Looking ahead

Hedge funds offer a window on the future for institutional money managers, three different reports conclude.

Investment techniques employed by hedge funds may be adopted by mainstream money managers, ushering in major changes in how money is managed, the reports speculate.

"Investors do not view hedge funds as an ‘alternative' asset class, but instead as a new generation of active management," a new study from Sanford C. Bernstein & Co. said.

Leading managers can use market-neutral, arbitrage and absolute-return strategies that employ derivatives and leverage, the Bernstein study said.

"Hedge funds are like fireflies before the storm, where the storm is the real disturbance to the system," wrote Alexander M. Ineichen, head of equity derivatives research at UBS Warburg LLC, New York.

Mr. Ineichen wrote that asset management is moving into a new paradigm. Pre-1982, money managers generally used an "absolute-return approach with a low degree of manager specialization." Through the 1980s and 1990s, managers adopted a relative return approach with increasing style specialization. Going forward, the third paradigm could be an absolute-return approach with a high degree of manager specialization, Mr. Ineichen wrote.

What this entails is giving more investment flexibility to money managers, shifting the responsibility for managing risk to individual managers rather than managing risk at the total portfolio level through asset allocation changes, he added.

That means giving managers the freedom to control losses by shifting assets from underperforming strategies and even potentially into cash during severe market downturns, Mr. Ineichen said.

The Bernstein report said institutional investors are attracted to this new generation of managers because of their ability to use derivatives, leverage and more sophisticated trading techniques.

Meanwhile, poor equity returns and low interest rates are "leading institutional investors to rethink how to structure their portfolios," wrote Ray Dalio, president and chief investment officer of Bridgewater Associates, Westport, Conn., in research published in an advertisement in the March 3 issue of Pensions & Investments.

Institutional investors increasingly are seeking to separate their market returns from the excess returns, or alpha, provided by money managers. Doing so gives investors the flexibility to engineer a portfolio that can generate more return for a specified amount of risk or less risk for a specified amount of return, Mr. Dalio said.

Hedge funds are a steppingstone in this process, since they have very little market exposure and offer high alphas through the use of leverage, he wrote. Many clients are overlaying these high-octane alpha strategies on top of derivatives that offer market exposure, he added. "Institutional investors' move toward hedge funds is a major step forward in the evolutionary process of devising the best way to manage portfolios."

This type of financial re-engineering makes sense to Christopher Campisano, director of equities for Atlanta-based Delta Air Lines Inc.'s $8.6 billion defined benefit plan.

"You may think the return you're getting is alpha, because the manager outperformed the S&P 500. But maybe the outperformance is caused by a bias toward smaller-cap stocks. Then, all you're doing is capturing the difference in price cycles between large-cap and small-cap. That's not truly alpha, it's just a different kind of beta than you were expecting."

A "sea-change in the institutional management business" may follow this separation of alpha — the enhanced returns — and returns generated from market exposure," Mr. Campisano said.

Jeffrey Geller, director of investment management and research at Frank Russell Co., Tacoma, Wash., said the idea of separating market returns from excess returns isn't new or revolutionary. Instead, he said, it represents the next logical step in the progression of investment management, following enhanced indexing strategies.

But hedge funds are just one wrinkle in this puzzle, and "far more profound changes" are coming, Mr. Dalio wrote.

"Soon they (investors) will be looking at the alphas that come from the active management of their traditional asset classes and thinking about how they can be re-engineered and combined into a larger portfolio of alphas that will include hedge funds," Mr. Dalio predicted.

Not everyone agrees with the reports. Charles Gradante, president and CEO of the New York hedge fund advisory firm Hennessee Group LLC, said limits on the availability of securities to short would be one reason not to expect hedge fund-like strategies to become the new norm in asset management.

"The issue becomes the short side of the business model," Mr. Gradante said. "That becomes the limiting factor in how much the industry can grow and still maintain its hedge fund-like strategy."

Other potential problems include the availability of top-performing managers, capacity constraints in various strategies and a proven reluctance on the part of pension executives to embrace derivatives and leverage, both keys to alpha generation, according to the reports.

The Bernstein report also said hedge funds may encounter problems in trying to service too many clients and because of the increasing number of players crowding the area. "How does a hedge fund grow assets and people without reverting to being the traditional asset manager that it once rejected?" the study asked.

Mr. Dalio wrote that the rewards of alpha are largely tied to picking good managers and balancing the alphas they provide.

Also, the Bernstein report suggests that top-performing hedge funds can have a limited shelf life. The average fund among the top 20 in terms of size has a 47% chance of remaining in the top 20 three years into the future and a 27% chance of remaining in the top 20 in five years.

Turnover in the pool of "winning managers" suggests more winning managers are needed to handle increased assets committed to hedge funds.

But there likely won't be any shortage of managers seeking to charge hedge fund-type fees. Base fees average 2% of assets; incentive fees exceed 20% of annual returns. So it's no surprise that hedge funds have grown at an 18% annual clip to 4,598 by the end of last year, from 530 12 years earlier, according to the Bernstein report.

The Bernstein study estimated that hedge funds generated $27 million in fees in 1999 — more than the $19 billion generated by the entire U.S. equity mutual fund industry, which had six times as much money under management.

Hedge funds can generate as much revenue as stock mutual funds just by cranking out an average 6% return, assuming that no hedge funds are below their high-water marks, the report estimated. Elsewhere, however, the report calculated that as many as 60% of hedge funds now are below their high-water marks.

E. Lee Hennessee, founder and chairman of Hennessee Group, sees indications of a shift in thinking similar to those outlined in the Bernstein, UBS Warburg and Dalio reports.

"If family offices are an indication of what happens way out in the future, half of the families we have as clients do not invest in any long-only managers," Ms. Hennessee said. "They have 100% of their assets in hedge funds, private equity or venture capital, or some combination of those."