Meeting the hedge capacity challenge

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What is very interesting is the recent rise in pension fund investment in hedge funds. Driven by increasing membership and sponsor pressure to generate absolute returns, pension fund trustees are increasingly considering hedge funds as part of their overall investment portfolios. Now that consultants and even the UK government (Myners) are advocating at least the consideration of hedge funds in pension plans, we believe the stage is set for significant growth in this sector. Today, the hedge fund industry is estimated to encompass $600bn (e532bn) in total assets globally, according to Hedge Fund Research. With pension funds now looking to invest in hedge funds as well, many professionals in and around the industry are beginning to question whether there is enough capacity to absorb the expected growth.
On a global scale, hedge fund investment by pension funds is still very small at around 0.5% of global pension assets, according to consultants Mercers. However, many investment advisers are now beginning to advocate larger allocations to hedge funds. Our group for some time now been suggesting that somewhere between 5% and 18% allocations make sense for most pension plan sponsors. With many consultants also advocating similar allocations, questions of capacity are being asked within the industry. The prospect of more pension fund investment is forcing investors and managers to focus on capacity. How well will the hedge fund market deal with such growth in demand?
To answer this question we believe you have to first understand why hedge funds are not by definition always scalable. Capacity is in fact a complex function of investment style, security liquidity, manager diversity and economic environment.
q Manager capacity: The late 1990s provided a salutary lesson to hedge fund investors; that bigger is not necessarily better when it comes to hedge fund investing. In particular, in 1998 when a small number of very large hedge funds such as Long-Term Capital Management got into difficulty, the substantial size of their positions meant that it became almost impossible for them to exit their trades when they wanted to, without dislocating the marketplace and incurring substantial trading losses. This limitation to individual manager size is now well known. While markets can often sustain a great many small hedge fund managers, only the most liquid marketplaces can accommodate the larger single strategy managers and their trade positions. As a result, investors should always look to diversify across multiple managers even within similar styles. Diversification is the key to so much in investment, and hedge funds are no exception to this rule.
q Style capacity: What is perhaps not obvious to newcomers to the market is that there are a wide variety of different hedge fund investment styles being implemented. These different styles vary greatly in their risk and return characteristics; they also have different degrees of scalability. As a result, capacity is not just a function of size but also highly dependant on investment style and trading approach. For example, global large cap long/short equity is a very scalable strategy, with many liquid opportunities to exploit and few capacity constraints. Asian merger arbitrage on the other hand is both geographically limited and dependent on there being mergers available. While it is easy to conceive of many hedge funds all being able to invest actively in global large cap long/short equity, only a limited amount of capital could ever be applied to Asian merger arbitrage. Investors therefore need to be aware of the total assets managed in each investment style if they are to avoid becoming the victims of investment fashion through excessive style popularity.
q Trading environment: An added complexity is that not only are there many different hedge fund investment styles, but also that they each perform better or worse depending on the prevailing market and economic conditions. As a result, capacity for each strategy will vary over time, as different opportunities become available and others become restricted due to exogenous factors. A good example of this is convertible arbitrage, which is generally heavily dependent on a favourable credit environment and reasonable equity market volatility. In a scenario where credit spreads are stable to narrowing, and equity market volatility is high, convertible bond arbitrageurs, in general, can make significant profits and manage significant amounts of assets. Should volatility fall or credit risks deteriorate, it may become more difficult to generate returns and as a result, capacity in the strategy may become more limited.
The challenge therefore for hedge fund investors is to make sure they both diversify their hedge fund investments by investment style and reallocate between styles over time to position for changing investment environments.
q Number of managers available: While the above might sound daunting, the potentially good news is that there are an increasing number of talented hedge fund managers coming into the market. This is due to a number of factors. The growth in hedge funds and the service industry that surrounds them has meant that the costs of setting up hedge funds has come down and it is significantly easier to create a hedge fund today. At the same time, many banks have been paring back their proprietary trading teams, although this appears to be changing, and traditional asset management companies have seen reductions in their fee income. These changes have combined to create a fertile ground for new emerging managers to set up from successful proprietary trading and asset management operations. The price of exit is usually manageable, the costs of entry are low, and the future earnings potential for the industry winners is significant. As a result, a growing number of new hedge funds have been set up in recent years. We fully expect this trend to continue and with it the number and range of hedge funds available for investment.
q Hedge funds, a self-correcting business model: One final point that is worth stressing is the fact that hedge fund managers work from a business model that drives positive performance and encourages managers to exit unprofitable strategies. As hedge fund managers generally invest alongside their clients and earn performance-related fees, they tend to quickly exit strategies where positive returns are not attainable. This characteristic creates a long-term tendency within the industry for continued development of new strategies and the avoidance of over-crowded investment approaches.
In the short term, of course this rebalancing does not always go so smoothly. Indeed, historically we have seen several instances where hedge funds have incurred losses as a result of sharing identical or similar positions. Nonetheless, the basic characteristics of innovation and absolute return focus tends to drive the industry away from over-crowded markets and into new sources of return. This self-correcting business model will also help to manage capacity pressures in the future.
In conclusion, we continue to believe that while capacity with top managers will always be an issue for hedge fund investors, the industry is nonetheless well placed to grow significantly from current levels. We fully expect to see a steady growth in hedge fund investment from pension funds in coming years and expect the bulk of that investment to be made via hedge fund of funds. Through fund of funds investment, pension fund managers will be able to diversify their absolute return investments across large numbers of managers and a wide range of strategies. The challenge for hedge fund investors will be to understand and adapt to changing capacity characteristics of individual managers, investment styles and trading environments. More new managers will bring more new ‘opportunities’ and none of these will be without risk. To contain these risks in the future, we believe that comprehensive and on-going manager due diligence and diversification by manager and strategy will remain the best risk management approach.
Adam Sorab is director sales for Europe and Middle East, DB absolute return strategy group, Deutsche Asset Management in London

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