With rampant consolidation in the alternative investment industry, the top players in each discipline (e.g. hedge funds, private equity, real estate…) now control a significant proportion of assets.  As a result, the views and experiences of these rarefied groups are becoming more representative of the greater industry.  This fact was surly not lost on the good folks at Watson Wyatt, who recently polled the top 100 managers of alternative assets.

The report is available for free (with quick registration) here and makes for interesting reading.  The firm examined only the pension assets managed by these asset managers, not their retail or endowment assets.  The overall size of the pension allocations to the top 100 alternative asset managers in 2008, according to the firm, was $817 billion.

Despite some media reports that this number was a poor showing for the industry (ex. “Allocations to alternative assets dip“), it was down only 1% from last year’s $823 billion.  In North America, the number actually grew from $395 billion (48% x 823b) to $433 billion (54% x $817b) - a 10% increase…

Real estate continued to be the drug of choice for pension funds across the globe, although funds of private equity funds and commodities jumped from $172b to $236 billion.  Funds of hedge funds assets managed by the top 100 fell from $131 billion to $106 billion.

In 2008, there were 28 funds of hedge funds in the top 100.  When the top 50 largest funds of hedge funds were analyzed on their own, the overall AUM figure was closer to $123 billion according to Watson Wyatt.

A simple sanity check confirms this number: Assuming the entire hedge fund industry manages $1.2 trillion, and roughly half of all investment dollars are from institutions, the total institutional investment in hedge funds is about $600 billion.  If about half of all hedge fund allocations are made via funds of funds, then the total institutional investment in funds of funds would be about $300 billion.  Further, if you assume that two-thirds of those institutions are pensions and two-thirds of those are “top 100″ managers, then you get down to about $130 billion - pretty close to Watson Wyatt’s $123 billion estimate.

In case anyone needs more evidence of concentration in the fund of funds industry, check out this graph from the report:

As you can see, the top 10 funds each manage an average of 5% of the top 50 funds’ pension AUM.  The next 30 manage an average of 1.3% and the final 10 manage less than 0.5% each.  The remaining few thousand funds of funds are left to fight over, at best, another $100 billion.

However, the level of concentration seems to have dropped as the largest dozen managers seem to have taken the biggest hit in 2008.  The graph below shows what amounts to a falling Gini coefficient (see related post: Hedge Fund Asset Concentration: Is the Gini climbing back in the bottle? ) for the hedge fund industry.

Interestingly, the story was reversed in the private equity industry with the top dozen managers now managing a largest proportion of the AUM than they did at the end of 2007.

With the notable shenanigans perpetrated by some hedge fund managers, managed accounts seem like a no-brainer.  After all, who wouldn’t want to be in full control of their own private hedge fund?  You could redeem whenever you wanted, get real time position-level transparency and even do your own valuations.

But as we have suggested in the past, the situation is not quite this simple.  Unfortunately, no managed account is an island.  The legal separation of assets does not sever the fund’s destiny from those of other similar (especially parri passu) managed accounts and funds.  If the managed accounts are not parri passu (for example, if each investor overlays their own risk management rules) then this problem would be solved.  But it would open up another issue: each fund would be different and would have no appropriate track record.

This is one of the points raised in a slide deck being circulated by due diligence company SwissAnalytics.  One of the slides in the presentation (available here at Barclayhedge’s website) contains the following helpful summary of the pros and cons of managed accounts: More…

We’ve moved from Bermuda to Boston today on our tour of places starting with the letter “B” this week.

A cradle of traditional investing civilization, Boston also has a vibrant alternative investment community.  Even the long-only stalwarts are now joining the revolution.  Putnam Investments for example, has recently showed some interest in alternative strategies - albeit in a decidedly traditional wrapper (see recent post).  Putnam’s interest in hedge funds is matched by at least one major pension plan - laying the groundwork for a crowded industry as it emerges from the doldrums of 2008.

It’s no surprise then that Putnam CEO Robert Reynolds revealed to local university students earlier this week that he really does want to get into the alternative business.  Reuters reported that Reynolds wants to “round out (his) product palette.”

We’d guess that many retail mutual investors might be kind of freaked out if they thought Putnam was turning into a hedge fund company.  So perhaps to avoid alienating this critical constituency, Reynolds quickly followed that he sees this as a way to “appeal to a different market segment.”

Not a “real” hedge fund?

In a situation reminiscent of the 130/30 debate, hedge fund managers are skeptical of traditional investors’ ability to do justice to their craft.  For example, one of the co-founders of UK hedge fund company GLG Pierre Lagrange, suggested to the FT last week that hedge funds managed by mutual fund companies lack that certain je ne sais quoi that only a hedge fund could deliver.  Said Lagrange: More…

We have compared the dot-com “bubble” to the hedge fund “bubble” several times on these pages.  Nearly three years ago, for example, we suggested that hedge funds were to mutual funds as e-business was to bricks-and-mortar businesses in the late 1990’s - a disruptive technology that has the potential to delineate and re-organize traditional value propositions and their supporting business processes.

Last summer we told you about professor Richard Taffler, the British pioneer in the emerging field of “emotional finance” (note: different than behavioral finance”).  Taffler wrote an interesting paper in 2007 that compared the emotional stages of the hedge fund bubble to the parallel stages in the dot-com bubble (namely: Emerging to View, Rush to Process, Psychic Defense, Panic Phase, and Revulsion and Stigmatization)

While Taffler’s model lacks a happy ending, another dot-com analogy introduced in the FT yesterday ends on a far more positive note.  In a column titled ” Hedge fund industry climbs its ’slope of enlightenment’ “, GAM’s David Smith draws on yet another technology rubric to explain the current state of affairs in the hedge fund industry.

