When to step out of your “traditional footprint”

Not a day goes by now without a media story about some traditional firm announcing the launch of a new long-only product or a hedge fund manager launching a UCITS-compliant version of their core offering.  As the investment management industry matures, more of its participants are trying to step out of their “traditional footprints” – even if investors aren’t really demanding it.

Just last week, for example, a traditional Irish long-only manager launched a hedge fund version of its strategy, prompting HFM Week to report:

“Hedge fund-style UCITS funds continue to develop apace, with over 250 currently in circulation.”

Alas, the publication continues:

“…however, despite the busy pipeline of launches, investment has been slower than anticipated, with a relatively low £50bn ($76.5bn) allocated to the sector.”

Is it possible that investment managers are a little too excited about “convergence” between traditional and alternative investing? If it is, then surely this would be the first time fund managers have been overly bullish on a new product…

Convergence is a mega-trend that has been playing out for over a decade and will continue to play out over the next two since, at the end of the day, investment management is not about mutual funds or hedge funds; it’s all about alpha. But a survey released late last month by BNY Mellon suggests that convergence is more of a glacier than a rushing river – painfully slow, but still able to fundamentally alter the landscape.

The survey finds that there are pragmatic business drivers powering the move by traditional and alternative managers into each other’s domains. Hedge funds, it says, are motivated to launch traditional funds by “a desire to tap into the huge universe of long-only investors.” Likewise traditional managers hope “to capitalize on institutional demand for hedge fund strategies.”

Like a volcano underneath an Icelandic ice sheet, the financial crisis may have accelerated the glacial pace of convergence. Poor investment returns have prompted managers to diversify their offerings and the Madoff Scandal showed hedge funds why it was good to adopt the common practices of traditional funds.

But the report also cites managers from both camps who say they have been “converging” for a decade or more and that too much is being made of the “convergence” trend. (Or too little, given they’ve been at it for over 10 years.)

But what do investors think? According to the BNY Mellon survey, institutional investors are nonplussed about the whole thing – although they seem to slightly favour the hedgies:

While institutional investors seem to think that each side should stick to their knitting, the managers aren’t so sure. The survey cites several hedge fund managers who seemed to have “investor relations envy”.  Apparently, hedge funds wish they had “a better understanding of the needs of institutional clients, stringer reputations and brand names and robust market knowledge” – all competitive advantages of their traditional-fund brethren.

Meanwhile, the report says that traditional managers envy the hedge funds’ “nimbleness” and “strength of hedge fund research capabilities”  (Galleon’s “research capabilities” aside).

Curiously, investors also differed from both types of managers on the topic of regulation.  As you can see from the chart below from the survey, institutional investors were far more likely to believe that future regulations would accelerate convergence.

Ironically, one area where hedge fund managers and institutional investors seem to agree is fee structure.  Despite barbs from the long-only industry, the media and several high profile institutional investors, hedge fund fees don’t seem to be budging much.  In fact, as BNY Mellon points out, some are even going up:

“While hedge fund performance fees across the industry have dropped on average from 20% in 2008 to 19% in 2009 [Ed: wow!], annual (management) fees paid to hedge funds increased from 122 basis points on average in 2008 to 128 basis points in 2009.”

So when the survey found that a full quarter of hedge fund managers saw “no improvement needed” in hedge fund pricing / fee structure, this may just mean that hedge funds know that investors are crying wolf over fees (although 58% thought at least “some improvement” may be required).

Overall, we were a little surprised at how investors seemed to recoil at the mere suggestion of buying a hedge fund from their traditional manager, and vice versa.  But what didn’t surprise us was that investors are unsure who to believe…

“One investor flatly stated that he will not be receptive to a manager operating beyond its traditional footprint until that manager is recommended by his consultant.”

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