OFA: Investors bullish on hedge funds

05 Mar, 2014

Investor interest in both large and small hedge funds, not to mention managers running liquid alternative strategies is set to grow exponentially, it has been said.

“We are seeing a growing number of multi-billion dollar hedge fund launches coming to market – at levels not seen since 2005. We are also seeing more and more investors such as pensions and endowments actively looking to allocate into smaller hedge funds,” said Joel Press, founder of Press Management, a consultancy, speaking at the Operations for Alternatives Conference in Palm Beach, Florida.

Institutions have piled capital into the largest managers over the last few years although this concentration in bulge bracket organisations appears to be subsiding. A survey by Preqin found 57% of investors would allocate to hedge funds running between $1 billion and $5 billion in 2014. That same Preqin survey highlighted hedge funds managing in excess of $5 billion had the lowest proportion of investor interest indicating allocators have less enthusiasm for putting money to work at the industry behemoths. Investors are also more open to smaller managers with 52% of allocators planning to invest in hedge funds running between $100 million and $500 million in Assets under Management (AuM). Forty-two per-cent of investors told Preqin they would consider a hedge fund with less than $100 million in AuM.

“Following the financial crisis, investor assets were concentrated in the largest hedge funds. Today, approximately two-thirds of money went to the $5 billion plus managers whereas before it was about 80%. There is an opportunity for greater dispersion regarding the allocation of capital into hedge funds,” commented Paul Roth, founder of Schulte Roth & Zabel (SRZ).

Overall, hedge fund AuM is expected to reach $3 trillion by the end of 2014, up from $2.6 trillion in 2013, according to the Deutsche Bank Global Prime Finance Alternative Investment Survey in 2014. This number is based on investors’ predictions of $171 billion in net inflows at hedge funds and performance-related gains of 7.3%, representing an additional $191 billion in capital. The majority of these inflows will be driven by institutional investors. The survey, which polled 400 investors with more than $1.8 trillion in hedge fund assets, found nearly half of institutional investors increased their hedge fund allocations in 2013 and 57% plan to increase their exposure over the course of 2014. It added institutional investors now account for two thirds of industry assets compared to one third before the financial crisis.

Enthusiasm for liquid alternatives such as ’40 Act hedge funds remains high, the panellists added. “More money was invested in mutualised hedge funds last year than in private hedge funds. We saw approximately $90 billion go into alternative mutual funds last year compared to $70 billion flowing into the private market,” added Roth.

Roth highlighted one of the key investor targets among managers running regulated alternatives was the Defined Contribution (DC) pension plan market. A report by SEI said 60% of the DC plan market’s $5.1 trillion in assets were parked in mutual funds, adding this investor class had historically been averse to alternatives. Nonetheless, the report added plan sponsors had become emboldened and were increasingly investing in real estate, inflation protected treasuries and commodities in search of greater yield.

A number of service providers are bullish on the future of liquid alternatives.  Citi Prime Finance said it expected $939 billion of the $12.8 trillion in retail assets available to flow into liquid alternatives by 2017. Meanwhile, McKinsey & Co estimated retail assets had grown by 21% annually since 2005 with the sector now managing around $700 billion. PricewaterhouseCoopers (PwC) recently predicted assets managed by alternative investment strategies could reach $13 trillion by 2020, an increase from $6.4 trillion in 2012. The PwC study said this growth would primarily be driven by greater investor interest in retailised alternative strategies, namely regulated alternatives in the US and UCITS in Europe.  

Several brand name private equity shops and hedge funds, most notably AQR, Blackstone and Apollo Global Management have recognised the potential opportunities available with regulated alternatives, and developed vehicles aimed at retail, with minimum investments as low as $2,500 in some cases.   AQR has been one of the biggest enthusiasts for retail alternatives, having launched 20 mutual funds which are now running $9.2 billion.

Nonetheless, ’40 Act hedge funds are not without their challenges. While the distribution benefits are hard to falter, 40’ Act hedge funds are subject to onerous restrictions. The absence of leverage (capped at 33% of gross assets), lack of performance fees (with a management fee of between 70 bps and 1%), restrictions on investing in illiquid assets (capped at 15% of AuM), rigorous corporate governance standards and mandatory third party custody will all lead to higher compliance costs, at a time when profits are rapidly receding. These costs could also make it unsustainable for smaller hedge funds to launch regulated products.

However, challenges do remain for hedge funds as an asset class as a whole, with many experts expressing concern as to where the next generation of managers will come from.  “We do not see many mutual fund managers leaving to join hedge fund managers – something which was common in the past. Where are the new hedge fund managers coming from in this post-Dodd-Frank environment? They are certainly not coming from the proprietary desks run by Goldman Sachs or Morgan Stanley, for example,” said Press. 

OFASchulte Roth & ZabelPress ManagementPreqinPwCliquid alternativesCitiSEIDC plans