The asset management industry is changing fundamentally,
and aligning itself much more with investor needs. One facet
of this is the increasing importance of absolute return managers
providing a pragmatic mix of alpha and beta.
Conventional managers are tied closely to market risk ("variance"
away from market risk is considered risky) and therefore by
definition are precluded from generating much alpha. However,
fees have historically defied the empirical and intuitive
evidence, and have been high. Now they are falling rapidly.
Index managers by definition deliver pure beta, less their
fees, and compete both on the accuracy of their index exposure
and the fineness of their fee. In other words, pure beta is
available very cheaply.
An alpha strategy aims to generate positive returns independent
of market movements by exploiting a particular investment
opportunity which almost inevitably has a huge (and welcome)
variance from the market, but with a lower incidence of negative
returns. This is difficult and one of the last bastions of
human excellence-and therefore expensive. And investor demand
will ensure that the cost remains high.
Why do investors like alpha? Because it is independent of
market movements and therefore appears to be more robust than
beta. And because there is a growing disillusionment with
relative return strategies that-naturally-have lost money
as markets have been weak. Furthermore, it is a truism that,
on average, investors must underperform the market (since,
on aggregate, they are the market; but they have transaction
and other costs), and investors are unwilling to pay for returns
that are statistically likely to underperform.
Lastly, and mostly powerfully, the best investment is always
the one that matches the liability profile most closely. And
while no investor that we can think of has a liability profile
corresponding to market risk, many do have a liability set
best served by consistent positive returns-a much more "alpha"
The big limiter, of course, is capacity. While market risk
is plentiful, and the conventional industry's mix of beta
with a sliver of alpha is broadly scalable, most non-correlated
strategies have a finite capacity to attract investor assets.
Like any goods, increase in demand will tend to increase
price and create supply, and vice versa-though the relationship
is rarely linear. We are seeing the following changes in demand,
price, and supply:
||already very cheap
|beta+ (conventional asset management)
There is a fourth category of manager who has been around
a long time-though not always that visibly. In Asia at least,
the absolute return universe is flourishing. Managers who
do not hedge or hedge only at the periphery of their portfolios-but
have no interest in market benchmarks-are attracting assets
and attention. A good absolute manager will understand how
to benefit from the power of a rising market, often has a
real skill in understanding fundamental mis-pricings, and
has the experience and skill to defend the portfolio in falling
markets. Because they do not have the constraints of a short
book, and usually little or no leverage, they have holding
power and can trade over a longer cycle than many hedge funds.
And they are in an increasingly powerful position.
We recently attended a client meeting with a major absolute
return manager, who has managed to increase their aggregate
(institutional) fee significantly last year while doubling
assets under management; the meeting was to discuss the amount
of increase for the coming year. What conventional manager
would be having this discussion currently?
The best of the long only managers offers a very attractive
proposition to investors. For example, one of the Japan managers
we track has delivered a net return of 23% to investors since
inception in 1999; this during a period when the Nikkei 225
has fallen 40%. Another Asia regional fund has delivered a
202% return since its inception in 1997 during a period when
the MSCI FE ex-Japan has returned broadly zero. Interestingly,
this latter fund's "benchmark" is a 20% p.a. nominal
return. Both these managers are conservative, conventionally
trained, and well disciplined money managers working in small
Like hedge funds, absolute return funds have many different
characteristics but no clear definition. Typically however,
they fall between hedge funds and conventional managers in
fees, liquidity, capacity, etc., but resemble hedge funds
in their organisational structures. Up till now, the client
bases have been more drawn from conventional asset management
space-endowments, foundations, and of late more conventional
institutions fleeing from the "Alice in Wonderland"
world of benchmarked managers.
While capacity is limited, it is typically less limited than
for a hedge fund operating in the same asset class, and, importantly,
the long-tail risk is much less as most absolute return funds
operate without leverage, and-with a long only mandate-cannot
be squeezed or have stock called back. For example, an Asian
long/short fund operating in small or mid-cap stocks would
wisely limit capacity to US$100 million or US$200 million.
But there are a couple of Asian small-cap absolute return
long-only managers with funds in excess of US$1 billion. Although
market correlation is necessarily higher, overall risks in
well managed absolute return funds are, in our opinion, broadly
in the same range as for a hedge fund.
Increasingly, these managers are seeing interest now from
what would more usually be hedge fund investors-family offices
and funds of funds.
A global bear market persisting into early 2003 has helped
equity investors realise the constraints of beta. And persistent
low interest rates mean that any risk premium is applied to
a low nominal base, and that returns in the future are likely
to be lower
hence cost-effective strategies are at
In other words, when interest rates were 8%, and the equity
premium was (say) 5%, an unambitious equity portfolio over
the long run would converge on a 13% return, allowing for
2%-3% a year in fees and expenses to be taken out and still
give the end-user a double-digit return. Now, with interest
rates at 2% and the equity risk premium arguably around 3%,
that same portfolio is trending to a 5% return, making the
end-user acutely sensitive to fees and charges. Customers
that decide they do want simple market returns are seeking
more cost-effective routes, such as index funds and ETFs,
than conventional money managers.
