HEDGE FUNDS: Wave of the future

The nation's largest hedge fund managers have a surprisingly harmonious view of what their industry will look like in five years, despite their notorious individualism.

A baker's dozen of hedge fund and fund-of-funds managers, consultants, attorneys and service providers interviewed for this story predict:

• Hedge funds will continue to see asset growth of 10% to 20% a year;

• Institutional investors will fuel the bulk of that growth as they seek reliable sources of alpha;

• Hedge fund managers will continue to create innovative investment strategies and exploit new investment niches;

• Accelerated institutionalization will lead to a bifurcation in the industry between very large, multistrategy players and small, specialized niche players, with few funds in the middle;

• Increasingly sophisticated institutional clients will push hedge funds to provide transparency, stronger risk controls, better reporting, improved client service, lower fees, shorter lock-ups and more concessions; and

• Legislative changes to the Employee Retirement Income Security Act will permit hedge funds to accept more than 25% of their assets from ERISA plans without seeking a qualified plan asset manager exemption.

Kenneth C. Griffin, president, chief executive officer and founder of Citadel Investment Group LLC, Chicago, said investors will have to identify "top-tier performers who will successfully generate alpha over a long period of time vs. paying managers to deliver returns driven by beta or the underwriting of other systematic risk factors."

"As a result, (I) expect to witness consolidation through attrition as investors refuse to compensate managers that are unable to attract the talent necessary to produce meaningful amounts of alpha," Mr. Griffin said. Citadel manages $12.5 billion in multistrategy hedge funds.

Mr. Griffin noted that throughout his firm's 15-year history, hedge funds "evolved from niche participants … to become meaningful providers of risk capital and liquidity to the global financial markets.

The early success of hedge funds and the high return on invested capital prompted a deluge of capital and an eight-fold increase in the number of competitors. At the same time, improved access to information has resulted in the commoditization of know-how and elimination of strategy-specific alphas."

The industry has become a complex network of funds, investors, consultants, financing counterparties, prime brokers and others, all with a vested interest in driving future growth, Mr. Griffin noted. Recent growth in the industry, however, "has been achieved in the context of mediocre performance (adjusting for beta). This is not sustainable."

Said J. Tomilson Hill, CEO of Blackstone Alternative Asset Management LP, New York: "Institutional investors globally want targeted exposure to alpha generators, and are using hedge funds as the most efficient way to get that exposure."

"My view is that hedge funds will continue to evolve and find new niches as globalization continues and new markets spring up," Mr. Hill said. With the unparalleled brain drain from securities firms and all the disruptions post-Enron bringing so many natural resources traders into hedge funds, there will be new opportunity sets arising continuously in the energy trading space."

As hedge funds move into new investment areas, Mr. Hill said he expects institutional investors to follow, just as they have with activist and commodities strategies recently. In particular, Mr. Hill said, institutions have been willing to hire managers that bridge the gap between private equity and hedge funds, despite longer lock-ups necessitated by illiquid investments. "With investment horizons between five and 10 years, rather than monthly or quarterly, some institutional investors are not worried about time frame — they're worried about meeting their actuarial return requirements." Blackstone Alternative Asset Management has had strong institutional interest and investment in a recently debuted fund of funds with a three-year lock-up, as well as in an older dedicated commodities fund with a focus on energy trading, Mr. Hill said.

Blackstone Alternative manages more than $13 billion in hedge funds of funds for 220 institutions.

Eric Mindich, CEO of Eton Park Capital Management LP, said a change in the culture and composition of newer multistrategy firms is part of the reason the firms can successfully invest in more private equity-like deals. New York-based Eton Park manages over $5 billion in multistrategy hedge funds with a multiyear lock-up.

Eton Park and other firms like it are different from the multistrategy firms that grew in the 1990s and collected investment teams with different strategies, but kept those teams in separate investment silos, Mr. Mindich said. "Because of the nature of hedge fund managers — they are very independent and focused on their individual investment strategy — it can be hard to aggregate teams and get them to work together," he noted.

But aggregation within hedge funds is becoming easier if top management creates a multidisciplinary culture with a continuing influx of talented deal-makers from the sell side. Mr. Mindich noted that he and his Eton Park colleagues are part of a trend of senior executives from large sell-side firms who have moved to a hedge fund format and are applying the techniques that worked for them in those larger organizations.

