Alternative Viewpoints: A “Golden Age” of higher returns, new managers & smaller funds on its way

30 Nov 2008

Peter Douglas, CAIA, the founder of Singapore-based hedge fund consultancy and money management firm GFIA, is a well known and often-quoted figure in the alternative investment industry.  Regular readers may recall our conversation with him in his Singapore offices last fall (see post).  But Douglas also has another claim to fame.  As the Asia-based director of the Chartered Alternative Investment Analyst (CAIA) designation, he is a pioneer-cohort charterholder, and was the first CAIA in Singapore.  So we are pleased to bring you Douglas’ latest comments on the hedge fund industry as part of our monthly column featuring the ruminations of a CAIA charterholder, “Alternative Viewpoints”.

Today, Douglas pulls out his crystal ball to look at the future of the hedge fund industry.  He says that a dearth of alpha-seeking capital will usher in a “golden age” for alternative investing.  He also foresees larger hedge funds regulated as investment banks, and most large multi-strategy funds morphing or fading.  He says that as boutiques flourish, diversification across funds will become easier and price differentiation will finally take hold.  In addition, predicts Douglas, leverage will fall out of favour, operational expertise will become even more critical, and regulatory arbitrage will remain alive and well.

Special to AllAboutAlpha.com by: Peter Douglas, CAIA, Founder, GFIA pte.

The future (not ‘may’) hold many surprises, and some could make a huge difference to our world view.  However, here are our thoughts on how the hedge fund world may pan out over the next 2-3 years.

In summary, the hedge fund world will (i) see higher returns (ii) see strong new manager formation (iii) be dominated by small boutique managers (iv) have relatively few very large funds.

Returns will be higher, possibly much higher, than they were 2006-2008

Of (very roughly, erring on the conservative side) US$2tn of hedge fund assets, and >US$4tn of investment bank trading assets, at the beginning of this year, we will, by the beginning of 2009, have lost perhaps 1/3 of the hedge fund assets and 3/4 of the world’s banks’ prop trading assets.  Assuming (and this is perforce guesswork) that aggregate leverage in the hedge fund ecosystem falls from 3x to 1.5x, and that ditto in the prop desks drops from 20x to 10x, that means that US$86tn of alpha-seeking capital will become US$12tn, an almost 90% implosion.  This is conservative. At a recent conference, we heard Paul Marshall, of Marshall Wace, estimate that half of all hedge fund capital, and 80% of investment bank trading capital, would evaporate.

(Goldman Sachs’ reduced their overall leverage from 24x to 16x, still, to our mind, an extraordinary number. We’re assuming that the majority of the new owners of investment banks will not be as confident of their new-found treasure’s ability to manage risk and will run significantly lower leverage. Professional trading units outside banking, such as Cargill, typically run at around 10x and we feel this is a realistic estimate.)

This accords with our view of the number of stocks in Asia with institutional levels of liquidity.  (From a Singapore base, we naturally see more data points from Asia than the ‘developed’ markets.) In the summer of 2007, this was perhaps 500.  Now, it’s more like 50, across the whole region.  In brief, alpha-seeking capital has shrunk by an order of magnitude.  As liquidity across the financial system continues to ebb, we believe that we may still not be at the low point.

Other discretionary flows into risk assets will also slow, as individuals and trustee-directed investments will lose their enthusiasm for market-related investments, further constricting liquidity.

Without market liquidity, arbitrage opportunities will be wider for longer, and markets will generally offer far more persistent opportunities.  Whether the opportunity is simply a hugely undervalued equity, or a mispricing in a complex derivative relationship, inefficiencies will be larger and more persistent – creating supernormal returns for investors with the skills to find and execute.

With a lack of general appetite for equity market risk, indexed or quasi-indexed returns will be meager, making the relative attraction of alpha returns much stronger.

We will, at some point in the next 6-12 months, enter a golden age much like that of the 1990’s, for hedge fund returns – indeed, returns from all but simple benchmark investing will be high.  We prophecy that the broad hedge fund return indices will annualize at 20% from 2009-2011.

The >US$5bn funds will be the new investment banks, and no longer relevant as hedge funds

We’ve pointed this out before, but hedge funds have been far better risk managers than any other investor group.  In 2007, aggregate hedge fund profits to investors were roughly equal to bank write-offs.  So far in 2008, although hedge funds have had a disastrous year, it’s been only half as disastrous as that for mutual funds, and exponentially less disastrous than for the owners of the banks (the other main risk-takers in financial markets).  Clearly this is where risk capital should and will be concentrated.  We can only suppose why this should be… but our supposition is that risk is best managed in discrete pools, by experienced professionals, remaining close to their specific experience, and with their own wealth at stake.  That mandates a boutique approach.

