than 50% of the investors in the Deutsche bank survey say they’ll only invest in funds with $1 billion or more in assets under management, while just 25% of investors say they’d choose funds in the $500 million to $900 million range. That’s a big change from the 2006 survey’s results: Just 35% of respondents back then preferred $1 billion-plus funds and another 33% were content to invest in funds managing $500 million to $900 million.

“It means that smaller hedge funds will disappear,” observes Andrew Ang, professor of finance and economics at Columbia University’s business school. Bigger funds are in a better position to have good risk management and can borrow more cheaply, he points out, and are more likely to have a track record.

“There is a magic number where economies of scale really kick in,” Mr. Ang adds. “It’s at about $2 billion to $3 billion. With funds smaller than that, it’s much harder to get significant rewards.”

One of the more telling changes in the collective consciousness of investors can be traced directly to the Bernard Madoff scandal: The so-called ‘pedigree’ of a fund manager is no longer among the top-three criteria investors use in assessing a fund manager, according to the survey.

In past years, hedge fund investors revered the so-called 3Ps—performance, philosophy and pedigree—when selecting a fund manager. Yet Mr. Madoff’s spectacular fall from grace proved that a solid pedigree can prove meaningless. In this year’s survey, “risk management” entered the ranks of the top three selection criteria (for the first time), and “pedigree” fell to a distant fifth.

“This is a performance-driven industry,” said Scott Carter, head of the Hedge Fund Capital Group at Deutsche Bank. “People are not going to keep their money with you because they think you’re a really great guy.”

The survey also predicts that investors will withdraw a further $200 billion from hedge funds this year, which would bring total assets in such funds to $1.3 trillion, from the current $1.5 trillion.

More than 36% of investors think U.S. and Canadian investments will perform the best in 2009, while nearly 25% believe Eastern Europe will perform the worst.

In addition, 44% of the money managers polled said they will be investing in China in the coming year.