"People will put up a big tent for their hedge fund company and in it combine fundamental and quant orientations, but people also are finding alpha in private deals — not conventional private equity deals, but in other kinds of privately negotiated investments. Opportunity to find alpha lies in the gap between hedge funds, with their market-neutral, liquid vehicles, and private equity (funds) with their leveraged, control-oriented, long-locked vehicles," Mr. Mindich said.

The migration of investment banking converts into hedge funds is making it possible to exploit the gap, Mr. Mindich noted. "To succeed, you need a real sourcing network for private deals — which the investment bankers bring — and you need long-term, committed capital from investors. To find this kind of alpha, you need to have long-dated commitments and not have to worry about a run on the bank."

For the next five to 10 years, Mr. Mindich predicts, the industry will have "a handful or less than 100 of large, complex, global investment management firms with long-term, committed capital; a significant deal sourcing network; and broad human resources. Big, complicated, grown-up companies are what is needed to serve institutional investors. But there will always be room for small, extremely committed managers with a good investment idea."

All the industry executives interviewed shared Mr. Mindich's vision of how the hedge fund industry will look in the future.

"Institutional investors want to deal with institutional hedge fund managers with expanding businesses, a global footprint, diversified sources of alpha and very robust infrastructure. The big players will continue to get bigger, although investors will (also) want to access interesting, smaller hedge fund managers," said Colin Smith, chief executive and chief investment officer, Deephaven Capital Management LLC, Minnetonka, Minn. Deephaven manages more than $3 billion in multistrategy hedge funds.

Three large, global money management firms intend to take advantage of the trend toward big institutional firms: Tribeca Global Investments LLC and Lehman Brothers Absolute Return Strategies, both in New York; and Man Group PLC, London.

Tribeca CEO Tanya Styblo Beder, who started the multistrategy hedge-fund firm in June 2004 for New York-based Citigroup Alternative Investments, predicted that the number of hedge funds today — about 9,000 — will likely be reduced "by a factor of a few thousand." She also envisioned fees, probably with hurdle rates introduced.

Ms. Beder sees continued growth in hedge fund assets, saying: "Once the big institutional investment platforms are in place, pension funds and other institutions will be in a position to give as much as $500 million, for example, to a single manager. I've always thought that this size limitation on single mandates was the reason managers have been unable to satisfy institutional demand."

Tribeca executives expect to meet the target of their growth plan — to manage between $10 billion and $20 billion by 2011. Tribeca manages $1.8 billion, all for institutional investors.

Jolyne Caruso, managing director and global head of absolute-return strategies at Lehman Brothers Absolute Return Strategies, said her unit now manages $6 billion in a combination of single-strategy hedge funds and hedge funds of funds for institutional and high-net-worth investors. Lehman ARS will continue to take minority ownership stakes in early-stage hedge fund managers, Ms. Caruso said. The firm already has three such stakes, and "that gives us a good window into the hedge fund industry. We're watching closely as hedge funds morph their businesses," Ms. Caruso said.

The hedge fund industry is 18 months into an important transition period which has been characterized by challenging market returns, she noted. "The industry has crossed the $1 trillion mark, institutional money is coming, and I think we are only in the top of the sixth inning in hedge fund evolution. It's not over yet."

Ms. Caruso predicts a doubling of hedge fund assets during the next five years because "the wave of institutional investment is just beginning. So many institutions have only a 2% or 3% allocation, and this will definitely increase."

The world's biggest hedge fund manager is Man Group, at $54 billion. Man Group manages hedge funds of funds, single-strategy and multistrategy hedge funds, and structured and guaranteed strategies for institutional and high-net-worth investors.

Man Group CEO Stanley Fink is also confident that industrywide, hedge funds will continue to grow by about 15% annually over the next five years, a little slower than the 20% average yearly industry growth over the past 10 years.

He foresees a good pace of growth in the United States, although not as good as in Europe, especially in the U.K. Also, "coming up will be Asia, especially Japan. There is really enormous demand globally, but especially outside the U.S. as less developed markets begin to offer derivatives and other financial instruments," Mr. Fink said.

He also predicted a plethora of fresh investment strategies, mainly variations on global macro, using many of the newly minted derivative instruments.

Man Group's assets are expected to grow at the same pace as the market, doubling over five years, as the company capitalizes on its strong global distribution, robust infrastructure, and clear branding, Mr. Fink said. (Man Group owns several investment subsidiaries with well-known names such as Chicago-based Glenwood Capital Investments LLC.)

