Factors Facing Alternatives Managers as an Industry Realigns
Alternatives, and specifically hedge funds, have come a long way since the early 1990s when the industry’s total assets were below $100 billion. Since then the industry has weathered periods of drawdowns and redemptions and what was seen by some as the very grim prospects for hedge funds post-2008. Moreover, multiple high-profile frauds and failures—from Bernard Madoff to Raj Rajaratnam at Galleon—have created additional obstacles, some notably warranted, to raising and managing a fund.
Yet today, in spite of these challenges, we have multiple, singular hedge fund platforms that individually manage on an absolute dollar basis what was in 1990 the total industry AUM—$38 billion. One may ask how the industry has developed to the tune of $2.25 trillion in current assets,1 with projections for both greater inflows and additional market lift in 2013. It might be reasoned that in today’s low-yield environment, alternative strategies present attractive options given their risk/return profile and lower correlations to more traditional products. Because of these attractive product attributes, institutional investors continue to be interested in alternatives managers. Accordingly, managers are focusing on governance and transparency as a key factor to success in this area.
Gaining trust via independent, third-party validation
A manager’s word is no longer enough. Gone are the days when managers could singularly produce net asset values and use unknown service providers with untested processes and controls. A service provider’s governance models and financial strength are now important as they are seen as an extension of a manager’s infrastructure. Weak service provider governance and capital structures could adversely affect a manager’s ability to operate seamlessly and, ultimately, lead to capital inflow obstacles. The manager process around counterparties, compliance and valuation, therefore, is crucial to success.
“Alternatives managers can be the net beneficiaries of industry capital realignment by embracing various global transparency protocols and initiatives.”
An additional consideration is that, as institutional investors have come to market, the inclusion of consultants is often a condition precedent to raising assets. Consultants typically look to manage both investment process and operational due diligence in equal parts. Accordingly, consultants see service provider choice as part of a broader analysis of whether to facilitate investment in a manager.
What the Open Protocol Offers
The Open Protocol Enabling Risk Aggregation solution was launched in 2011 as an effort to “standardize reporting procedures for collection, collation and conveying hedge fund risk information.” The organization promotes efficiency for managers and transparency for investors. With a working group comprised of 16 industry players, the organization has developed templates and a manual for investment managers seeking to report risk and exposure information to their investors within a standard format.2
Developments in risk reporting and disclosure frameworks
As institutional investors look to alternatives broadly speaking to play a role in their portfolios (additional asset class exposures, volatility reducers, liquidity plays, etc.), the ability to compare them and their broader portfolios on a consistent basis becomes crucial. Certain transformative initiatives—two developed within the industry and one without—are affecting the ability to attract investors:
- For the hedge fund space, risk reporting has matured and the Open Protocol Enabling Risk Aggregation standards are broadly gaining acceptance and investor adoption. The Open Protocol was launched in August 2011 by an industry group as a means to align transparency reporting formats and methodologies to benefit investors.
- The Institutional Limited Partners Association (ILPA) and International Private Equity and Venture Capital Valuation (IPEV) Guidelines Board are Open Protocol equivalents in the private equity space inasmuch as they advocate moving toward standardization of principles and communications around capital flows and transparency.
- Globally, both Dodd-Frank in the U.S. and AIFMD in Europe have raised the bar in terms of the transparency, fund liquidity and overall risk framework managers must work toward. By way of example, Form PF in the U.S. requires detailed information on liquidity, portfolio exposures and risk measures. An investor could then accordingly find comfort that managers need to adhere to these new rules.
Other shifts in the investment landscape
Three topical trends demonstrate the nature of a more global evolution:
- Pensions—Global economic uncertainty and the low interest rate environment have left many pensions, both public and private, looking for additional alpha opportunities. Enter more nimble alternatives managers and pension plans now have the option of more attractive, diversified risk-adjusted returns and correlations versus those offered by traditional equity and fixed income portfolios.
- Hybrid funds—Larger alternatives players have employed these structures as they continue to evolve and match their products to client demand. These products, unlike traditional hedge funds, are closed-end vehicles—yet they are similar to traditional hedge funds in the underlying, more liquid instruments they trade. All this is to say that institutional investors look to these products in certain cases as the investor liquidity profile provides some benefits.
- Retail fund flows across traditional mutual fund structures—There has been strong industry flow to lower-cost ETF products. Moreover, we have also seen capital flows to liquid alternatives or traditional mutual funds employing hedge fund strategies. To be sure, these new registered liquid alternatives products cannot replicate all hedge fund strategies given some of the liquidity and leverage constraints of the Investment Company Act of 1940. Nonetheless, they present some attractive low-tracking error versus non-registered private fund opportunities. This has translated into emerging curbside appeal for wealth management platforms and investors looking for exposure to these return streams.
Opportunities for alternatives
We are still in the driver’s seat as an industry, and alternatives managers can be the net beneficiaries of industry capital realignment by embracing various global transparency protocols and initiatives. Moreover, the ability to generate alpha and non-correlated investment returns across emerging structures will allow alternatives managers to capture an even broader pool of potential investors.