Originally published in
Benefits Canada, November 2013, by Yaldaz Sadakova

November 11, 2013
In the media

Return of the Hedge Fund

With the financial crisis behind them, are investors ready to re-risk? We brought together money managers and consultants in a virtual roundtable to discuss whether Canada’s institutional investors are, once again, exploring this space.

Q: Are hedge funds making a comeback among institutional investors?

Jean Baram: Simply based on assets under management, it is true that the assets in the industry are at an all-time high, and that can be seen as a comeback following the losses posted during the 2008 financial crisis. However, when taking a more granular view, we observe that the industry has experienced significant changes after the crisis. While investors were mainly funds of funds, family offices, high-net-worth investors and private banks, the demand in the industry is now predominantly driven by pension plans and other institutional investors. These investors are allocating more to hedge funds than in the past, as the 2008 crisis awakened their need for diversification and downside protection.

From our perspective, the crisis has generally led to an increase in demand from institutional investors for hedge funds (and not a decrease—thus, not a comeback per se). These investors have changed the way they invest, switching from the traditional funds of funds model to direct investment and, more specifically, via managed accounts. However, the other groups of investors that reduced exposure to hedge funds after the crisis have been reluctant to increase their allocation to the space.

Q: How has institutional money changed the hedge fund space, for better or worse?

Baram: The changes to the industry are notable. Institutional investors have changed the way they invest. They have also increased their requirements in the areas of fund governance, risk management process, enhanced transparency and legal terms. For example, they require a clear separation of tasks between portfolio management and risk management. Some also require the hedge fund manager to amend its general offering documentation to reflect these enhancements and have other clients benefit from it.

In terms of fees, they are certainly pressuring managers to move away from the traditional 2-20. We are seeing a lot of variations on fee structure that we didn’t see before. Overall, the increasing needs of institutional investors have pushed hedge fund managers to make their processes more robust and scalable in order to attract these large allocators.

Q: From a pension fund’s perspective, what are the risks involved with investing in hedge funds?

Baram: When investing in hedge funds, pension funds face similar risks as those they face in traditional funds, such as market risk, geopolitical risk, operational risk, fraud risk, blow-up risk, liquidity risk, etc. Due to the nature of hedge fund investing, they face additional risks such as diversification risk, credit and counterparty risk, and leverage risk, as well as reduced regulatory supervision. This has given rise to the popularity of managed account structures, as they mitigate some of these risks.

Q: What are the possible benefits?

Baram: Pension funds gain important benefits through hedge fund investing, such as access to broader strategies, better usage of each dollar deployed (via leverage and notional funding), improving the risk/return profile of their investment, diversifying their portfolio or reducing the drawdowns.

Q: How can institutional investors that have been let down by hedge funds before prevent it from happening again?

Baram: Generally, the performance of the hedge fund industry in the last few years did not meet investors’ expectations. However, many hedge fund strategies performed well. Like many investments, past performance is not indicative of the future, so a thorough due diligence process aimed at understanding the strategy, its drivers, favourable and unfavourable environments, and the manager’s investment process is key for investors.

Q: What trends are emerging in the hedge fund space?

Baram: We have seen many trends slowing down, such as the interest in structured credit and credit managers. On the other hand, we are seeing the continuation of some trends, such as more variations of managed account structures, a big wave of hedge funds being offered to retail and more concentration in client portfolios (i.e., fewer hedge fund managers). Generally, investors should expect more changes and regulations, and these changes will lead to opportunities. For example, due to increased regulatory scrutiny, banks are exiting some business lines that they traditionally dominated, allowing asset managers such as hedge fund managers to step in and fill the gap.

Jean Baram, managing director, investor relations, Innocap Investment Management

Yaldaz Sadakova is associate editor of Benefits Canada. yaldaz.sadakova@rci.rogers.com