Over the next five years, a large pool of institutional money will pour into hedge funds. Those funds with highest operational standards will catch the wave.

For several years, explosive growth has been the norm in the hedge fund industry. While that growth is not likely to abate any time soon, the source of new capital is shifting rapidly. Institutions - particularly pension funds - will become the primary source of capital for hedge funds. Their demands will change the industry.

To gauge the extent and likely effects of this shift, The Bank of New York and Casey, Quirk & Acito LLC published a comprehensive paper entitled: "Institutional Demand for Hedge Funds: New Opportunities and New Standards" This paper was the result of in-depth interviews with over 50 leading institutional investors, hedge fund managers and experts. We also surveyed over 80 participants at Institutional Investor's June 2004 Spring Hedge Fund Investment Roundtable. We asked: what are institutions' objectives in hedge fund investing? Where do hedge funds fit within the institutional portfolio? How is the role of fund of funds changing? How will hedge funds need to change to meet the demands of institutional investors?

Among our findings: institutional investment in hedge funds will continue to grow rapidly-we forecast a nearly fivefold growth to $300 billion in the next five years.. Institutional investors are looking to hedge funds not so much to significantly enhance returns as to serve literally as a hedge, providing relatively modest returns with low volatility and low correlation with broad markets. To this end, institutional investors will continue to channel approximately half of their hedge fund investment through the fund of hedge fund industry, relying on FoHF expertise to provide diversification and quality control.

To meet institutional investors' needs, successful hedge funds will have to "professionalize" their management--demonstrating not only the investment acumen that is their hallmark but also operational excellence, high integrity, robust risk management and responsive customer service. Based on our extended conversations and survey questions, we have identified 'seven attributes of highly successful hedge funds' suited to the institutional market. They are outlined in the second half of this article, following an examination of the evolving goals and needs that institutional investors are looking to hedge funds to fulfill.

At present, wealthy individuals are the source of over 90% of hedge fund assets-some $800 billion, compared to $66 billion in institutional money. But that $66 billion is up from almost zero five years ago. To date, endowments and foundations have been the institutional vanguard, accounting for more than half of institutional capital allocations. Defined benefit plans, which control nearly five times as much in assets as endowments and foundations, currently account for just 40% of institutional hedge fund capital.

Defined benefit plans and other institutions, however, will drive growth over the next five years. The stock market bubble, ensuing bear market and resulting swing to under-funded status have forced pension funds to reassess their investment policies. Over the past two years, pension funds have not only begun to invest significant assets in hedge funds-they have also begun to adapt their investment policies and seek legislative approval to include hedge funds in their strategies. These structural steps, long in coming, are certain to accelerate capital flows over the next few years. We expect institutional assets under management by hedge funds to rise to $300 billion by 2008.

To date, the bulk of the institutional capital allocated to hedge funds has come out of fixed income portfolios. The trend, in effect, has been to use a diversified pool of hedge funds as a substitute for fixed income. At the same time, we found surprisingly modest return expectations. Over 70% of our respondents reported an expected net-of-fee return in the range of 6.5%-9.5%, with an average of about 8%. This represents a drop of some 400 basis points from expectations reported in similar research done three years ago.

What accounts for this resetting of expectations? First, many of the newer entrants to hedge fund investing - especially defined benefit plans - prefer a lower volatility aggregate hedge fund portfolio than was typical among earlier adopters. Second, many institutions are setting target returns on a risk-free-rate-plus basis, rather than as a static absolute number; expectations have accordingly come down with rates. Third, most institutions are looking to hedge funds more for diversification and stability than for eye-popping returns. This conservative agenda makes institutional investors willing to accept an anticipated decline in returns as more capital pours into hedge fund strategies.

Conservative criteria in hedge fund selection will gain further traction as pension funds' proportion of institutional capital invested in hedge funds grows from 40% today to over 65% by 2008. Pension fund executives have been slower than foundations and endowments to enter the market because they are subject to more regulatory constraint and more public scrutiny. They are therefore more wary of "headline risk"- the danger that poor performance by their hedge fund investments will attract more negative attention than comparable performance from traditional managers. Pension funds are thus even more apt than endowments and foundations to seek more fund of fund assistance. They will also seek more assurance that the hedge funds in which they invest are stable, reputable and have disciplined operations.

Attracting Institutional Capital

Institutional investors were quite detailed about the attributes that hedge funds need to display to win their confidence. It is true that the primary driver of hedge fund success remains the investment professionals' ability to deliver investment returns. Yet sterling past performance, "superstar" status, and innovative investment strategies will no longer in themselves prove adequate to win investors' confidence in such ability. Plan sponsors, foundations and endowments will require that hedge funds display robust operational capabilities that satisfy a host of "due diligence" requirements. In effect, institutional investors will require hedge funds to prove on several fronts that their glittering performance is true gold. To satisfy these demands, hedge funds will need to develop a much more mature business model than was previously expected.

