Hedge fund industry to change as pension investment rises

In an Industry Outlook paper published yesterday, Moody's said the downturn and post-crisis environment had resulted in structural shifts amongst several hedge fund industry stakeholders, particularly pension funds and banks.

Although net inflows were marginal in the first half of 2010, they accelerated in Q3 (US$19bn) and Q4 (US$13bn), a trend which Moody's expects to continue in the short to medium term.

The ratings agency said the primary rationale behind this expectation is the shift in investor sentiment in light of post-crisis economic conditions and the change in conventional wisdom away from the traditional substantial allocation to equities which has historically shaped the allocation policies of institutional investors.

"This shift in thinking and the need for alpha-producing strategies in addition to investors' improved understanding of alternative investments has increased the attractiveness of hedge funds vs. traditional long-only investments," the report said.

"The size of the investment pool controlled by institutional investors is so large that even a small percentage increase in allocations to hedge funds could have a profound impact. The US pension fund industry alone controlled over $15trn, as of December 2010, according to estimates from Towers Watson, nearly 10x the size of the global hedge fund industry."

However, Moody's believes the shift to an institutional investor base poses several risks for the hedge fund industry. It predicts fund managers will need to increase their investor relations teams, improve reporting systems, adjust their procedures to meet client demands, which would likely stretch existing operational staff and result in the addition of new staff, systems and procedures.

As the composition of hedge fund investors shifts towards pension funds away from high net-worth individuals and funds of hedge funds, managers may also be forced to adopt a more conservative risk tolerance in order to attract and retain investments from institutions, said Moody's. This, in turn, could change the flexible and entrepreneurial nature of the hedge fund industry and would have far reaching consequences, it added.

Over the last two years the negotiating leverage has shifted in favour of investors and as hedge fund managers have started to focus on attracting a more institutional clientele, many have therefore had to offer better terms and in doing so had to lower their management and performance fees.

"This has affected all hedge funds (regardless of size) and even those with good performance," said Moody's. "This is a trend that looks set to continue in the near term.

The report also predicted the rise of managed accounts. In 2010, several large institutional investors announced that they would be investing in managed accounts offered through large platforms rather than investing directly. Although managed accounts represent a fraction of the total hedge fund industry size, Moody's believes the trend is set to continue in the short term given their perceived advantages, such as independence, transparency and liquidity.

However, the report concluded the proliferation of managed accounts as a major mode of investment in hedge funds also poses a number of risks, such as concentrating operational risks into fewer counterparties (in the case of the large platforms), increasing the expense of managing investments and causing further fragmentation in the hedge fund industry.

Meanwhile, in a separate report evaluating the asset management industry as a whole, Moody's said it revised its outlook to stable from negative. The ratings agency said asset managers have improved their earnings capacity and strengthened their balance sheets. There has also been more clarity around regulatory reforms and the stability of the capital markets, said Moody's.

"The earnings picture for asset managers has much improved since last year," said vice president and co-author of the report Robert Callagy.

Dagmar Silva, vice president and co-author added: "Moody's-rated asset managers' balance sheet strength appears to be at or near an all-time high. We expect these managers to take a slightly more conservative approach to capital management in the post-crisis environment, and hold more cash on the balance sheet."

However, Moody's said managers still face some headwinds including weak organic growth, pricing pressure resulting from regulation and competition; and "investors' heightened sensitivity to unexpected events, such as the recent developments in the Middle East and Japan".