Institutional Demand for Hedge Funds 2: A Global Perspective

6 November 2006

By: Casey, Quirk & Associates, The Bank of New York
Published: October 2006

This report is chalked full of interesting tidbits for the “hard to buy for” money manager on your holiday list.  It’s an update of an equally interesting report published in 2004 by Casey, Quirk & Associates.  While we would love to get into many of the findings regarding the institutional adoption of hedge funds (the chart to the right, for example), we will focus here on the elements of report that pertain to alpha per se.  

The Alpha-Beta “Squeeze”

The authors suggest that institutional investors will begin to consolidate their alpha holdings and delineate them from their beta positions: 

“Today’s “active” allocations and hedge fund allocations are blurred. The active/absolute return components of institutional investors’ portfolios converge into a single more absolute return-oriented portion of the portfolio while the beta portion of portfolios is comprised primarily of index-like mandates.”

However, they still foresee a role for alpha/beta combinations in the form of 1X0/X0 funds:

“Long-oriented hedge fund products are a prominent part of the hedge fund landscape. Despite the “squeeze” discussed above, long-oriented products (for example, 120/20- type products or products with systematic net long exposures) will become more important. Partly a result of hedge funds applying their investing techniques to less capacity constrained products and partly due to investors’ continued, but changing, interest in long-oriented exposures, these products are a major part of many institutional investors’ portfolios. Many of today’s traditional managers will use these products to transform themselves into viable ‘hedge fund’ managers.”

Note the last line in the excerpt about traditional long-only managers morphing into de facto hedge fund managers.  They call this the “Alpha-Beta Squeeze” (see diagram).

Fee for Alpha

The report also says that institutional investors will wise up to overpriced beta and learn to better match fees to alpha-generation:

“Institutional investors have a more sophisticated view on fees and their relationship to value/net returns. Through experience and a deeper understanding, institutional investors are better able to discern value and understand the ability of hedge funds to deliver on their net return requirements.”

“Performance fees are explicitly tied to alpha.  Hedge fund performance fees are increasingly levied not on the total return (anything greater than 0), but on alpha. Hedge funds that can demonstrate they are delivering alpha and exceeding institutions’ cost of capital will command the greatest performance fees, even well in excess of 20%…”

In excess of 20% performance fees?!  Woo Hoo!  No, wait…

“…In addition, performance fees may be subject to a clawback when and if future performance falters.”

Ouch.  No more asymmetric return profiles for the manager?  Lucky Amaranth didn’t have this clause…

The report goes on to recognize the growth in synthetic hedge fund exposures (like the ones discussed in the recent report from Merrill Lynch). 

“The alpha-beta separation framework has impacted the hedge fund industry and, while not all hedge fund strategies lend themselves to it, innovative managers have found ways of creating synthetic exposures to certain strategies.”

The authors conclude with a warning to the industry about taking on too much beta exposure in response to their own  underperformance:

“What could cause this underperformance? The sudden and dramatic inflow of assets into hedge funds (which we are in the middle of seeing) could lead hedge fund managers to drift from their absolute return roots and take ever-greater beta exposure. Might hedge fund strategies too closely resemble the traditional long-only strategies investors they are seeking to replace?”

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4 Responses to “Institutional Demand for Hedge Funds 2: A Global Perspective”

1. All About Alpha » Blog Archives » SEC Hedge Fund Registration: Now Just A Seal of Approval? Says:
   January 24th, 2007 at 9:09 pm

   […] This article from Money Management Executive (via Financial-Planning.com) says that - contrary to many expectations - hedge fund managers are continuing to register with the SEC even though they don’t have to.  Why?  Because they want the implicit marketing endorsement that comes with registration.  They know that most of the growth in the hedge fund industry over the next few years will be fueled by institutional investors and that these investors need all the assurances they can get that a hedge fund has met some (any) kind of standard.  Reports Money Management Executive: “‘Some may say, Hey, you know what? What’s the big deal?’ said Thomas R. Westle, an attorney with BlankRome in New York. When no one was registered, it wasn’t an issue, but now institutional investors with a fiduciary responsibility to uphold are getting pickier, he said. […]

2. All About Alpha » Blog Archives » Hurdle Rates: Institutions Need To Take the First Step Says:
   February 15th, 2007 at 9:25 pm

   […] So we seem to have two opposing forces now.  A flood of cost-conscious institutional investors entering the industry over the next 5 years and the existing stock of hedge fund managers who would rather have root canals than drop their premium fees.  Perhaps, as Teague suggests, the solution lays with new alternative beta managers who will “appear to fulfill the demand.” […]

3. All About Alpha » Blog Archives » ABN AMRO’s Asset Management Business: A moment of truth for Barclays Says:
   March 22nd, 2007 at 7:31 am

   […] So why not combine passive and active under one roof?  The growth of the hedge fund industry shows there is obviously a growing global demand for active management - especially among institutional investors.  Why should the largest asset manager in the world get out of the active management business?  […]

4. allaboutalpha.com: Welcome to AllAboutAlpha.com Says:
   June 28th, 2007 at 9:58 pm

   […] If gala attendee John Casey (Casey, Quirk) is right about the coming flood of institutional assets into the hedge fund industry, “manager of the year” and “institutional manager of the year” will soon be the same award.  But for now, this Soc Gen subsidiary (not to be confused with the Vegas casino “Luxor” - a whole other type of risk) won these dedicated “institutional” honors.  […]