The hedge fund industry's operational infrastructure and client base has become increasingly institutionalised and its investment practices continue to converge with those of traditional asset managers, writes Todd Groome

The perception has long been that those who invest in hedge funds are high net-worth individuals. That was largely true when hedge funds first began many years ago, but it is no longer the case. Today, investors in hedge funds are more likely to be institutions, such as university endowments, charitable foundations, public and private sector pension funds, and sovereign wealth funds.

This investor transformation has been a gradual process that reached a material milestone last year when, according to research by AIMA, institutions, for the first time, accounted for an absolute majority of hedge fund assets under management. Research has also shown that during much of the past 10 years, institutional investors represented the majority of net new investment capital in the industry.

A recent survey by also found that 75% of assets managed by the largest hedge fund firms came from institutional investors. And this is a trend we expect to continue. For example, a Deutsche Bank study indicated that 68% of institutional investors intended to increase their allocation to hedge funds in 2010.

Such institutional interest is also evident among smaller hedge fund managers - a strong endorsement of the industry and its entrepreneurial nature. Many institutional investors are attracted to early-stage managers and smaller funds, even start-ups, believing that they offer the opportunity for very attractive returns, preferred capacity arrangements as they grow, and the ability to influence portfolio structure and investment terms. Such investors, however, remain very demanding and typically continue to require an institutional ‘infrastructure'. As such, today smaller firms and even start-up funds demonstrate world-class asset management systems and operations.

Within the institutional investor base, pension funds are a very important constituency. Of the total capital from institutions, AIMA's research suggests that about one-third comes from pensions. Pension managers describe their interest in hedge funds as the ability to realise higher quality returns (ie, lower volatility, and downside protection or capital preservation), as well as additional risk management expertise and increased trading or market nimbleness (ie, the ability to process market opportunities) - attributes which are particularly valued in recent markets. From a macro perspective, advanced economies across the world are facing demographic pressures, and the funding positions of many pensions are challenged. Therefore, it is not surprising that hedge funds are valued for their superior risk-adjusted and diversifying returns.

The evidence backs this up. Hedge fund managers have typically outperformed equity and other indices over medium and longer-term periods; the Hennessee Hedge Fund index gained 88% from 2000-09, while the S&P 500 experienced a decline of 23%, the Dow Jones Industrial Average fell 9%, and the NASDAQ Composite index declined 44%. Moreover, Hennessee's annualised ‘volatility index' over the last decade experienced a standard deviation of only 7% for hedge funds, compared with 16% for the S&P 500 and Dow Jones Industrial Average, and 27% for the NASDAQ. Of course, such performance figures are even more pronounced in favour of hedge fund investments during specific down market periods.

Pensions and other institutional investors view hedge funds as a growing part of their diversified investment portfolios. Pension funds globally, for example, typically have allocated less than 5% of their portfolio to hedge funds or funds of hedge funds (generally targeting 8-10%). While this share has increased over the past few years, many analysts expect both pension fund allocations and targeted exposures to double or even triple in the years ahead.

This is a global trend. In the US, private sector pension funds look to allocate, on average, about 10% of their assets to hedge funds, a little ahead of public sector pensions, which target 8% on average. In the UK, some of the larger schemes have allocated up to 15% of their portfolio to hedge funds. In continental Europe, the allocation to hedge funds by pensions has been more mixed, but pension funds in some markets, such as the Netherlands, have embraced hedge funds and other alternative investment strategies, particularly following the adoption of new pension regulations and tougher risk controls and funding requirements.

The global economic crisis caused only a temporary interruption to the growth of institutional capital in hedge funds, with inflows returning to healthy levels in the second half of 2009. Recent surveys by Credit Suisse and Deutsche Bank suggest that the industry may attract $200-300bn of net new capital this year. It also appears that a large portion of the redemptions during the 2008-09 period were made by high net worth individuals, rather than institutions, and that institutional investors continued contributing new capital throughout much of 2009.

Growth of operational infrastructure
As part of its growth and maturation, and in line with greater institutional investor participation, hedge fund firms of all sizes have become more institutionalised in terms of their operational infrastructure and systems. This can be seen in the increased number and professional experience of non-trading staff, as well as the robustness of the risk management systems, compliance procedures, performance and risk reporting (internally and externally), governance structures, and overall operational infrastructure employed today throughout the industry. Institutional investors demand the highest quality of operational and risk management systems from their investment managers, and therefore both to attract and in response to investor feedback, hedge fund managers have developed among the most sophisticated asset management and trading infrastructures in the financial services sector.

