Hedge funds – not the newest new thing in terms of innovation

Innovation, or the art of creating something fresh and insightful, reinventing something that takes a product or idea forward to the next level, in some form. In reality, the term innovation is pretty old; first used in modern language in the mid-1500s, it derives from the Latin innovatio, the noun of action from innovare, or “to renew or change.”

If anyone can lay claim to innovation in the capital markets, certainly it should be the hedge fund industry. So this is why the most recent annual survey of institutional investment managers by CREATE-Research entitled Investment Innovations: Raising the Bar (click here to download) really has us shaking our heads a bit, even if we allow for our somewhat natural bias .

The good news is this year’s report, which surveyed both asset managers and pension funds representing combined assets under management of around US$29 trillion, doesn’t call into question whether or not actually alpha exists, as it did last year (click here to read AllAboutAlpha.com’s assessment back in July 2010).

The bad news is that it paints a rather dismissive picture of some of the concepts that many in the alternative investment space live and breathe by: portable alpha, the use of leverage, structured products and shorting, to name a few.

What the report does paint as “innovative” are some developments over the past 30-odd years that according to survey respondents have significantly changed the game  – namely new asset classes, new asset allocation techniques, new risk- and return-enhancing tools, new theme funds and new business models.

More specifically, the report looks at innovations in specific types of strategies and asset classes, ordaining five as the most innovative in the past decade or more: emerging market equities, emerging market bonds, high-yield bonds, liability-driven investing and exchange traded funds (ETFs). The chart below says it all, but according to the survey results, being innovative hasn’t really counted much for being innovative.

“Pension plans that benefited from them attribute their success to strong beliefs in their intrinsic worth, a disciplined approach to buying and selling, and in-house capabilities to chase early mover advantage,” the report notes.

Balancing out that yin was the yang of the least most-value-inducing innovations which according to the survey included leverage, structured products, portable alpha and currency funds, among others.

“Pension plans that lost out attribute the outcomes to the absence of intrinsic value, herd instinct and low engagement with their asset managers,” says the report. “They did not heed the ‘health warnings.’ Nor did they have the skills and governance to enter into anything complex or risky.”

Ouch.

The results didn’t come arbitrarily. Using results from two different surveys involving responses from 108 pension plans and 396 asset managers, pension consultants, third-party administrators and distributors, the collective conclusion was that the five asset classes cited have allowed for the most innovation in terms of investment strategy and success.

And truth be told, after more than a decade of uncorrelated absolute returns that thanks to stocks’ amazing march upwards was for most easier to come by than shooting fish in a barrel, the alternatives industry post-2008 has certainly had to innovate.

But the report takes in our view a precariously accusatory stab at hedge funds and other alternative strategies, noting that the alternatives industry still has a long way to go – and a lot of innovating to do – if it is going to continue attracting and retaining institutional assets.

To be sure, investors have taken their lumps in good measure. Pension plans have learnt that asset allocation is the alpha behind alpha, which according to the report means “not going to anything radically new without strong investment beliefs, a disciplined approach to trading and skill sets to understand risky products.”

Fair enough.

On the asset manager side, however, things get a bit prickly, particularly since the report concludes that to really be innovative, they collectively need recalibrate how they create products, evaluate them and convert them into something that is “fit-for-purpose and seeks the ‘best endeavour’ outcomes.

And we thought that’s what the majority of those on the asset management side were already doing.

But, as the report notes, “Clients have wised up. Asset managers have started a fresh narrative on what they can deliver. Time will tell whether their current efforts will fare better than previous ones.”

Our question, of course, is whether asset managers, specifically those focused on alternative investments, really need a fresh narrative, or if they just need to better explain what they do.

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