All aboard for a big new hedge fund growth cycle

January 23, 2014  

Hedge funds look well set to be the main beneficiaries of many of the changes that are sweeping through the investment banking and investment management worlds

By Nick Evans

Five long years after the banks brought the global financial system to its knees, the hedge fund industry enters a new year in healthier and more confident shape than it has done since the pre-crash days.

Performance has been strong, especially in equity-focused strategies – although CTAs and macro have been more of a struggle. Money is starting to pour in again. The investment outlook looks promising across a number of core hedge fund strategy areas.

New talent is infusing fresh blood into the industry. New investors are being reached in both the institutional and retail arenas through mutual fund, 40 Act, UCITS and other new hedge fund-type product structures.

The opportunities for hedge funds to move into a number of areas from which the banks have retreated (either by choice or by force) are growing all the time, creating the potential for firms to add new business and revenue streams.

The restructuring of the industry precipitated by the financial crisis is largely done, creating a more stable and solid base. And the increasing appreciation by asset owners and allocators that the hedge fund industry is home to most of the world’s best asset managers is resulting in a growing number of long-only, customised and other investment offerings by proven hedge funds that give new types of investors access to top manager talent in new and different ways.

The entire world of finance is in the throes of wholesale, far-reaching upheaval. And hedge funds look well set to be the main beneficiaries of many of the changes that are sweeping through the investment banking and investment management worlds.

It is little surprise that the industry is entering 2014 on something of a high, certainly in performance and asset management terms. For many firms, 2013 was a great year – the best since 2009. And the constant carping in the mainstream media about disappointing hedge fund performance relative to equity indices entirely misses the point, as usual.

Most investors have plenty of exposure to equity markets as it is. They don’t need other investments to outperform equities when they are rising – although it is of course welcome if they do, as many long/short equity managers did so dramatically in 2013.

But what investors do need, now more than ever, is an additional return stream that provides much better performance than they would get either from fixed income, at a time when bonds would seem to have only way to go – or from cash, at a time when interest rates look likely to stay at heavily repressed levels despite the start of QE tapering in the US.

And what they also need, now that investors are so much more sensitive to the downside risks after several painful experiences over recent years, is access to a style of asset management that places so much greater focus on managing risk and protecting capital than other types of investment managers are able – or equipped – to do.

Equity indices are not the appropriate benchmark to judge hedge funds. They never have been. Hedge funds should be judged on risk-adjusted performance and on absolute returns, on their ability to generate alpha, to offer diversification, to manage risk and to provide a degree of de-correlation. On that score, most – but by no means all – are delivering handsomely.

Investors understand that, even if some commentators don’t (or won’t). And so they are voting with their feet – allocating money at a fast-accelerating rate to hedge fund managers who have proved many times, even in the darkest and most desperate days of 2008, their ability to constrain the downside risk while providing plenty of exposure to the upside.

Sure there are some dark clouds in the sky – mainly at a business management level. The insider trading stain from SAC is a gift to those people wishing to blacken the reputation of the hedge fund industry as a whole.

Regulation – partly necessary, but largely excessive – is changing the dynamics and the economics of the business, particularly for the much-needed smaller funds that provide so much of the diversity in the hedge fund world that is lacking in the mainstream asset management space.

And the restructuring of the banking system – which is nowhere near over – could result in some big and unwelcome changes for many hedge funds in terms of rising margins and fin-ancing costs as banks are forced to adjust to a much-altered return on capital environment.

But, in a world that is still full of risk and where much can still go wrong, one fact seems pretty clear. Unless you have a gift for picking the wrong funds at the wrong times – which, alas, is a skill that some investors do seem to show now and then – you are better off having money invested in hedge funds than not, whether markets are going up or going down.

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