Secondly, the businesses-formerly-known-as-investment-banks will be very tightly constrained, not just by penal regulations, but also by their new owners, the commercial banks or sovereign entities.  While hedge fund regulation is clearly going to tighten, the hedge funds may be better placed to work round whatever’s put in their way.  The regulatory arbitrage between implementing a strategy within an investment bank, and within a hedge fund, will be strongly in the hedge funds’ favour.  The U.K. F.S.A. chief executive recently said:

“Hedge fund managers in general are weathering the market turmoil pretty well in the circumstances, certainly versus other components of the financial services industry.”

However, while a few months’ ago, we would have argued that hedge funds will be regulated fairly lightly compared with investment banks, we’re having doubts.  The industry’s larger players are increasingly being found guilty by their investors of having abandoned their fiduciary responsibilities, in favour of entrepreneurial zeal.  While 18% of hedge fund capital has been subject to gates or other restrictions on redemptions, this is concentrated within about 5% of funds by number.  In other words, it’s the big boys who are alienating investors.  The building crescendo of complaint from investors will I’m sure reach regulatory ears.

We think there’s an argument for regulating very large funds pari passu with investment banks, while leaving the boutiques largely unregulated.  We have a comparable situation in Singapore, where large institutional managers are generally subject to full investment management regulation, comparable with that mandated by the SEC or FSA, while smaller specialists can opt to be exempted.  This has worked remarkably well in balancing the growth of a dynamic indigenous industry, with the needs of very large allocators and their preferred managers.

Thirdly, running large amounts of money will be very difficult in a world of shrunken and much less liquid securities markets.  Much of the trend to multistrategy funds has been an attempt to create the scale that institutional investors would like to see (our humble opinion has been that ‘multistrategy’ has always been far less an investment strategy than a business model – and it’s always been the most difficult strategy to recommend to clients).  Alpha is never scaleable at the best of times and we believe the optimum size for almost all strategies has decreased very substantially of late.

We believe that the current very-large hedge funds will see the most dramatic changes.  Some will fragment into their constituent parts, some will become investment banks and be regulated as such, and some will disappear having committed suicide by gating their investors.

One effect of this is likely to be that a few remaining mega-funds will typically compete for similar returns, finding their scale a handicap.  They will also be among the few able to run heavily leveraged strategies, meaning that this universe is where the system-shaking implosions will happen next…  but not yet!

Strong growth in new boutiques and strategies

There is, and will be, attrition of hedge funds.  While there will be consolidation of funds of funds, which have an asset aggregating business model and therefore clear scale advantages, hedge funds won’t generally consolidate. Diseconomies of scale, and the extreme individuality of hedge fund professionals mean that hedge funds evaporate, not merge. Furthermore, the prospect of a year or two scrabbling back to high watermarks and therefore performance bonuses, will loosen the ties of many investment people to their current firms.  In addition, the overall contraction of the financial services industry will result in a widespread freeing of talent.

There will be increasing numbers of Ronin on the streets – skilled warriors answering to no master – easing dramatically the key constraint to growth of the industry, namely finding experienced people.  While some will attach themselves to the relative security of large funds, many will try their hands at starting their own shops, however tough fund-raising may be for a while.  We started GFIA in the depth of the Asian crisis, and can attest first hand that it’s far easier to start a business in a recession, with little competition for resources as diverse as research talent and airplane tickets, than in a booming economy.

We will a return to the early noughties, with plenty of highly skilled professionals starting firms with few staff and few assets, producing very attractive returns for a few years before gradually attracting assets from initially-shy investors.  This is exactly the experience post the Asian crisis, which left a lot of excellent but dislocated talent looking for a home for their skills.  The period 1998-2002 was the genesis of the boom in Asian hedge funds, which really happened from 2003-2006 before leveling off.  We will see a rerun of this movie starting in 2009, but this time it’ll be global not regional.

The way the investment world will change, with the current huge dislocations opening new arbitrages, and new ways to access the opportunities available, will facilitate plenty of good new pitchbooks.  The revised realities of working in a world with few mega-buck opportunities in investment (or any other sort of…) banking, with a backdrop of a vicious developed-economy recession, will make it relatively attractive for very good people to manage a few 10s of US$m in a strategy.

Conversations with law firms and prime brokers confirm this is in motion.  While prime brokers see a lot of wannabes alongside the likely starters, the law firms (who cost money!) only usually work on high-likelihood propositions.  And they’re seeing a strong pipeline of new funds for 1Q and 2Q 09.  While as an allocator, we’ll find it hard to allocate to any PM that didn’t have p&l responsibility through 2008, we’re sure we’ll be kept busy reviewing the propositions.

