BNY Mellon and Casey Quirk & Associates
This is the third collaboration between BNY Mellon and Casey Quirk & Associates, marking the latest instalment in a series started in 2004 with ‘Institutional Demand for Hedge Funds: New Opportunities and New Standards’, and expanded in 2006 with ‘Institutional Demand for Hedge Funds II: The Global Perspective’. In our first two papers, we outlined how institutional investors would become a key source of capital for hedge funds, leading to profound changes in the industry.
Please note: Due to length, this article will run in two parts over two consecutive issues of Alternative Intelligence Quotient; this is the first section of the article and the second half will run in the upcoming issue (Issue #35).
The state of the industry
During the past decade, hedge funds represented one of the fastest growing segments in asset management, with industry assets under management expanding at more than 20% per year between 2000 and mid-2008. These years of rapid expansion were marked by a shift in both hedge funds’ investor base and in several core investment attributes, while some of the industry’s more controversial traits, including its obsession with secrecy and an antagonistic attitude towards any regulation, calcified into business as usual.
Since peaking in 2008, hedge funds experienced a severe contraction, with total assets under management falling by half by mid-2009. High-net-worth investors, primarily from European and Asian platforms, led the redemption charge. Certain institutional segments, however, saw meaningful outflows — in excess of 20% in the case of Japanese institutions. The result is not only a smaller industry, but a capital base that is more institutional and more North American. Remaining investors across the board are broadly committed to hedge funds, but need to be convinced that the industry will correct the business model imbalances and the flaws exposed by the recent crisis.
Hedge funds’ evolution since 2000
There have been three distinct phases to the hedge fund industry’s rise and recent fall: their coronation as ‘bear market heroes’ during 2000-2002, their expansion through the asset-growth wave of 2003-2007 and their contraction from crisis and redemptions during 2008-2009.
During the ‘bear market heroes’ phase, hedge funds comprised a relatively small and peripheral industry, characterised by small funds; a selective and savvy investor base of ultra-high-net-worth groups and a few large, innovative institutions; and investment strategies that promised to be both liquid and uncorrelated to the equity markets. In this first phase, the stable returns hedge funds provided investors during the equity bear market of 2000 to 2002 (without the illiquidity costs other alternatives imposed) awarded the industry powerful credibility and acted as a beacon to a wide swath of new investors, both individual and institutional.
During the industry’s second phase of evolution, between 2003 and 2007, four major trends further shaped the growth of hedge funds:
Source: HFR eVestment Alliance, and BNY Mellon & Casey Quirk Associates
Mainstream investors enter
Institutions in ever-growing numbers began using hedge funds as a source of diversification and more stable, ‘absolute’ returns. Sustained low interest rates and flattening equity returns, coupled with institutions’ required rates of return, helped stoke this interest. Our 2004 report indicated that US institutions had $66 billion invested in hedge funds in 2003, or roughly 8% of total hedge fund assets under management. By year-end 2007, that figure mushroomed to US$290 billion, approaching 16% of total hedge fund assets. Globally, institutional investment in hedge funds rose from US$361 billion as of year-end 2005 to US$748 billion just two years later.
High-net-worth individuals also flocked, as wealth advisers and bank platforms subscribed to the same investment premise institutions found so attractive. In particular, a combination of stable returns with high levels of liquidity made hedge funds ideal engines to power the structured notes favoured by many European and Asian investors.
Growing beta, leverage and illiquidity
Asset growth and shifts in the capital markets environment changed the mix of hedge fund strategies, with growth occurring in equity-oriented strategies (primarily long-biased, long-short equity), multi strategy and event-driven, at the expense of the ‘classic’ hedge fund strategies that dominated prior years. Higher correlation of returns to equity markets, less dispersion among hedge fund managers, growing use of leverage and creeping portfolio illiquidity accompanied these changes. In addition, funds of hedge funds’ liquidity terms failed to evolve with the liquidity of underlying hedge fund investments. In short, key features that attracted new investors to hedge funds during the bear market began to fade.