This high level of operational infrastructure and risk management was evident during 2007-08, and later highlighted favourably in various studies conducted by national and international regulatory authorities, including with regard to such issues as counterparty risk management. Most simply, hedge fund managers have always understood that, unlike other institutions, they will not receive government support during a crisis or market disruption and, therefore, risk management practices and related systems must be of the highest quality.

Such infrastructure development has required significant investment by managers in technology and people. However, by any calculation, the benefits to investors and managers clearly outweigh the costs. The growing emphasis by investors and policymakers on transparency, risk analysis and risk reporting will serve to reinforce this infrastructure build, and the industry is working closely with investors and regulators on such issues. Indeed, beyond near-term changes related to a new regulatory framework, the most influential changes to our industry are likely to be driven by the private sector (ie, initiated by investors and managers). The industry has been, and will no doubt remain, very focused on investor requirements, and thus can be expected to continue to develop world class investment platforms.

The relationship between institutional investors and hedge fund managers has also been evident regarding regulatory reform. For instance, some of Europe's largest and most sophisticated pension funds have expressed concerns about the proposed EU Alternative Investment Fund Managers Directive (AIFM). Through letters submitted to the Commission and the European Parliament, several groups of pension schemes have outlined how they would likely experience less investment choice and lower investment income as a result of the proposed Directive, and thus be forced to increase contributions (in some cases materially). Said differently, while such investors support steps to improve financial stability, they do not desire product level regulation or other public initiatives that may dramatically alter the business model or the investment framework, preferring private investor initiatives in this regard.

Convergence of alternative and traditional asset management practices

Throughout much of the ongoing regulatory reform debate, it has been apparent that some policymakers lack a reasonable understanding of the important role of non-banks, including hedge funds, and the function of markets in today's economy. This is of course a concern, since the proposed reforms have important real economy implications. More broadly, hedge funds should not be viewed as a distinct asset class, mere speculators (as distinct from investors), or a high risk group. Rather, hedge funds should be seen as part of the asset management industry. More specifically, hedge fund managers should be viewed as providing an active style of portfolio management - utilising a variety of hedging practices to reduce volatility, protect capital, and improve returns.

Hedge fund managers provide such investment skills through a variety of legal structures, products and strategies. In addition to a wide range of investment strategies, covering both very liquid and less liquid asset classes, many managers today offer long-only actively managed portfolios, attracting existing and new institutional investors, and more recently have offered UCITS funds, ETFs and various fund of hedge fund products for institutional and individual investors. This trend has been largely investor demand-driven. As a result, traditional asset managers are also employing a variety of hedging tools, such as short selling and derivatives. Many traditional asset managers also offer UCITS funds, ETFs and fund of fund products to institutional and individual investors. We believe that this is both a healthy and logical trend, and reflects the on-going convergence of hedge fund and traditional asset management practices.

Throughout its existence, the hedge fund industry and managers have demonstrated an innovative and robust approach to asset management and, as such, the industry has successfully responded to changing market conditions and investor demands. The business model, product offerings, and investment practices of hedge fund managers will undoubtedly continue to evolve, and given the growth of the institutional investor base and the related operational infrastructure developed by managers, the industry is increasingly viewed as an established and mature sector within the asset management and financial services industry.

Indeed, with increasing demand for higher quality returns from all types of investors, we expect more fund managers to employ hedging practices typically utilised by hedge fund managers. Interestingly, some investors have begun selecting external managers unconstrained by whether they are a hedge fund or a long-only manager, but rather seeking the best manager, strategy, and portfolio exposure. This seems a sensible way to manage investment portfolios, and to select the best investment partners.

The institutionalisation of the hedge fund industry has been a developing theme throughout the past decade, and will no doubt continue. Hedge fund managers of all sizes and from all regions are equipped to professionally manage the capital from a growing and sophisticated institutional investor base. The operational infrastructures developed and evident across the industry today will also enable hedge fund managers to meet the emerging regulatory framework, as well as to offer a growing variety of products to an expanding investor base.

Todd Groome is chairman of the Alternative Investment Management Association and a former adviser at the monetary and capital markets department of the International Monetary Fund Fund (IMF)