Corporate and Public Affairs

Wake up call for hedge funds

We may come to look back on the current crisis as an inflection point for the hedge fund industry. It certainly faces a number of challenges – reputation, transparency, liquidity, lower fees, and increasing regulation, to name but a few. ¹A recent report suggested that during the crisis, hedge funds saw High Net Worth Investors (HNWIs), traditionally the bedrock of the industry, withdraw about half a trillion dollars - when permitted to do so by gates, suspensions and other obstacles.

The relationship between hedge funds and HNWIs has clearly been changing for a while, and this was the subject of a debate that Lansons hosted earlier this year (“The Future of Hedge Funds & HNWIs”). The key issue discussed was that of credibility – not just for hedge funds but for the financial services industry overall. The Madoff scandal – and a slew of other, smaller frauds which have beset the industry of late – delivered a nasty blow to the industry’s reputation, but not a fatal one. Banking collapses, bailouts, state intervention and perceived political and regulatory failures have had a much wider felt impact. True, hedge funds have been used as a diversionary tactic by some and some people will always blame hedge funds for pretty much everything they see as wrong with the world, but the world’s rich don’t generally see hedge funds to the primary cause of the market crisis – this they lay at the door of bankers, politicians and regulators.

"...people will always blame hedge funds for pretty much everything..."

Nonetheless, hedge funds do need to work to repair the reputational damage done by Madoff and by the substantial losses funds made during the market decline. Despite the acres of column space given over to the former in the world’s media, it’s possibly the latter issue that is more telling. Investors had bought into the idea of hedge funds delivering uncorrelated, absolute returns and were therefore not expecting the level of declines they experienced. They did not fully comprehend that absolute return works over the lifetime of a market or economic cycle. Ring-fenced from the mainstream by regulation over the years, hedge funds need to engage less with each other and more with the wider investment market. There is no shortcut to education. It is a long, laborious task, but it is a vital one.

There are wider issues at play here as well. Tim Mitchell of Invesco Perpetual and a panelist at our event points out that hedge funds need to “redefine what they are”. A clear one-size-fits-all definition of what a hedge fund is has always been elusive, but recently the term has been stretched further to fit all manner of exotic strategies and products. It is not a case of trying to reposition the industry – that is already being done by the regulators and the investors, whether alternative asset managers like it or not. Hedge funds need to be in control of their own destiny, and take the lead with the issues that they face. Some would say that this requires better lobbying and better PR. I’m not going to argue against that, but this requires hedge funds to find their voice on a wider stage than they do at present.

The prognosis for the hedge fund industry must be seen as positive.  Tim Price of PFP Wealth Management, the renowned strategist and author of The Price of Everything blog, reasons that “the best hedge fund managers are adaptable….they are efficient in a Darwinian sense.” Hedge funds are, by nature, entrepreneurial businesses and can thrive in times of adversity. So, just as the oscillating markets provide one great opportunity set for hedge funds, the challenging regulatory and investor environment provides another. To take advantage, there are few things hedge funds need to be seen to be doing to set their house in order. As panellist Greg Taylor, director of product development at fund of hedge fund manager FRM, explained “the key structural areas [hedge funds] need to address are transparency, definitive liquidity, a zero appetite for operational risk, good pricing and a reasonable fee structure.”

“the best hedge fund managers are adaptable… they are efficient in a Darwinian sense.”

Certainly, despite the reported outflows, appetite for hedge funds remains. Moreover, the hedge fund industry is now looking closely at the retail sector. This is not as extraordinary as it may seem to some. Although hedge funds have historically been bankrolled by HNWIs, recent shifts have seen institutional investors emerge as the primary source of capital. Pension funds have played a significant part in this shift as they have been increasingly allocating to alternative assets to better manage their long-term liabilities. But these pension fund allocations have come largely from DB (or “defined benefit” schemes) and they themselves are a declining breed.

The trend is towards defined contribution (DC) schemes in which the employee chooses the investment strategy from a selection of, typically, relatively plain vanilla mutual funds. Hedge funds will not find cracking the DC market that easy. As Greg Taylor explains “the ability for the hedge fund industry to deliver its services are seriously restricted by regulation because a DC offering is essentially a retail offering.”

Regulation does threaten to impinge on alpha generation and increase running costs, and I concur with Tim price’s view that the restrictions it implies will deter some managers. Regulation does open up new markets however, and Invesco Perpetual’s Tim Mitchell identifies target date funds (which shift allocation over time as the investor approaches retirement) as a potential future source of assets.

From a marketing and communications viewpoint, regulation potentially provides a more level playing field and therefore a better opportunity for the hedge fund sector to manage its reputation. It will also speed convergence between the alternative and traditional ends of the asset management spectrum which in turn stimulates competition and should lead to greater innovation and improved alpha generation. Not withstanding the flawed draft EU directive (which will doubtless be diluted before implementation), regulation offers a tremendous opportunity to those hedge funds nimble enough and willing to embrace it. And that opportunity will be the topic of our next hedge fund debate in July.

¹ BONY Mellon / Casey Quirke