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Race for Institutional Dollars Could Compromise Hedge Funds' Integrity

Hedge funds are a little too secretive for the appetite of most institutional investors, but if the funds change too much in order to suit a broader audience, they could lose the very thing that made them appealing. The cachet of the inside know on where the smart money is.

While hedge funds increasingly serve a larger range of institutional investors, including public and corporate pension plans, the funds once reserved for the very rich will need to change their approach if they want to embrace a larger share of institutional assets.

This is according to a white paper by SEI, titled "Five Critical Challenges for Hedge Funds Taking Aim at the Institutional Market."

Hedge fund assets under management have been growing at a compound annual rate of 25% since 1990, with a large part of that growth coming from the institutional market.

That growth in hedge funds has dropped off recently, partly due to the declining economy-and also partly due to the exclusivity and mystery surrounding them.

"To maintain that growth trajectory, the hedge fund industry will need to branch out from its traditional high-net-worth foundation and endowment clientele to serve the broader institutional market," said Paul Schaeffer, managing director of strategy and innovation for SEI's investment manager services division.

"The industry must recognize that large institutions have a distinct set of demands concerning issues such as the quality of infrastructure, transparency and risk," Schaeffer said.

Partnerships between hedge funds and instuitional investors have gradually been increasing over the past few years as investors seek to have a larger alpha component from alternative investments, but this shift is nothing new.

Now, however, as the partnership among the inner circle becomes more prevalent, more institutional investors are beginning to take notice of the value of investing in hedge funds, said Joe Gieger, managing director of GAM USA.

Institutional investors are getting up to speed on learning how to utilize hedge funds in their portfolios and are becoming more confident in using the funds as part of their overall portfolios.

"By having a partnership, institutional investors feel as if they truly understand what they are investing in," said Ben Phillips, head of strategic analysis for Jeffries Putnam Lovell. "An ongoing complaint is that hedge funds are opaque, and investors worry about them blowing up."

Approximately 85% of people interviewed for the SEI report said they would not invest in a strategy that they don't fully understand, and 80% said it is critical for managers to stay focused on a fund's original strategies.

Hedge funds can do more to improve communication with clients and make sure their investors have a clear understanding of the underlying portfolio's articulated objectives, Gieger said.

Institutional attitudes are fundamentally different from hedge funds, with more of a focus on a fund's strategy than its individual manager, and a longer, "more patient" investment timeframe than typical hedge fund investors, SEI said.

Headline Risk

"Institutional investors clearly have a real concern about headline risk," Schaeffer said. "They like the nimbleness of hedge funds, but they don't want to pick up the paper and see that their investment has blown up."

Thirty-seven percent of interviewees in the SEI survey named headline risk as their top worry about investing in hedge funds, while 19% listed transparency as their biggest worry.

"Hedge funds should have a team in place to fill information requests and become more transparent in the process," Gieger said.

Transparency is also a cultural issue, according to SEI. "With their longstanding focus on profiting from unique investment insights, hedge funds have been accustomed to keeping their methods close to the vest."

So far, hedge funds in the U.S. and in Europe have managed to avoid calls for greater regulatory intervention by regulating themselves and creating model codes of conduct.

Government officials also note that most hedge fund investors are highly sophisticated, extremely wealthy individuals or endowments like Harvard and Yale that are willing to take greater risks.

Mall of America

There is enormous potential for hedge funds to capture some of the trillions of dollars worth of institutional assets, but some experts say hedge funds shouldn't try to change too much.

Part of the reason hedge funds are so successful is their ability to be secretive, innovative and iconoclastic. If they become too commercial, they become like that indie rock group you used to like before they sold out and started to sound like everyone else, or the left coast coffee shop you used to hang out in before they automated everything.

The number of hedge funds and funds-of-hedge funds currently number around 10,000 and have grown almost twice as fast as the assets within those products, according to a Jeffries Putnam Lovell study, titled "After the Belle Epoque: The Future of Fund Management."

"There is an over-proliferation of hedge funds," Phillips acknowledged.

"Hedge funds are not only increasingly correlating with one another, they are more closely tracking broad market indices, exactly what they are supposed to avoid doing," Jeffries said.

Out of Business'

Increased scrutiny, savvier institutional investors and less liquidity to lubricate returns will drive 20% of hedge funds and funds-of-hedge funds out of business in the next five years.

"Institutions clearly prefer to do business with institutional-style organizations," Schaeffer said. "Some firms will decide to stay small and boutiquish, but the hedge fund industry as a whole will remain fragmented with a variety of winners and losers and a variety of business models that will be successful or unsuccessful.

"For hedge funds, the challenge will be to fit the profile of an institutional-quality fund, while preserving the performance attributes that attracted major investors in the first place," he said.

(c) 2008 Money Management Executive and SourceMedia, Inc. All Rights Reserved.