"I have a very different perspective from the hedge fund managers because I've talked to so many institutional investors, and from looking at money flows," said consultant Alan Dorsey, managing director and director of non-traditional investments and research at CRA RogersCasey, Darien, Conn.

"Multistrategy hedge funds are being hired to tactically allocate assets and manage risk. The return of T-bills plus 500 or 600 basis points is acceptable in many portfolio applications. Institutional investors should not be chasing performance. Hedge funds are there to manage risk and to produce moderate returns and diversification," Mr. Dorsey emphasized.

Hedge fund companies that want to stand out to institutional investors are actively building their businesses to become partners with their clients in allocating assets and managing risk, Mr. Dorsey said. "Old-line" firms that don't provide robust risk management, clear client service and reporting, lower fees, increased transparency and short lock-up periods "will be surpassed by the firms that do. They will become artifacts. Some really well-regarded hedge funds are just not suitable for institutions. Their fees are too high, their lock-ups too long. My role for clients is to say ‘no' to hedge funds that are not embracing the characteristics institutions need, and to be sure the ones that do make the cut keep doing what they are supposed to," Mr. Dorsey said.

However, he emphasized, "Big is not necessarily bad as long as the investor focus is concentrated on (the hedge fund's) risk management, rather than off-the-charts performance."

In addition, a blurring of the lines between traditional and hedge fund managers "is enormously important," Mr. Dorsey said.

Many of the hedge fund executives interviewed for this story say those lines will be blurred or completely erased in the next five years.

"The distinction between hedging or not isn't that important, and it's going to get less important in terms of how we view the business," said Joseph Scoby, head of alternative and quantitative investments at UBS Global Asset Management, Chicago.

"The successful firm of the future is going to be global and based on scale, and whether you hedge or not is not that critical. Hedge fund managers have had more flexibility and the ability to transcend geographic and product boundaries. Meanwhile, traditional managers and investment banks haven't had the same flexibility. Soon, traditional managers may be hedging and more hedge fund managers are likely to add a long-only strategy with higher tracking error, but definitely not benchmarked. Let me put it this way: It's no surprise to me that we are going into long-only strategies in my area. About $7 billion of the $47 billion on my platform is managed in long-only," Mr. Scoby said.

Mr. Scoby also sees the near future belonging to large, multistrategy and highly-specialized boutique hedge fund managers, but he strongly agreed with Eton Park's Mr. Mindich about the necessity of information sharing systems within multistrategy managers. "Because investment firms are operating so many strategies in so many different time zones, success will come to those with the culture to share information between their teams. Not all multistrats will survive, and those with silos are going to be in big trouble," said Mr. Scoby.

Managers will also have to develop more useful ways of separating alpha and beta and then delivering it, said Howard M. Rossman, president of Mesirow Advanced Strategies and vice chairman of its parent company, Mesirow Financial Holdings Inc., both of Chicago. Mesirow manages $10.4 billion in hedge funds of funds.

"The industry is naive in its separation of alpha and beta. How clients are using hedge funds will lead them — and managers and consultants and others — to learn how to aggregate those funds better into a portfolio. This will force managers to provide more systematic ways of delivering risk and investment strategies as well demonstrating that they are achieving their goals," Mr. Rossman said.

Institutional interest will also mean a call for greater transparency. Joe Mansueto, chairman, CEO and director of Morningstar Inc., Chicago, is intent on building a source of hedge fund information equivalent to the firm's massive mutual fund database. Morningstar is getting voluntary information from about 3,000 hedge funds, a bit less than the number of funds covered by the industry's largest databases. No single database covers all existing hedge funds, especially the largest funds, which don't provide that information to any publicly available source.

"As the hedge fund industry becomes more institutional and gets more money from that part of the market, they will have to provide more transparency. The information sources and analytical tools available now are primitive, to say the least," Mr. Mansueto said. "People want a tool like Principia (Morningstar's mutual fund database) that will let them compare apples to apples with in-depth information for all funds," he added.

Mr. Mansueto acknowledges that Morningstar has an uphill struggle when it comes to convincing hedge funds to cough up information, "but we helped fill that role in the mutual fund industry. Mutual funds weren't cooperative with us, either, until potential and existing clients started telling them that they had to provide Morningstar with data to be hired or retained. We think grass-roots demand will have the same effect on hedge funds."