Institutions committed to hedge funds but the message is clear: more information please

Date: Monday, February 27, 2012
Author: HedgeWeek

Following the publication of Part 1 of SEI’s The Shifting Hedge Fund Landscape report last month, Part II of the report, officially released 27 February, continues to reinforce the message that despite facing tough performance headwinds in 2011, institutional investors remain committed to investing in hedge funds.

To read Part II of The Shifting Hedge Fund Landscape click here
But there are certain conditions that investors now expect managers to meet.
Whilst meeting performance expectations was found to be the top challenge facing investors in Part I, Part II finds that 51 per cent of investors cite lack of transparency as their biggest concern. More Information on how a fund strategy works is no longer just a ‘nice to have’ for investors – increasingly they’re insisting on it. The survey found that 64 per cent of investors want managers to communicate with them on a monthly basis.

In addition, 31 per cent and 22 per cent of investors respectively cited ongoing liquidity risk and leverage as other key concerns: perfectly understandable in the context of last year’s head-spinning market volatility.

Ross Ellis (pictured), Vice President, Knowledge Partnership, Investment Manager Services at SEI, says that as the industry matures investors want to better understand complex trades/strategies. “Investors want to talk more to the portfolio manager to understand the market conditions under which a particular strategy works, much like they do in the long-only world. Stand-alone trade blotters aren’t that helpful. Investors want more information before writing tickets today.”

Small and mid-sized managers need to be more open and transparent to compete with multi-billion dollar fund managers who know exactly what investors want and have the institutional-grade infrastructures to attract inflows. One of the recommendations that Ellis and his colleague David Mumford, Director of Research at the Knowledge Partnership, Investment Manager Services at SEI makes, aside from creating more opportunities for dialogue and focusing on clearly articulating their investment strategies, is that they focus on making operational improvements.

The report finds that 60 per cent of investors think there’s too much similarity among hedge fund strategies. Mumford, though, wasn’t too surprised by this: “There are a lot of similar-looking funds out there. Portfolio managers are leaving established hedge funds where they know the strategy works well and setting up the same strategy for themselves. It’s what they’re familiar with.”

Adds Ellis: “Investors find long/short equity reasonably easy to understand but managers have to have the mindset of ‘Why am I different from everyone else?

What’s the compelling reason why an investor would select me over my competition’? They have to try even harder to differentiate themselves otherwise investors will always go with bigger well-known managers because they are the ones they’re already comfortable with.”

Given that 57 per cent of the survey’s respondents said they wanted details on leverage, 46 per cent on valuation methodology and 41 per cent on risk analytics, the message coming out of Part II is simple: more information is needed.

Prior to 2008 managers gave out information reluctantly. In that sense they held all the aces. This report is perhaps telling us that that is no longer the case. As Ellis points out: “The investor base is clearly getting more experienced and sophisticated but it’s a bilateral relationship, not one-way. The Newton Cradle is a good visual – when the investor speaks the manager reacts and vice-versa.”
Understanding risk was the fifth biggest challenge facing investors – whilst this may not sound significant, only one out of five respondents felt that managers actually did a good job of risk management. Tellingly, half of respondents sat on the fence. 58 per cent identified risk of management infrastructure as their third key factor when selecting a manager.

To illustrate the disconnect between managers and investors, Ernst & Young’s Nov 2011 global hedge fund survey found that those managers not chosen by an investor gave risk management the lowest ranking. “Although managers are getting better at understanding their investors they still don’t understand how important risk management is to them,” says Ellis.

Another revealing statistic is the apparent willingness of institutions to consider emerging managers. Nearly a quarter said they’d consider managers with a one to three-year track record, with a significant 49 per cent disagreeing that smaller emerging managers had no place in their portfolios. Investors are open to new ideas so the onus is on these guys to show what they’re made of.

“Some of these managers have got the pedigree having already worked for established hedge funds. They’ve got the chance of becoming the industry’s new stars provided they do the right things,” says Mumford. “Given their backgrounds they have a head start but they need to meet institutional standards to attract institutional money.”

When asked what is the key message to come out of the report, Ellis says that managers should see today as an opportunity. The time is ripe given the volatility in equity markets and falling bond yields.

“But investors seem to be saying ‘If I invest I want to get value for my money, I’m going to ask for lower or gradated fees and I want to talk to the portfolio manager more frequently’. Investors have indicated they want to invest in hedge funds but with lack of clarity, liquidity and risk management being key concerns, managers need to increasingly play by their rules.”

As Mumford sums up succinctly: hedge funds are here to stay, no question, but investors want more information.