However, the demand for alpha-driven strategies is such that
there is little fee sensitivity for the manager that consistently
delivers absolute returns-hence the substantial fees earned
by hedge, real estate, and private equity managers. One of
the longer-standing Asian equity hedge funds recently closed
its existing 1% and 20%, monthly notice fund, and opened two
new share classes, one with three months' notice and a 1.5%
management fee, and a second, to take capital when the first
new share class is full, with six months' notice and a 2%
We talk to retail investors who are being offered funds of
hedge funds. We read of the 40% growth in the number of institutions
globally investing in hedge funds, and the growth in total
commitments and proportion of assets held in these portfolios
. We see the growth of multi-billion dollar funds of funds.
Demand is undeniably accelerating.
The constraints however are very real. Consistent alpha strategies
are almost all highly dependent on the size of investment,
and cannot take large amounts of capital. Intuitively, this
makes sense. If these strategies were fully scalable then
they would eventually become the market
and hence alpha
would become beta. More prosaically, to extract consistent
and non-correlated returns from volatile and complex markets
is not straightforward, and with few exceptions, managers
succeed because of focus on one asset niche or strategy, beyond
which they will not venture and risk performance.
So with increasing demand and capacity increasing at a lesser
rate, if at all, alpha is going to become scarce. It is already
expensive, and cannot get much more expensive without seriously
impacting investor returns. Managers can and do ration capacity
by choosing their investors and excluding others, imposing
lock-ups and long notice periods, or simply closing to new
As more investors come to understand the difference in types
of return, and demand to include alpha-driven strategies,
how can the industry deliver?
The Big Shift
Currently the asset management universe looks like this:
| pure beta
indexers, ETFs etc
| active beta
conventional money managers
absolute return managers
where active but index-relative managers dominate, with small
outposts of cheap beta and pure alpha, but it is moving to:
| pure beta
indexers, ETFs etc
| active beta
conventional money managers
absolute return managers
where beta is cheap, active beta is still a subset but not
dominant, and the alpha strategies are much more popular.
Pure alpha becomes more desirable but is limited by supply.
What will happen is not of alpha drying up, but that aggregate
returns will come down and higher returns will become available
to a smaller universe of favoured investors.
Furthermore, most of these pots of return are packaged in
separate industries. An index manager is unlikely to lunch
with an absolute return manager any more often than a hedge
fund is likely to chat to a conventional money manager very
What we are seeing is a huge shift in investment fashion from
a world view that says:
"Markets go up, buy on the dips, never mind the fees,
and your risk is in not being in the market"
to a world view that says:
"Markets are volatile and volatility destroys value,
fees matter, and your risk is in losing money or not meeting
your target return".
What that means for investors is a shift from using a few
conventional managers to cover the main geographic asset classes,
to using a much more fragmented range of specialists to weight
the difference points of the alpha-beta spectrum in a more
sophisticated fashion. But the constraints on pure alpha generators
can only become more difficult.
What we believe will happen-and we are beginning to see this
from some more sophisticated investors-is a shift towards
portfolios constructed of a wide range of specialists, optimising
not only the risks and returns, but also the costs of portfolio
management. A typical fund of funds in the future is much
less likely to remain dogmatically a fund of hedge funds.
It will be composed of hedge funds, but also CTAs, and absolute
return manager that do not hedge but aim to make money from
high index variance.
We are beginning to see this. Talking to CTAs and managed
futures managers, they are already seeing more funds of hedge
funds including their strategies. And the better absolute
return managers are filling their capacity with increasingly
sophisticated investors. For these players, the handicap of
fitting neither into the conventional nor hedge fund pigeonholes
is turning into an advantage of offering a pragmatic mixture
of returns driven by alpha and beta, with greater capacity
and lower fees than pure alpha strategies.
The growth of the hedge fund industry is not infinitely scalable.
We do not know where ultimate capacity is. The warning signs
At that point, pure alpha-driven returns will self-limit, and
the absolute return industry will fill the gap.
- the acquisition of a major conventional asset management
house with a few hundred billion of assets under management,
by a hedge fund group with a few tens of billions of assets,
in a stock swap;
- two or three years of falling aggregate returns for
the hedge fund industry masking increasing performance dispersion
within strategy groups; and
- the automatic inclusion of funds of hedge funds in
every mutual fund manager's product range.
Furthermore the disillusionment of conventional allocators
with paying full price for index+ management will stimulate
further manager formation from conventional space into absolute
return management companies. We already see this: good individuals
from conventional long-only space do not only take their reputations
to hedge funds; they take them to absolute return boutiques.
This trend will pick up again as the hedge fund industry gets
Peter Douglas is a Chartered Alternative Investment Analyst
and the Alternative Investment Management Association's Council
Member for Singapore. He is principal of GFIA Pte Ltd, a hedge
fund research consultancy, and research partner of Dewey Douglas
Ltd, a fund of funds consultancy.