Some (not so) random thoughts on the future of the hedge fund industry

Call it some random albeit coherent, insightful and well-articulated thoughts on the future of the hedge fund industry.

A report entitled pretty much just that (“Thoughts on the Future of the Hedge Fund Industry”) written by Christopher C. Geczy at Wharton (click here to download) is full of fascinating detail on where the hedge fund and fund of hedge fund industry is headed, and how investors, particularly pensions, are looking more closely at everything from liquidity to risk to fees to valuation methodologies, regulation and even hedge fund replication.

The study, published back in April, is a culmination of research and conclusions based on various surveys and responses covering different aspects of the hedge fund industry: investors, institutional consultants, managers and “industry stakeholders.” It uses specific research methodologies to arrive at its conclusions on what the future of the hedge fund industry might look like.

Of particular interest is the report’s focus on institutional investors’ perspectives, namely “returns-based sources of interest” in hedge funds as well as past and future risk exposure and how investors are blending the need to accommodate risk with the need to produce decent returns. Indeed, the table below indicating how consultants in particular expected certain hedge fund strategies to fare through 2009 and beyond is telling in terms of it’s predictions (a quick glance at HFRI‘s indices as well as a general look back at economic conditions this past year suggestions they were pretty much on target – click on the chart below to enlarge).

According to Geczy, one of the ways an increasing number of institutional investors are doing that is via hedge fund replication. While noting the pitfalls of many different types of hedge fund replication efforts and techniques, Geczy does note that the future may involve more intricate attempts at replicating illiquid or substantially difficult to access strategy performance – private, large-scale infrastructure exposure, for instance, or more exotic stuff like carry trade techniques.

“Given how accessible ‘vanilla’ replication appears to be, replication technology may likely be useful for hedge funds and especially funds of funds to equitize their asset flows,” he says. “That is, rather than parking inflows in cash in advance of investment, they may capture benchmark-like returns while finding investments in which to deploy assets.”

On the flip side, Geczy also takes a closer look at the new requirements imposed as part of the adoption of Statement of Financial Accounting Standards 157, which on one hand has improved investors’ ability to examine and ascertain risk but has also made defining returns a little more challenging for hedge fund managers – particularly when it comes to less-liquid securities, and even more particularly when crises hit.

Of particular interest to Geczy is the continued overlap between private equity-oriented strategies like mezzanine and distressed financing, with many hedge funds titling strategies toward the higher yield camp last year. The trend is apparent from the chart below, which presents the asset class positions in underlying investments of an ETF of ETFs that is designed from replicate the performance of hedge funds – the “QAI” from IndexIQ (click on the chart to enlarge).

From a broader vantage point, the business model of both hedge funds and FoHFs going forward is likely to better match the liquidity of underlying investments, according to Geczy, particularly since the majority of the institutional investment side’s post-2008 woes stemmed from what is now affectionately referred to as an “asset-liability” mismatch.

“Certainly institutional investors and their consultants will be incorporating to an even greater extent due diligence in this important area,” says the report. “Also apparent from our survey of consultants is an expression of interest in separately managed accounts as a method for improving transparency, monitoring and control of managers.”

Indeed, if past performance is still indicative of future returns, the chart below certainly has something to tell.

So what are the takeaways from the otherwise random thoughts and observations?

That the industry on whole will continue to grow, but that the business model has changed for good – no more begging among institutions to get into hedge funds, and no more hedge funds running the show from a “don’t worry about what’s going on behind the curtain” approach.

In other words, transparency, transparency and more transparency, likely a lot more managed account structures, certainly some negotiations on fees and a lot more cooks in the kitchen – which is all arguably where things should have been in the first place.

While clearly broad and somewhat esoteric, the report does seem to conclude that hedge funds do indeed have a future.

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