Inevitably, of course, a few of the new mini-boutiques will achieve scale, and the cycle will turn again…  But we feel that the next few years will be remarkable for the crop of new, small, skill-driven boutiques that appear.  It will be very exciting for investors.

Leverage will be used in fewer strategies

Only the very large funds will be able to convince their bankers to make significant leverage available.  But in any case, referring back to our earlier comments, you won’t need leverage to find good alpha returns.

This is likely to provide a conundrum, however.  In a generally unleveraged world, markets are likely to be substantially less leveraged than of late.  Large firms may well have access to leverage, but in relatively illiquid and volatile markets, will they be able to deploy that leverage well?  We expect that some will, and some won’t, and that the inherent riskiness of larger funds will, if anything, increase.

Systemic risk may reappear, but concentrated in the mega-funds, while mitigated in the smaller funds.  This is a further reason why the very large hedge funds will increasingly be regulated like investment banks – it’s because that’s where the risk will be concentrated.  Smaller boutique houses will be fragmented and largely unleveraged, and will operate with considerably more freedom.  It’ll be easy to argue that large funds be regulated like investment banks.

Diversification will become easier

Their will be clearly be a period of good beta returns from dramatic market swings, as investors grapple with the likely direction of the new world order.  While simple ETF-like exposure is likely to be a rollercoaster, good directional equity managers with stock-picking skills will make good returns.

(From 1929 to 1934 there were 5 dramatic bear market rallies, 2 of which were >100%, before the Dow finally bottomed, with a peak-to-trough fall of almost 90%.)

Buy, hold, work-out and sell distressed strategies will make money.  So will arbitrage specialists whether they be event driven, market neutral, or any other convergence strategy.

But in the absence of blanket leverage floating all boats, it’ll become much easier to identify the specific characteristics of various sources of return, and it’ll become significantly easier to achieve effective diversification again, reviving the fortunes of the fund of funds industry again (albeit, see below, likely within a fragmenting range of business models).

Differentiation of fees

Investors will be in control, given the new scarcity of investment capital.  2 & 20 may be the sticker price, tho’ some new funds may go for a more conciliatory 1 & 20, but the effective pricing of investment strategies is likely to disperse dramatically, through the use of separate accounts, co-investment rights, and advisory contracts, as well as through simple fee rebates.

Differentiation of liquidity terms

Recent experience has shown that there cannot be one-size-fits-all liquidity terms.  Long term institutional investors want limited liquidity to protect themselves from other investors.

Intermediating investors (such as FoFs) legitimately need frequent liquidity to be able to adjust their exposures.  The two don’t mix.

Within the proviso that of course fund liquidity must match underlying asset liquidity, hedge funds will increasingly polarize between the two investor groups, defined by their liquidity needs.

The classic upward mobility of successful hedge funds, graduating investor profiles from agency to principal investors, may be constrained, as funds are defined either as “intermediary” or “proprietary/fiduciary” in nature.

Operational infrastructure will be more fragmented and expensive, and therefore operational expertise will be critical

Hedge funds will continue to appoint multiple prime brokers as a need-to-have rather than a nice-to-have; they will diversify their counterparties as much as possible; manage their cash more proactively; and quite possibly disaggregate many of the current package of prime broking services.  Investors will require this even if hedge funds don’t see it.  The de minimis internal infrastructure within hedge funds, needed to manage this increase in professional relationships, will increase, even for very small firms.

As the current prime broking model morphs, prime brokers will charge in more visible ways for their services; service providers generally will act for a larger number of smaller players with a corresponding impact on their cost base…  frictional costs will rise.

Good hedge fund ops managers will, even in the near-term shrinking environment, be bid-only.

Strong geographical movement to less politicized jurisdictions

The current financial crisis has galvanized policymakers to think and act globally, and regulatory agencies will be under pressure to homogenize regulations.  However, there will remain underlying philosophical differences, as well as different models of political and regulatory interaction.  In particular, we envisage that the main continuum of regulatory policy will be along the axis “politicized – non-politicized”.

Jurisdictions where regulatory policy is relatively free of political interference, and hence regulatory environments driven by pragmatism and effectiveness rather than dogma and populism, will see measurable increases in business.

Regulatory arbitrage will continue to exist, but be driven as much by perceived regulatory policy as by current compliance cost.  There’ll be further arbitrage between those managers serving investors with little need to deal with regulated entities (who will inevitably find ways to structure themselves to avoid burdensome regulation), and those managers serving investors that do need regulated counterparties, who are likely to maintain a far more costly compliance overhead.

– P. Douglas, November 2008

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com.

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