Opportunities and Challenges for Hedge Funds In the Coming Era of Optimization

Citi GPS Opinion Article

By all metrics the hedge fund industry is thriving, with assets having attained new record highs, and our outlook is for growth to remain strong. By 2018, we forecast core hedge fund industry assets under management (AUM) to rise to $4.81 trillion — an increase of 81% from the $2.63 trillion noted at the end of 2013.

Institutions will account for 74% of those assets as these investors expand their use of hedge funds in risk-aligned portfolios and as they start to rely increasingly on the advisory relationship provided by leading hedge fund managers in support of the institution’s holistic portfolio, direct and co-invest programs.

We also see a new tier of hedge fund investors becoming an entrenched part of the market — the retail investor. Demand for “40 Act” alternative mutual funds[1] is surging with net investor flows into these products at $95 billion in 2013 versus only $67 billion into the entire global hedge fund industry. We see AUM in these products (excluding alternative ETFs) rising from $261 billion at the end of 2013 to $879 billion by 2018. Dynamic growth in this area should spill over and help support growth in alternative UCITS[2], where we see AUM doubling from $310 billion in 2013 to $624 billion by 2018.

Publicly offered funds will therefore offer a further $1.5 trillion in additional alternative industry assets. Today, our forecast is that 50% of those assets are being advised by managers also running hedge fund products. By 2018, we forecast that figure will rise to 65%.

In addition, we see the total pool of capital being advised by hedge fund managers rising from $2.9 trillion in 2013, of which $286 billion — or 10% — is being managed on behalf of the retail audience, to $5.8 trillion in 2018, of which $977 billion — or 17% — will be managed on behalf of the retail audience.

Key Investor Trends Following the Global Financial Crisis
The majority of changes occurring in the hedge fund industry in the five years since the Global Financial Crisis (GFC) have stemmed from the emergence of risk-averse institutional investors as the dominant source of capital. In tracking this evolution over the course of our past four industry surveys, we have laid out a number of key themes that we revisit and update in this fifth annual report. (Citi Investor Services Annual Hedge Fund Survey May 2014)

With the benefit of hindsight, we are also able to position these trends within a broader framework. We now see the past five years as a period in which there have been three key changes in the strategic imperative driving the industry.

Survive
In the immediate aftermath of the GFC, the industry imperative was to “Survive.” Several structural flaws were uncovered in the events of late 2008 and early 2009. Addressing liquidity mismatches, transitioning to a more transparent investor-manager engagement model, eliminating adjacency risks, ensuring better alignment of fees and terms, and creating a robust culture of oversight were all activities required to ensure investor allocations and position the industry to rebound from the dramatic losses and issues that surfaced in that period.

Diversify
As a more stable structure took hold, the imperative changed. Participants looked for ways to “Diversify” their risks and create a more robust and resilient environment. There are three main diversification themes that we highlight in this year’s report that show how different today’s industry is from the one most participants were familiar with pre-2008.

The first diversification trend involves institutional investors moving from a singular “hedge fund” exposure to a more nuanced approach where hedge fund strategies fall into different categories based on their transparency, liquidity and directionality. Those exposures that have more embedded beta are being repositioned in many investors’ portfolios to provide “shock absorption” against potential downside and excessive volatility. This is part of a broader shift in investor portfolio configuration that focuses on better managing and balancing portfolio risks after many institutions saw their historical “60/40” portfolios move almost one-for-one with the underlying equity markets in the GFC.

* Our analysis shows that hedge fund AUM now represents $1.72 trillion or a post-GFC high of 10.2% of the record $16.92 trillion in institutional assets invested across mutual funds and hedge funds. This is up from 9.4%, the previous record high level of assets noted in 2012. This increase in hedge funds’ share of total institutional investments occurred in 2013 despite hedge funds themselves having significantly underperformed the major equity indices. This illustrates the growing use of these instruments as a risk tool in investor portfolios.

The second diversification trend we identify is the shift to multiple tiers of investors, each focused on a unique hedge fund segment, and the growing divergence in the profile of hedge funds that align to each of those tiers.

* Boutique Hedge Funds & Direct Institutional Allocators: Pension allocators choosing to select their own hedge funds and allocate capital directly to those managers became major drivers of the post-GFC landscape and remain a critical audience. These direct allocators affirmed their “sweet spot” of targeting managers just coming through the $1.0 billion AUM institutional threshold but not having grown much beyond the $3.0 – $5.0 billion AUM band that we first wrote about back in 2011. These investors also continued to cite hedge funds in this AUM zone as best positioned to absorb large $100 million-plus ticket size, deploy capital nimbly and be willing to build their advisory relationships with the allocators.

