We report today from a three-day London gathering of some of the world’s largest institutional investors and the hedge funds that serve them (see postings from sister event in Boston last fall). The event focuses not on hedge funds per se, but on how institutional investors use them (portable alpha, fees, alpha/beta separation, 130/30, alternative beta, analytics etc…all the good stuff). In order to create an open atmosphere for candid discussion, organizers have us on a tight leash (there are otherwise no media present here and we can’t even tell you the name of the event). And while we can’t really tell you who said what today, we can pass along some of the major themes from the conference floor. Here’s some of what we heard…
Hedge Funds: Innovation from the garage?
After years of steady growth, it’s no surprise that traditional long-only money managers have been licking their chops over the potential to offer hedge funds. Meanwhile, hedge funds have been strangely attracted to the gazillions of dollars under management by the long-only managers. Today in London, managers and investors debated the relative merits, not of hedge funds and long-only funds, but of hedge fund management companies and long-only management companies. While many people can tell you the difference between a hedge fund and a traditional long-only fund, few seem to agree on the unique characteristics of each type of company.
Most here held the opinion that hedge funds was no longer a useful definition of an asset class. One panellist put it in terms of innovation. He described hedge fund companies as a platform for innovation. In an allusion to innovation in the technology sector, he said that innovation usually happens in garages, not in large corporations (a clear reference to the oft-cited garage where tech behemoth Hewlett Packard was born – pictured above). In other words, it may be difficult for a large traditional manager to deliver on the major promise of the hedge fund sector – innovation. Issues such as profit- (and risk-) sharing, for example, can often confound the efforts of long-only managers (e.g. banks â€“ see related WSJ piece from last week) to maintain hedge fund programs over the long term.
Panellists agreed that fostering innovation wasn’t just a challenge for large long-only shops, but was actually becoming a challenge for large hedge fund managers too â€“ as industry concentration pushes the assets of the biggest players well north of $10b each. In many cases, said one panellist, small long-only managers are actually becoming more nimble than large hedge fund managers. Still, some said that long only manager can’t change their culture and structure overnight – the hedge funds had a head start in the innovation race.
This tech analogy is powerful because it helps explain what might be one of the only enduring differentiators between hedge fund companies and long-only companies at the end of the day â€“ a culture of innovation. Technology innovation is usually borne out of entrepreneurial risk taking and is often acquired by larger companies only when it reaches commercial potential. It turns out this may be no different in the money management industry.
In the eye of a hurricane
Bad news… If you think the recent stormy market is over, a room full of hedge fund managers and major institutional investors disagreed with you today. A show of hands confirmed the general agreement here that we are in the eye of a hurricane. One panellist, a global macro manager, said the current macro-economic imbalances could have been solved by simply printing money. But peak oil means that policy makers are in an unusually weak position right now. Ergo, the Greenspan/Bernanke put simply does not exist. Warned another manager, It may be possible that the lessons from the liquidity crunch haven’t been shown to us yet.
The other side of the hurricane may contain powerful demographic winds of change. According to one panellist, a zero real return environment demands that we all save approximately 40% of our pre-tax income (yes 4-0-%, not a typo). Looking for a place that has a sustainable national retirement strategy? Move to China. It was described here today as the only place with a sane national savings policy.
Several sessions confronted the quant melt-down and the common assumption that most quant managers were caught off guard by using the same models last summer (see related posting). But how could everyone in the world really use the same models? According to one London-based CTA, they actually didn’t. The reason why everyone looked like they were reading from the same song book, was because of deleveraging â€“ a secondary impact of the relatively small overlap in the quant models themselves.
Funds of funds: More than just training wheels
The manager of the pension fund for a major Western European country cautioned funds of hedge funds managers not to pitch the same product to every investor. He complained on a panel today that managers should spend more time trying to understand the specific background of each pension. The CIO of another national pension said funds of funds pitch him on their diversification benefits â€“ yet tail risk remains an issue.
A large North American fund of funds said that two incorrect urban myths remain about his sector: that funds of funds are only for new investors (training wheels), and that funds of funds simply make passive allocations and wait for the fees to roll in.
Myths or not, another manager said that the industry has reached a difficult point as founders look for a way to crystallize their investments. But many aren’t diversified businesses at all. A third said that the so-called key-man risk was lower for funds of funds than it is for single-managers since the breadth of experience required to manage a fund of funds was becoming so large.
Some funds of funds acknowledged that core elements of their initial value proposition â€“ exclusive access to funds and hedge fund education have now been commoditized. While other elements of that initial value proposition, one-stop outsourcing and diversification still remain, some said the fund of funds industry needs to get back to basics â€“ identifying winners.
Thankfully for them, that task of picking winners is becoming more difficult. As we found out last week, smaller funds (the funds that only a fund of funds has the time and resources to research) actually produce higher returns. The hidden risks (operational risks etc.) implied by the inexplicable and consistent high returns of small funds (see related posting) are exactly the risks that this renewed focus on smaller managers can potentially mitigate.
Lock-ups: Love â€˜em or hate â€˜em
Perennial issues such as investment management fees and lock-ups made their appearance here in debate format (not unlike a format used successfully by AIMA â€“ see related posting). In a nutshell, here are some of the arguments put forth for and against the motions set forth to the floor:
Motion #1: Given recent performance, investors should get back some of the fees they have paid over the years.
Great idea! Performance fees are calculated over too short a period â€“ so claw backs after the fact are entirely appropriate. And LIBOR was always too low a hurdle rate anyway. There are lot of busses coming down the street. If we don’t like the fees, we’ll just hope on the next bus.
No way! Hedge funds need to retain staff and pay for extensive research. We don’t ask long only managers to do this, so why should hedge funds? Besides, the market determines fees, and apparently, the market thinks fee structures are okay. And hey, you get what you pay for.
Motion #2: To optimize returns, institutions should invest in hedge funds with at least a 3-year lock-up
Great idea! We don’t want hedge fund managers to be too short-term oriented. This removes the distraction of running a business. We complain that CEOs are too short-term oriented. Well, hedge fund managers are also too short-term oriented. This would allow them to focus on the long-term. A side benefit would be that some investors would not be able to invest, allowing the fund to remain small and nimble for the remaining investors.
No Way! Lock-ups simply aren’t justified given the relative liquidity of the underlying investments held by hedge funds. Besides, locking up your money allows the institutional investor to side-step their responsibilities to actively monitor and manage their investments.