FL, Aima: Perhaps to start with it would be helpful if I set the scene. Hedge fund assets under management globally are estimated at around $1 trillion. In Europe, 228 funds were set up last year that raised $20 billion of new money. Europe today is growing faster than America and, in turn, Asia is growing faster than Europe. So let's first look at the positioning of hedge funds: what do we know about the investor base? Barry why don't you go first?
BB, Deutsche Bank: Well, the volume figures are instructive. That $1 trillion represents a 10-fold increase over the past decade, and it's more than a doubling since the 1998 crisis. Interestingly, less than half of the growth has been from asset inflows: 55% has been a result of performance. The number of funds has also grown rapidly with about 6,300 managers now in existence. According to an internal survey we carried out, about 55% of those are funds of funds. Of the remaining 45% the largest sectors are 15% family offices, 7% banks. In terms of assets, the funds of funds represent around $300 billion, with the top 50 controlling $210 billion of investments.
The direct institutional investment has been driven by two factors: first, asset/liability gaps in the pension side. Last year, despite the rally in stock markets, S&P500 pension underfunding grew from $212 billion to $259 billion. We suspect it's only going to get worse. Second, the institutions are following success stories such as the endowments of Harvard and Yale, both of which have a very high proportion of assets dedicated to alternative investments.
Their 10-year records – annualized returns of between 14% and 16% – have given a lot of institutional and academic gravitas to the idea that these belong as products within an institutional portfolio. And we're beginning to see that in Europe as well: recent surveys show that 47% of the 73 largest pension institutions in Europe are intending to or have made investments into the alternative asset class.
OK, Permal Investment Management: Barry's last comment raises the question of whether hedge funds are a separate asset class or a portfolio component. My view is that how they are viewed is a learning curve issue. Those new to hedge funds treat them as a separate asset class to be handled with care. They start with 1% or 3% or 5%, monitor that position and build structured products around it to prevent accidents.
People who have had more experience and are further up the learning curve view hedge funds as a portfolio component – as a superior way of investing in traditional investments not as an alternative set of assets. Private clients who have been exposed to hedge funds for more than a decade would very much view hedge funds as core and not as a separate asset class
AP, CSFB: I agree. The questions we are asked by our clients about risk imply that institutions are treating it as a portfolio component. They are now looking beyond the investments and strategies and performing principal component analysis themselves to try to isolate their fundamental risks. This is so they can integrate those risks into their investment portfolio.
DE, Société Générale: This raises the question of whether it is sustainable for an institution to consider alternative investments as part of its portfolio as any other type of investment. In other words, once people move from the 5% that Omar mentioned to, say, 25%, then how will the industry cope? Is there a capacity constraint?
BB, Deutsche Bank: I think the answer to that is that the personal economics of running a fund are very good so there is no lack of people who'd like to do it. Also it's a very Darwinian space and so the biggest challenge the capacity constraint creates for the institutional investor is to force them to make investment decisions much earlier in the life cycle of a manager than previously. Today if an investor wants exposure to the hedge fund sector it often has to be willing to forgo the requirement for a long-term track record.
TB, UBS: Just to bring the private investor into this: private investors are the natural investors in hedge funds, especially given that many hedge funds were originally set up by wealthy families. And whereas one might think institutional investors are much more sophisticated just because they are large, it's the private investors who have been investing their own money in hedge funds for years who have really taken the trouble to understand them.
We would never consider hedge funds to be an asset class. In our view they are simply a business model that enables investors to manage money in a far more sophisticated way – able to hedge out the risks to which you don't want to be exposed and to take on very specific risks where you see opportunities. Given that, it follows that for a private client our job is to look at the overall picture, understand their needs and what it is they're trying to achieve, and then to advise them in the creation of a customized hedge fund portfolio around those objectives, to the extent that it makes sense and is suitable for them, asset class by asset class. In particular we take into account downside risk potential and liquidity requirements.
For example, some investors might want to take on a highish degree of equity market risk, but to take the edge off the potential level of volatility at the same time. For them, longer-bias equity hedge funds make sense. Others might want a lower level of volatility altogether, in which case the equity hedge fund component of their portfolios would tend more towards neutrality.
That exemplifies how hedge funds are not an asset class; they are just a different way of accessing a particular asset class. That is a very important distinction, and private investors very much understand it, whereas I'm not so sure many institutions do.
BB, Deutsche Bank: I think that's right.