New York – Hedge funds are back, and this is good news for alternative research. Predictions of the demise of hedge funds have proven premature. However, the comeback is concentrated in the largest funds and is being driven by the institutionalization of hedge funds, which is not an unalloyed blessing for alternative research.
In the depths of the financial crisis, there many dire forecasts about hedge fund closings. In October 2008, we posted an article citing a Credit Suisse projection that 30% of hedge funds would close in the following 2 years. Some in the hedge fund industry were predicting hedge fund assets would shrink by 50%. In fact, assets declined nearly 40% to $1.7 trillion in early 2009 from a high of $2.7 trillion in 2007.
This morning, Hedge Funds Review reported that global hedge fund assets rose 10 percent in the second half of 2009 to hit $1.89 trillion by the year’s end, based on a survey from Hedge Fund Intelligence.
For alternative research, the fortune of hedge funds is a critical issue. We estimate that hedge funds account for 40% of overall spending on alternative research. Hedge funds value non-traditional and non-consensus research, the less widely known the better. This makes hedge funds natural customers of the ‘long tail’ of research. For some types of research, such as primary research (expert networks, channel checkers, custom research) and specialized research such as forensic accounting, deception training or earnings quality, hedge funds represent the major market, encompassing 60 – 80% of spending.
Nevertheless, the nature of the hedge fund comeback presents challenges for alternative research. For one thing, the current environment is accelerating a trend that was present pre-crisis–a concentration of assets in the largest hedge funds. The biggest funds, with extensive infrastructure and risk- management systems, are benefiting the most from improved asset flows. Steven Cohen’s SAC Capital Advisors LP pulled in $1.3 billion between June and December, and Tudor Investment Corp.’s BVI Global Fund Ltd. raised the same amount.
The reality is that small hedge funds find financing difficult. Hedge fund startups are rare. The challenging environment for fundraising has played into the hands of the largest hedge funds. In the past bank traders often left to found their own hedge funds. Following the crisis, the hedge fund industry has continued to consolidate, making it more difficult for individuals to attract investment. It is harder to launch new funds than in the past, so existing hedge funds that have capital to deploy and have built out the institutional infrastructure have the luxury of choice.
The largest hedge fund managers have stepped up their hiring, adding traders and sales people from investment banks, as well as from their smaller fund manager peers. Among the most active recruiters in recent months have been large hedge funds such as Caxton, Citadel, Moore, SAC Global Investors and Tudor Capital.
For alternative research, the concentration of assets means fewer hedge fund clients. Small hedge funds often embraced non-traditional research as a way to generate alpha, and, with leverage, would generate sufficient commissions to purchase a respectable amount of research. The reduction in small funds shrinks one of the key customer bases for alternative research. Adding to the pressure, the largest hedge funds are increasingly using their purchasing power to extract fee concessions.
Pension Fund Inflows
The other challenging aspect of the comeback is the increasing institutionalization of hedge fund assets. According to David Harmston, head of the client group at London-based Albourne Partners Ltd, “The majority of dollars coming into hedge funds in the next 12 months will primarily come from pension plans.”
According to the Alternative Investment Management Association (AIMA), a trade association which represents the global hedge fund industry, institutions such as pension funds and university endowments now account for more than half of the hedge fund industry’s assets. The AIMA estimated that this had risen from one-third three years ago. Pension funds by themselves now account for one-sixth of overall hedge fund assets, based on AIMA estimates.
The portion of assets attributed to pension funds will continue to increase. About 15 percent of U.S. institutions plan to boost their allocations, and 80 percent will keep them steady, according to a survey by SEI Investments Co. The investors are seeking to accelerate returns after losses during the financial crisis.
Corporate pensions are about half a percentage point below their average hedge-fund target of 10.2 percent of assets, while public systems are 1.4 percentage points below their 7.8 percent goal, according to SEI. Both groups raised their targets in 2009, setting the stage for new investments this year.
Hedge fund performance has increased the appeal to pension funds. Hedge funds gained an average of 6.6 percent a year in the past decade through Jan. 31, according to the Credit Suisse Tremont Index. That compares with an average annual loss of about 1 percent by the Standard & Poor’s 500 and a 6.6 percent return by U.S. bonds, based on the Barclays Capital U.S. Aggregate Index.
The increasing institutionalization of hedge funds presents challenges for alternative research, partly because pension funds and pension consultants are increasingly scrutinizing ’soft dollar’ payments, defined as step out payments to third parties and CSA payments. As we have written previously, pension investors are pressuring funds to limit their payments to third party research, mistakenly thinking this reduces soft dollar payments. Unfortunately, pension funds’ perception of soft dollars ignores the bulk of soft dollar spending–bundled commission payments for proprietary investment bank research. This misperception is extremely dangerous for alternative research, which is heavily reliant on hedge funds. This trend, combined with the increasing concentration of hedge fund assets, means that the resurgence of hedge fund assets is a mixed blessing for alternative research firms.