Smith draws on an idea called “Hype Theory” originally proposed by tech consultancy Gartner Group.  Nearly a year before the dot-com bubble burst, Gartner consultant Alexander Drobik wrote that e-business would soon come to an “end”.  Argued Drobik: More…

It’s often assumed that the asymmetry inherent in hedge fund compensation contracts leads managers to “swing for the fences” if they are down.   If they hit the ball out of the park, the get a big payday; and if they strike out, they can always try again next year.  Although proponents of this theory often overlook the fact that striking out hurts the manager by alienating a generation of fans, the idea generally makes intuitive sense.

But a study we covered back in December showed that managers did not tend to swing for the fences when they were down by mid-year.  In fact, the opposite was much more likely: that they tend to lay down sacrifice bunts when they’re ahead by mid-season.  In other words, sensing a big year-end payday, winning managers tend to markedly de-risk in the second half of the year.

Nothing to Lose

However, a new study by George Aragon of Arizona State and Vikram Nanda of Georgia Tech suggests that such behavior - to the extent that it does exist - may actually be rife in funds that are in their “incubation stage”.  Newly minted funds are much more likely to swing for the fences than existing funds.  This makes a lot of sense, of course.  It’s as if every game was the last game of that player’s career.   He’s got nothing to lose.

With incubating funds exhibiting most of the so-called “tournament behavior”, it turns out that the established funds exhibit virtually no such propensity at all.  As the authors put it: More…

One of the more enduring criticisms of the so-called “hedge fund model” has been that the relationship between manager and investor is asymmetrical.  Mark Anson, CAIA, the president of mega-manager Nuveen Investments discussed three dimensions of this asymmetry in a column for Pensions & Investments on Monday.  Regular readers of this website may remember Anson as the former CIO of both CalPERs and Hermes (manager of the British Telecom pension plan among others).

Anson argues that managers have an advantage over investors when it comes to:

1. knowing the true amount of beta in their funds,
2. the fee structure (everyone wins when the fund is up, but only investors can lose when it’s down), and,
3. information on the true risks of a particular investment strategy.

While he does not prescribe any kind of remedy, you don’t have to be a rocket scientist to figure out that managed accounts would greatly mitigate these asymmetries.

So why the debate then?

But as we have recently observed, the debate over institutional managed accounts continues.  Sure, many sophisticated institutional investors are now turning to managed accounts to address age-old concerns about transparency, liquidity and fees.  In fact, the new CIO of CalPERS, Joseph Dear recently reiterated the pension plan’s concerns when he told Bloomberg News this week that: More…

There was more evidence last week that alpha-centric investing is rebranding itself.  Clearly alarmed about the negative imagery now associated with the term “hedge fund”, several alternative asset managers have adopted the moniker “absolute return” or have simply dropped any reference to alternative investments from their name.

One good example is the rebranding last week of Chicago’s Harris Alternatives LLC.  The firm adopted the name of its flagship fund, calling itself Aurora Investment Management since “Chicago already has too many Harrises“.

But notice another subtle change.  The firm also dropped the “Alternatives” bit in favor of the more traditional “Investment Management”.  In reference to investors’ habit of referring to Harris as “Aurora” all along, Pensions & Investments saw this as a case of “if you can’t beat ‘em, join ‘em.” But that observation also clearly applies to the firm’s decision to position itself as a provider of traditional investments - not just alternatives. (In fairness, Aurora’s home page makes it clear that the firm is still solidly in the alternative asset management business.)

Aurora isn’t alone.  Bridgewater Associates was recently crowned by Fortune Magazine as “The World’s Biggest Hedge Fund Manager”.  Yet despite this achievement, Fortune reports that Bridgewater “doesn’t use a lot of borrowed money” and that Dalio “hates being called a hedge fund manager.” (Though oddly, Fortune also says Bridgewater’s leverage ratio is 4:1, higher than the hedge fund industry average.)

Meanwhile, traditional investment managers continue to launch sorties into alternative territory.  More and more traditional UK asset managers are apparently adopting the “absolute return” moniker in effort to expand their product offerings.  As P&I also points out in this article: More…

“USA Today has come out with a new survey - apparently, three out of every four people make up 75% of the population.” - David Letterman

For all intents and purposes, the hedge fund “industry” has only been around for a decade.  Like snowflakes, no two years have been the same (or even close).  So polling industry participants is generally seen as the only way to keep a finger on the pulse of the industry.

The trouble is, precious few surveys are able to compare changes between one year and the next.  Without such comparisons, survey results usually serve only as good headline fodder, not as an indication of any material changes.  For example, who knows if a result such as “50% say they plan to invest in hedge funds” is atypical or not?  (Perhaps 60% of investors planned to invest in hedge funds last year.  Perhaps it was only 30%…).

State Street published the results from a survey last week that has been conducted for several years at the annual Global Absolute Return Congress (”Global ARC“) in Boston, London and San Francisco.  So we were particularly interested to see how the opinions of institutional investors in the October 2008 edition compared to those of October 2007.  Our analysis of the report (which is available for free by emailing State Street here) focuses exclusively on changes over time.

Stay the Course?

The survey found that 75% of investors did not plan to modify their asset allocations as a result of the (then) recent financial turmoil.  This sounds like a vote of confidence for the industry.  But it appears that many investors may have already adjusted their hedge fund allocations by the time they showed up in Boston last fall… More…