* Franchise Hedge Funds & Consultant-Led Institutions: Large pension and sovereign wealth funds supported in their hedge fund manager selection by industry consultants have focused on the industry’s largest firms in the post-GFC years — helping to drive the average allocation for these firms with greater than $5.0 billion AUM up by 127% between 2008 and 2013. While criticized by many as asset gatherers, these firms have instead used their size to create market-leading platforms that offer investors robust risk and portfolio reporting, highly tuned collateral management, far-flung research listening posts in emerging and frontier markets and a robust platform of trading talent. These firms have very much become “franchise” names with global clout and influence.

* Gen-2 Portfolio Manager Funds: Because many of the founders of these franchise level firms are now approaching the years where they may be considering retirement, and since several brand name hedge funds have opted to give back investor capital and instead operate as a family office, investors have been keenly focused on the new set of second generation — or “Gen 2” — portfolio managers coming out of these franchise firms. These individuals are typically exiting with the full support of and oftentimes a capital stake from their former employers and have large amounts of personal wealth to use to establish their own firms. They are launching near or even above the $1.0 billion AUM institutional threshold and the rush to lock in capacity with these emerging organizations is reminiscent not of the post-GFC capital-raising environment, but of the pre-crisis years.

The third diversification trend we have identified and that we update in this year’s report is the emergence of a completely new investor tier — retail-oriented financial advisors looking to place their clients that cannot qualify for the accredited investor status required to participate in a private fund vehicle into publicly traded funds, particularly “40 Act” alternative mutual funds, run by traditional hedge fund managers.

* The speed of growth in these strategies exceeded even our most optimistic forecasts. Indeed, we note in this year’s report the near identical growth pattern for these products between 2006 and 2014 and for the hedge fund industry itself between 1990 and 1998. Since the hedge fund industry went on to more than double in the next 5 years and then more than double again in the following 5 years, the similarities in trajectory between these products will be an ongoing focus of attention for the industry through 2014 and beyond.

Optimize
Having used our anniversary issue to update trends that we have been following to some degree for the past four years, we were interested to see in just how many aspects the strategic imperative is shifting once again in the hedge fund industry from “Diversify” to “Optimize.”

For the industry’s largest participants, this optimization is taking the form of a blurring of lines between investors and hedge funds. Many of the leading institutions that invest into the hedge fund market have built their own asset management organizations in recent years. In line with that move, these investors have also developed robust risk and portfolio management platforms that are allowing them to run factor analysis and trade overlay analysis on position level information being fed to them by their set of hedge fund managers.

This is allowing some investors to co-invest into securities and to directly invest into markets alongside their hedge fund counterparts. These participants are helping to fill a market-making and lending gap emerging on the sell side in response to the loss of proprietary trading talent, falling inventories and increased sensitivity to balance sheet impacts from the traditional dealer community.

Those investors who are too small to trade alongside their hedge fund counterparts are showing other signs of optimizing their approach to portfolio construction. Several survey respondents discussed their move to create opportunistic allocations that they saw existing outside their core hedge fund holdings. In most instances, these investors were looking to take advantage of small niche or “exotic” alpha opportunities for a short period of time and using those positions to up the risk exposure in their overall portfolio.

Another optimization theme evident in 2013 was the ability of hedge fund managers to leverage the broad investor community’s increased focus on categorizing the types of beta in their portfolio and being “smart” in the manner that they sought beta exposure. In some instances, this led to more hedge fund managers being given allocations to run long-only funds as AUM in this category rose to a new record of $183 billion in 2013. In other instances, the drive to identify diversifying or alternative beta streams allowed for the successful launch and funding of infrastructure concentrating on real asset-based hedge funds like those focused on timber or toll roads or airline leases — assets that would provide revenue streams uncorrelated to the securities markets.

Shifting Set of Drivers
Although developments in the investor landscape have been the primary drivers of change in the hedge fund industry for the past five years, we clearly see the coming wave of financial industry regulation having the same transformative impact on the hedge fund industry and financing markets in the coming period. We forecast the next five years being more driven by these influences than by investor trends.

 

[1] “40 Act” alternative mutual funds refers to mutual funds created by investment companies registered under the Investment Company Act of 1940.

[2] Undertakings for Collective Investment in Transferable Securities (UCITS) are a set of European Union Directives that allowed for funds authorized in one European Member State to be sold in each Member State without reauthorization.