Hedge fund assets are expected to surge 160% to $2.6 trillion by the end of 2013, fueled by $800 billion of net inflows, mostly from North American institutional investors, a new research report concludes.
The report, “The Hedge Fund Firm of Tomorrow,” done jointly by the Bank of New York Mellon Corp., New York, and Casey Quirk & Associates LLC, Darien, Conn., was to be released on April 20.
Hedge fund firms most likely to enjoy the windfall of another $1.6 trillion of assets will be those that radically restructure their business models within the next 12 to 18 months to offer institutional investors more advantageous fees, terms and investment vehicles, the report said.
That's because by 2013, 46% of all hedge fund investors worldwide will be institutions, including public, corporate and union pension funds; endowments; foundations; and sovereign wealth funds.
The expected growth in the institutional share of hedge fund assets over the next four years compares with a 37% institutional share at year-end 2008 and 24% as of year-end 2005.
The hedge fund industry was walloped by a “transformational crisis” beginning in the third quarter of 2008, “the result of deteriorating investment returns, a need for liquidity and overall investor derisking in the face of a systematic financial crisis. Combined with absolute underperformance, these factors created an abrupt drop in industry assets,” wrote the authors of the 50-page report.
But the hedge fund industry's megagrowth spurt won't start until the third quarter of this year, after managers worldwide are expected to sustain another $400 billion of redemptions. That contraction will be on top of about $530 billion of redemptions in the last six months of 2008.
In all, the “2008 experience,” as co-author Daniel Celeghin called it, will cost hedge fund managers about 47% of their combined assets, with the BNYM-CQA team estimating that hedge fund assets will decline to $1 trillion as of June 30, down from the industry high of $1.9 trillion a year earlier.
Mr. Celeghin, a director at Casey Quirk, said in an interview that the brutal decline is mostly the result of redemptions from high-net-worth investors, especially those in Europe and Asia.
The authors also broke down the total expected hedge fund decline for the year ending June 30: 57% or $535 billion from high-net-worth/retail redemptions; 31% or $288 billion from market-related performance declines; and 12% or $108 billion from institutional redemptions.
According to the report, “while hedge fund investors broadly expected better absolute returns in 2008, they still feel that their original rationale for investing in hedge funds is largely intact.” Mr. Celeghin commented, “It was really surprising to me that the 2008 experience hadn't turned institutional investors off. On the contrary, the vast majority said they would maintain their hedge fund investments. For all the difficulties and frustrations they may have had with individual hedge fund managers, institutional investors said their hedge fund allocation was the least troubled part of their portfolios.”
But in order to justify the loyalty of the institutional investors, hedge fund managers will have to respond to demands for change. “The implication is that hedge fund managers have to change everything from their operational structure, investment strategies, transparency and the internal and external alignment of interests. Hedge fund managers have to gear up to be able to offer a new paradigm,” Mr. Celeghin said.
From an operational perspective, because of failures of third-party providers such as prime brokers and the Madoff Ponzi scheme fraud, institutional investors will demand that hedge fund managers use multiple prime brokers and third parties for custody, cash management and valuation, said the report.
The BNYM-CQA team also had a prescription for curing the ills of the standard hedge fund model. That model revolved around mismatches between institutional investor needs for transparency, liquidity and alignment and that of the hedge fund manager, according to the report.