As the quinquennial of the financial crisis approaches, the intrinsic value of the hedge fund industry is being questioned by growing numbers of institutional investors. After nearly a decade of underperformance as compared to major equity indices, this should come as no shock. The real question is how this shifting paradigm threatens the hedge fund industry and what hedge fund managers can do to restore the confidence of the institutional investor.

Assets Under Management Growing

Although institutional investors are voicing a variety of complaints, assets under management have enjoyed a phenomenal increase of more than 60 percent since 2008, now totalling more $2.25 trillion. This suggests that institutional investors are seeking industry improvements, not alternatives. Further support for this view is the extraordinary expansion of hedge fund firms with an estimated 7,940 funds and 1,870 funds of funds in existence today. This is almost a 16 percent increase in the overall number of hedge fund firms, post-meltdown.

If we are to accept “supply and demand” as a fact rather than a theory, then it follows that institutional investors, wealthy individuals and wealthy families are creating demand. Increased competition among funds may be impacting fees. The standard 2/20 fee structure seems to be under pressure. While this may be a consequence of increased competition,  it could also be the result of client demand for a fee structure that is more faithful to performance. According to a study by the Edhec-Risk Institute, hedge fund management fees average 1.58 percent, while performance fees average 18.84%.

What Institutional Investors Are Saying

Institutional investors have expressed dissatisfaction on several fronts. Chief among these, according to SEI Investment Company’s Sixth Annual Global Survey, are difficulties in “manager selection.”  Secondly, seven of ten institutional investors responding to SEI’s survey, perceive inadequate differentiation in hedge fund investment strategies. Institutional investors seek firms capable of achieving their goal by virtue of an acceptable track record. Beyond that, investors say they need to be assured that the track record is the result of an investment process that can be sustained and repeated … not simply a consequence of good luck.

Since the report reveals that 70 percent of survey respondents fail to see  adequate diversity in hedge fund strategies, it is apparent that both manager and fund selection predicate on enhanced methods of differentiating one fund’s strategy from another’s and the development of tools to differentiate one fund manager’s talents from another’s.

Will the Industry Respond?

A response to the institutional investor’s concerns is likely, but with so much data pointing to industry growth, not only in terms of assets under management, but organic growth in the number of hedge fund firms, any industry response is likely to be measured. The only evidence of any institutional investor success must be extrapolated from the decrease in average fees cited earlier. Startup funds have the most to gain from complying with investor demands and these startups are the first and best hope investors have for the implementation of changes. Startups and smaller hedge fund firms will be the catalyst for broader industry compliance with the needs of the institutional investor.

The data certainly does not support the pending irrelevance of hedge funds, however, change is inevitable.

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