After the Crash: The Future of Finance

4. The Future of the Hedge Fund Industry

83 4 christopher c. geczy The Future of the Hedge Fund Industry Examinations of the future of hedge funds are daunting tasks, not in the least because understanding hedge funds is still a subject of intense academic, industry practitioner, regulatory, and legislative examination. Even the very definition of a hedge fund defies easy characterization, an unusual irony given that, at least for the foreseeable future, hedge funds stand a substantial chance of remaining fixtures on the global landscape of wealth management. Perhaps the clearest definition of a hedge fund may be that it is a simple compensation contract and little else, systematically speaking. Other useful definitions may reference the fact that hedge funds find safe harbors from the 1940 Investment Company Act, the Securities Act, and other regulations. These safe harbors may facilitate certain investment strategies and trades, including those that use substantial leverage and great degrees of illiquidity. What is clear from both the academic and practitioner literature is that hedge funds do not necessarily hedge. By nature, any examination of the important elements of the hedge fund industry is subjective and incomplete. That said, the analysis offered in this chapter tries for objectivity by depending on research, the historical record, regulations , and a quantitative assessment of risk. I would like to thank Richard Herring, Robert Litan, the Financial Institutions Center at Wharton, and the Brookings Institution for financial support. Kyle Binder, Michelle Zhang, Kevin Burke, Helen Nguyen, Jamie Doran, and Amanda Wagner provided excellent research assistance. 04-0404-1 chap4.indd 83 7/12/10 6:05 PM 84 christopher c. geczy The Wharton Hedge Fund Survey of Pension Consultants A number of well-known surveys examine forecasted industry trends from both the institutional perspective and the net worth perspective. The Casey, Quirk, and Associates/Bank of New York survey, for example, queries institutional investors in hedge funds.1 But these institutional surveys do not necessarily query institutional consultants or focus on them to any great extent. With the purpose of understanding what these providers of investment advice see as important trends and to understand what they perceive as their clients’ views, in the fourth quarter of 2009 and the first quarter of 2010 we conducted a survey of the largest fifty investment consultants for pension funds. We measured assets under advisement, numbers of clients, and their ranking by Thomson Financial and Nelson.2 Of the consultants who responded (30 percent), 20 percent have thirty to a hundred employees and another 20 percent have more than a hundred. Respondents have thousands of clients who invest more than $7 trillion in assets, with most respondents (70 percent) having more than $7 billion under advisement. Type of client ranges from large state, corporate, and Taft-Hartley plans to endowments and foundations. Twenty-two percent of consultants indicate that their clients allocate 10–20 percent of their funds to hedge funds and funds of funds; 33 percent say that their clients allocate 5–10 percent to these funds; and 44 percent record a 5 percent allocation. Trends Uncovered by the Survey Answers to our survey provide insights into trends among both hedge fund consultants and their clients. The following examines several of these areas. When queried about the most important near-term trends in the hedge fund industry, every respondent mentions increased transparency in hedge fund manager strategies and positions. This notion relates to the more general theme of a power shift to investors from managers, as most respondents also mention decreasing fees, better liquidity terms, and more rigorous operational due diligence as being demanded by their clients and increasingly supplied by them, with more than 50 percent mentioning each of these items. Other trends mentioned include declining leverage, consolidation, and institutionalization, broadly defined. 1. Bank of New York (2009). 2. Thomson Financial (2003). 04-0404-1 chap4.indd 84 7/12/10 6:05 PM the future of the hedge fund industry 85 More than 90 percent of consultant respondents cite increased regulation as one of the most important issues facing stakeholders in the industry at large. With the possibility of increased regulation imposing greater costs and limitations on investment activities as well as decreased risk of fraud, consultants indicate that whether and how hedge funds fall under increased regulatory oversight or enforcement is a critical element in how they might advise clients in the future. In addition, likely reflecting their and their clients’ experience during the recent...