Based on the research we jointly conducted with Casey, Quirk and Acito, we have identified seven components of this more robust business model. Taken together, these mutually reinforcing "habits of highly effective hedge funds" serve as the underpinnings of a maturing hedge fund industry. They are:

1. Business Management
2. Culture of Integrity
3. Operational Excellence
4. Disciplined Investment Process
5. Investment Strategy Innovation
6. Comprehensive Risk Oversight
7. Sophisticated Client Interface.

1. Business Management

Strong tactical business management skills are the sine qua non for ensuring that the other attributes on our list are institutionalized. It is therefore rational for institutional investors to expect CFOs and COOs to complement investment professionals. Institutional investors want to be assured their hedge fund advisor is a viable long-term business, that investment professionals are free to concentrate on their core competence, and that they act in accordance with well-defined rules and procedures.

It may be a challenge for many hedge funds to find this business management talent, and meeting the demand for it may contribute to industry consolidation.

2. Culture of Integrity

While a culture of integrity starts with the individuals in charge, it is fostered - and demonstrated - through well-designed rules and procedures. Hedge fund managers must instill unimpeachable ethical standards not only by personal example but by dedicating adequate resources to compliance. Best practices include a series of independent checks and balances, especially with regard to valuation, risk management, trade settlement, cash movements and custody. These duties should be segregated and in many cases performed by third parties.

3. Operational Excellence

Along with "outstanding risk management," "operational and infrastructure excellence" topped the priority lists of the institutional investors we surveyed. During our interviews, institutions most often mentioned these operational concerns:

• Third party pricing verification.
• Documented policies and procedures. This requirement is a prime guarantor of both risk management and a culture of integrity.
• Well-designed trading infrastructure that links trade-order management, best execution, portfolio accounting and risk management.
• Robust disaster recovery.
• Senior professional operational leadership independent of the investment team.

Meeting these requirements constitutes a significant operational challenge and is likely to spur the continued growth of outsourcing options. In addition, the rapid advance of technology in areas such as direct market access, algorithmic trading and risk management sets the bar high but also provides numerous opportunities for cost-effective outsourcing.

4. Disciplined Investment Process

Hedge funds must have investment processes that are understandable, consistent, risk-aware, and demonstrably repeatable. A clearly defined investment process establishes confidence in the consistent delivery of performance within the agreed-upon risk parameters. It also provides insulation against "headline risk" if performance is dramatically below expectation.

Other aspects of a disciplined investment process often cited by survey participants include the ability to articulate competitive advantage; a team large and talented enough to implement the process described; and an informed use of quantitative tools.

5. Investment Strategy Innovation

This quality might be thought of as the inverse of a disciplined investment process. Disciplined does not mean rigid, and institutions look for evidence that hedge fund firms constantly evaluate the effectiveness of their investment process and are able to adjust to cycles and secular trends.

6. Comprehensive Risk Oversight

Broadly construed, risk oversight is at the heart of operational excellence. It is also vital to a disciplined investment process-and impossible without a culture of integrity. These core concerns of institutional investors are interdependent.

Institutions expect a strong handle on all market risk factors to which a portfolio is exposed. Proprietary tools are the most reassuring, though for some investment strategies, thoughtful application of third-party packages is also satisfactory.

Institutions are even more concerned to find robust safeguards against operational risk. As discussed above, "headline risk" is the major barrier to institutional hedge fund investing. Institutions also believe that operational breakdowns are the most prevalent source of hedge fund failures. Hedge fund managers must therefore have a compelling approach to operational, regulatory and counterparty risks if they are to appeal to institutional investors.

7. Sophisticated Client Interface

While good communication and distribution skills remain relatively low on institutional investors' priorities list, the importance of these skills will grow as the supply of hedge funds continues to expand to meet demand. Many of these skills lend themselves well to outsourcing, and hedge fund firms can gain a competitive advantage by finding the right partner. They include:

• Dedicated client service
• Quality communications
• Solutions resources
• Willingness to provide transparency

As in any business, sophisticated client interaction and prompt, thorough service inspire confidence and increase client receptivity to new investment products. While most institutions do not (yet) want full transparency on hedge fund holdings, most do want this information made available on demand to their fund of funds or third-party risk vendors

Conclusion

Institutional investors are a different breed from the wealthy individuals who have thus far provided the vast majority of hedge fund assets. Managers of pension funds, foundations and endowments are responsible to broad constituencies and are entrusted with sobering fiduciary responsibilities. Their robust due diligence, coupled with their relatively modest performance goals, shifts the ground considerably for hedge fund companies that seek their business. The requirements for operational excellence outlined above permeate every aspect of hedge fund management-including investment strategy, which must incorporate style discipline and sophisticated market risk management as well as ongoing strategy innovation. While the challenge is steep, the potential rewards are great, and fierce competition will strengthen the hedge fund industry. As the most successful firms will demonstrate, operational excellence will reinforce rather than detract from strong investment performance.

Note:
1. This article first appeared in the December 2004 issue of the AIMA journal.
2. Hard copies of the full text of the research paper published by The Bank of New York and Casey, Quirk & Acito LLC entitled: "Institutional Demand for Hedge Funds: New Opportunities and New Standards" are available on request from David Aldrich, Head of Securities Industry Banking, Europe at The Bank of New York, email: daldrich@bankofny.com.