Coming-of-age analogies are always great as they recount rights of passage (the first kiss, first love, first solo car drive, first million gained, first million lost…) and how one learns and improves upon their initial foray toward a particular practice or action.
Hedge funds are no exception, particularly in the eyes of institutional investors. According to SEI’s annual global study in collaboration with Greenwich Associates, institutional investors are finally looking at hedge funds as having passed the maturity marker and worthy of more serious consideration.
The report, entitled “Institutional Hedge Fund Investing Comes of Age: A New Perspective on the Road Ahead” (click here to download a summary of the report; the complete report can also be downloaded after a brief survey), certainly indicates that the hedge fund industry collectively still has a lot of growing up to do.
That said, institutional investors seem to have collectively decided to give hedge funds another chance, who in their view have made amends with their unruly pre-financial-crisis antics and for the most part developed a more mature approach that jives with what institutions need and want: augmented returns with a better way to ensure that no parties are going on when the parents are out of town. As the report puts it,
“The practice of hedge fund investing has leaped in maturity, as investors and fund managers alike have learned they can take nothing for granted, including liquidity and absolute returns…Having survived the firestorm, investors still believe in the benefits of hedge funds, but are seeking a better handle on the complexities.”
The numbers tell the story well: In 2009, less than 15% of investors polled by SEI had any interest in increasing their investments in hedge funds (click here for AllAboutAlpha.com’s coverage of the 2009 report). In contrast, well over half of investors surveyed by SEI say they plan to increase their contributions to hedge funds in the next 12 months. (See chart below.)
The anticipated increase in allocations is sharpest among public retirement plans (22.5% vs. 6.4% in 2009) as they continue to seek catching up to allocation levels of endowments and foundations and remain underwater in terms of their funding gaps, which were hit hard in the 2008 crisis and never quite recovered.
Indeed, a big focus of investors according to SEI is gaining access to returns disconnected from broader market trends – something that hedge funds have always promised to do but in 2008 left many investors burned by not really living up to their end of the bargain.
To be sure, like a teenager with car keys finally in hand, confidence and freedom are very much conditional. And subject to constant evaluation of performance. That kind of conditional confidence is equally prevalent among institutional investors, with a full 75% deeming risk management infrastructure “very important.”
“The study confirms what we have been seeing and hearing from our clients — that investors are committed to hedge funds, but managers must get and keep investors comfortable with their investment decision,” says Phil Masterson, Managing Director for SEI’s Investment Manager Services division.
And what do hedge funds need to tell their “parents” to put them at ease? Risk analytics, for starters, in addition to liquidity, regular disclosure (“I am driving to the mall, Mom, and picking up two friends”) and the ability to clearly articulate their value proposition and sources of alpha, as well as demonstrate institutional-quality operations and risk management infrastructure.
Of course, not every coming-of-age story is a good one. Star performers are still “few and far between,” the report notes, while the industry continues to suffer from shakeout, with only 130 net new funds introduced during the first three quarters of 2010, according to SEI.
Broader asset growth was also subdued, with assets rising a mere 10.5% during the first three quarters of the year, reaching $1.77 trillion (Figure 3), still short of the $1.93 trillion peak recorded in the second quarter of 2008 as well as the annual peak of nearly $1.87 trillion at the end of 2007.
Nonetheless, there is reason for cautious optimism, in that the industry’s fortunes have improved over the course of 2010. The third quarter saw hedge funds gain a net $19 billion in new capital, the largest quarterly inflow since late 2007.
Another positive: Rumors of the demise of funds of hedge funds (“FoHF”) has been greatly exaggerated, according to the report. While single-manager funds grew more popular in the last two years, nearly half of 2010 respondents say they invest exclusively in FoHFs (Figure 6).
Bottom line: Whether seemingly mature and ready to move forward in the world, no parent ever puts 100% faith in their kids’ coming-of-age, lessons-learned, “I won’t do it again” mistakes. But as institutions seem to be collectively figuring out, part of parenting is letting your kids grow – and hopefully reaping the rewards of their success.