Is there room at the hedge fund table?

Chambers: the industry can absorb additional flows from institutions without degradation of returns

It is not that the wealthy are removing money from hedge funds – indeed, their inflows are increasing. Rather, institutional investors, such as pension funds and endowments, have steadily been introducing hedge funds to their portfolios. They now hold about 25% of the $800 billion of assets in the sector. And it's only the start.

"The hedge fund industry is still at the adolescent stage," says Doug Wurth, head of investment solutions for Europe and Asia at JPMorgan Private Bank. "We could easily double the current amount of assets in three years' time. There's an awakening of the institutional giant here. If you assume institutional investors allocate just 5% to hedge funds, you'd have a quantum leap in terms of the number of hedge fund assets. The story is really just beginning." Institutional investors hold an estimated $40 trillion in assets under management: moving just to a 5% allocation would increase today's institutional assets in hedge funds 10 times over.

Such thoughts put a smile on the faces of hedge fund managers and their protégés but they are more likely to furrow brows at private banks and family offices.

One concern is that hedge fund managers will desert their relationships with high-net-worth individuals in favour of the large lump sums promised by the institutions.

As a hedge fund manager that caters solely to institutional investors puts it: "Why would we sell to private clients or their distributors? Extra marketing and reporting costs would wipe out any benefits in fees, and with dribbles of cash here and there it would be difficult to maintain control. Fewer clients with more money is a better situation to be in."

Nicolas Campiche, CEO of manager selection services at private bank Pictet, believes it is still unclear which investor base will prove preferable for hedge funds. "In theory," he says, "the private banks should continue to enjoy a privileged position because of the long-term relationships that have been developed with hedge fund managers. But some managers are of the opinion that institutional money is more stable than private clients' money."

Guy Paterson, London head of independent wealth managers Unigestion, says that hedge fund managers might feel more comfortable with institutional clients. "If you ask the really good managers, they would say they prefer the family offices and institutional money. After the poor returns we've seen in April and May, retail investors might lose heart and pull out. Good hedge fund managers would favour the clients of firms who are known to explain to their clients the real implications of their investments."

Decisions by pension funds and endowments to allocate to hedge funds are not taken lightly. "Asset allocation reviews tend to take place every three years, and after a pension fund decides to allocate to hedge funds, the trustees will usually have some training, receive professional advice, and then go about deciding how much they want to allocate," says Robert Howie, senior consultant at Mercer Investment Consulting. The whole process can take up to six months.

The protracted due diligence process can have its drawbacks, though. Some hedge funds open and close within six months, and institutional investors will be too slow to react, particularly if they are not familiar with the management team.

Rigid demands on track records and size will also hinder the opportunities available to them. "Institutional investors are only slowly becoming comfortable with the industry. If they apply normal criteria such as minimum size and track records, they risk being excluded from good hedge funds through not investing soon after launch," points out Tim Bell, executive director at UBS Wealth Management. Man Investments also finds that track record issues are frequently raised by institutional investors. "We face this issue on a regular basis when we open a manager that is new and seeded and so has a limited track record, or perhaps when we start up a new family of funds," explains Mark Chambers, head of sales management in Europe for the alternative investments group.

These constraints are leading some hedge fund managers to ensure that their investor base is a mix of private clients and institutional money. "Private banks are more flexible but institutional investors can be more stable from a long-term point of view, so we have a blend of the two," says Christopher Burden, chief operating officer of US fund of hedge funds manager Ferro Capital. "There are pros and cons to both so it pays to have a mix. Larger investors come with a lump sum, but that can have a big effect if they were to change their allocations. And because institutional investors come with more money, they tend to want to invest with customized terms and structures that can be time consuming to administer. There is usually greater efficiency with private clients."

Man Investments also has a mix of institutional and private investors and makes sure both client bases are catered for. "Three or four years ago private clients probably made up about 75% of our investor base, whereas now it's about 50:50," says Chambers. "It could swing further towards the institutional investors but private-client investments continue at as healthy a pace as ever. We will certainly focus on that base too and develop products for both types of investor."

Indeed, the different products required by the two types of investor base could mean that they don't stand in each other's way. Ferro Capital's Burden says: "Consultants play such a dominant role with institutional investors that they can end up with a narrower investment universe. The different consultants tend to apply similar criteria and end up with similar shortlists of hedge fund managers, whereas the private banks will use their own resources. There is some overlap on the strategies selected but the private banks consider different opportunities.