Exchange For the MBA Community at the University of Texas at Austin

Hedge Funds Gain Ground
Institutional investors fueling industry growth
By Tom Gerrow

As both aggressive pursuers of profit and havens of capital preservation in hard times, hedge funds have long appealed to sophisticated, extremely wealthy investors. These same attributes are now attracting another class of wealthy clientele—large institutional investors.

Hedge funds differ significantly from long-only investments, such as mutual funds, because they are not restricted in the types of assets they hold. Also, they can pursue investment strategies that are unavailable to mutual funds.

Hedge fund strategies can be generally grouped into three categories: market trend, event-driven, or arbitrage. Many of them deliver results with a low correlation to prevailing market trends, thus providing valuable portfolio diversification. For that reason, many institutions are increasing their hedge fund allocations.

And it’s the institutional allocations that are helping to drive the incredible growth of the industry—from about 60 hedge funds in 1990 to an estimate of more than 6,000 today. And that number is still growing. Assets under management are experiencing rapid growth as well.

Creating a New Asset Class

Tom Ward, MBA 81, senior managing director at Bear Stearns, said several studies predict that the hedge fund market will grow about 20 percent this year to around $750 billion in assets. While still relatively small in relation to the $20 trillion in the traditional institutional investor market, hedge funds are beginning to play a significant role in asset allocations.

“The term ‘hedge fund’ is really a misnomer,” Ward said. “They should really be called performance enhancers. Hedge funds often call to mind the image of a gunslinger or a pirate ship, but most hedge funds today look for risk-adjusted returns and offer some protection in down markets. Thinking of hedge funds as a new asset class called ‘performance enhancers’ provides a better understanding of how they fit into today’s asset allocations.”

Ward continued, “About five percent of the world’s assets are currently in hedge funds and that will be 10 percent in three to five years. Asset allocators like pension funds have traditionally invested in fixed-income securities, equities, real estate, and private equity. Now, there is a fifth category—performance enhancers, also known as hedge funds.”

Institutions Drive Growth, Change

“What is really going on in the money management business is that the current way of approaching investing—primarily through long-only mutual funds—is giving way to a new concept where assets are allocated either to index funds or to performance enhancers, i.e. hedge funds. The market is now coming to terms with these new entities,” Ward said, adding that he expects allocations from institutions to drive this market going forward.

Growing institutional involvement is changing the way the industry does business —and might give established funds a boost.

Brian Lemmerman, MBA 03, works on the long/short desk at Ritchie Capital. He notes that institutional investors have a different perspective—and different requirements—from that of individual investors.

“When you are a younger, smaller fund you tend to have more individual investors,” Lemmermen said. “As you get bigger, you establish a track record that can attract institutions. Once a firm grows to around $700 million in assets, institutions get interested.”

Institutions are also working on a different time horizon, and that can have an impact on the investor-fund relationship.

“Individuals don’t want to consign their money for long periods, but institutions are often willing to make a longer commitment,” Lemmermen said. “In return they want you to have more transparency, and you are more willing to do that if you can agree to a longer lock-up period.”

Most hedge funds require a lock-up period of one to three years, during which investors can’t make withdrawals.

Too Much of a Good Thing?

As more money flows into hedge funds, the industry faces a new set of challenges. Darren Myers, MBA 03, manages alternative investments for The University of Texas Investment Management Company (UTIMCO). He runs an internal “fund of hedge funds” and must determine where best to allocate assets. His position has given him a unique perspective on the growth of the hedge fund industry, and he sees some growing pains.

“We’ve been concerned about the massive inflows of capital into the hedge fund space,” Myers said. “It is becoming increasingly difficult to exploit market inefficiencies. What originally attracted investors to hedge funds was access to strategies and expertise that very few people had. Now, that expertise is more broad-based so there is less inefficiency. We have to continually find areas of specialization where people have unique expertise.”

That’s a challenge Lemmermen deals with every day at Ritchie Capital.

“In the traditional hedge fund arenas— risk arbitrage, convertible arbitrage, etc.— it’s getting harder and harder to make money,” he said. “Those strategies are influenced by more money being devoted to them; therefore, the information gets out much more quickly. To stay competitive, you have to find new places or opportunities to put the money to work.”

Ward of Bear Stearns agrees, “There are more hedge funds today and thus more talented people all competing to find stocks to short. In other words, there are a lot more wolves and a lot less sheep out there.”

Cashing In On the Action

Despite the increased competition, talented money managers are also driving industry growth as they enter the field in greater numbers.

“The economics of the hedge fund business are much more favorable than the mutual fund or long-only industry,” said Scott Canon, MBA 87, president of Ranger Capital. “Portfolio managers at mutual funds typically receive compensation based on assets under management. A hedge fund manager’s compensation includes a performance fee as well as a management fee. For talented portfolio managers, that performance-based compensation is very attractive.”

Hedge funds typically receive a one to two percent management fee and 20 percent of fund profits. In addition, most hedge fund managers have significant investments in the funds they manage. But despite the potential rewards, finding new talent remains a challenge for both investors and hedge funds.

“Shorting securities is a very different dynamic from investing long,” Canon said. “There is real skill, especially when using leverage. Sometimes you are fortunate and find someone who has that skill set and sometimes you don’t. But the people who are really talented are the ones getting assets allocated.”

But Ward points out that managing a hedge fund takes more than talent.

“Working at a hedge fund is very Darwinian,” he said. “The premium for the best talent is very high. What is less understood is the level of intensity required to succeed—16- to 18-hour days are common. Do you really want to do that? Turnover can be high because people either make a lot of money very fast and leave, or they don’t want to put up with the stress, because it’s 24/7.”

More Regulations On the Horizon?

Currently hedge funds are not publicly traded, so they are not required to report their investment activities or results. This has prompted demands for more transparency and contributed to the perception that hedge funds are unregulated investment “cowboys.” In reality, hedge funds operate with some strict limitations.

The primary federal regulatory bodies for hedge funds are the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), but they are also subject to state securities laws. Under current regulations, most hedge funds may accept only a limited number of investors, or they must sell interests only to “qualified investors”—individuals or organizations with significant assets. They are also prohibited from offering their securities to the public.

According to Bob Baird, an attorney with Vinson & Elkins who specializes in corporate finance and commodities and securities law, most are organized as limited partnerships. Their precise structure and reporting requirements, however, vary depending on the types of assets they hold and the strategies they pursue.

But recent calls for regulating hedge funds don’t seem to have industry professionals too worried.

“I don’t see the SEC coming in with a sledge hammer,” Canon said. “Regulators in Washington realize that hedge funds make a significant contribution to market liquidity.”