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.
Institutional Investors: Seeking
a True "Hedge"
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
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
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
- Business Management
- Culture of Integrity
- Operational Excellence
- Disciplined Investment Process
- Investment Strategy Innovation
- Comprehensive Risk Oversight
- 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
policies and procedures.
This requirement is a prime guarantor
of both risk management and a culture
trading infrastructure that
links trade-order management, best
execution, portfolio accounting and
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
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.
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: .