As the strategies of hedge funds and more traditional asset managers converge, three categories of buy-side firm are emerging, according to Dr. Anthony Kirby, director, financial services advisory, regulatory and risk management at consulting firm Ernst & Young. And occupying the middle ground in the battle for institutional funds, says Kirby, is a high return but also a high maintenance position.
Of the three sub-sectors likely to emerge, the first is hedge funds that are taking on more of a market-maker role – effectively functioning similarly to the prop desks of broker-dealers. The second category is made up of both ‘scaled-up’ hedge funds that are becoming more institutional and the more sophisticated traditional long-only managers that are adopting more advanced trading techniques – either by buying hedge fund operations or building the capability in-house. The third group is made up of asset managers that cannot or will not adopt such techniques, and will continue to focus on making money ‘the old way’.
The second category is being created by two trends. The first is hedge funds’ growing appetite for a bigger slice of the institutional pie. A big driver for this, says Kirby, is the desire to attract new funds, especially given the current financial turmoil. To do this, hedge funds, previously viewed as risky and opaque, need to be able to win investors’ and regulators’ confidence. “If hedge funds can demonstrate that they have got proper processes in place, it becomes easier to attract new institutional assets such as pension or local authority funds and take on new subscriptions,” says Kirby. “They will also be able to demonstrate to regulators that they are fit for purpose and are able to scale what they are doing.”
The second trend is traditional asset managers’ growing acceptance and adoption of hedge fund techniques. “We are increasingly seeing more traditional managers – those which had a buy-and-hold, long-only orientation – looking quite enviously at the alternative market and trying to decide for themselves if there are certain aspects of that market they can import,” says Kirby.
He points out that some large asset managers have already made a good fist of implementing hedge-fund-style strategies. “You are seeing managers such as Gartmore and BGI that have already got into the alternative space and are operating models in that space very successfully,” Kirby notes.
Nevertheless, those traditional managers that wish to adopt alternative strategies may have to clear some hurdles. “The factors that stop them from doing it are firstly, their ability to generate the transactions in an automated-enough state, and secondly their ability to monitor, control and manage the collateral that is passing through their middle offices,” says Kirby.
For hedge funds looking to occupy the middle ground, there are also operational as well as strategic challenges. “As they are institutionalising, and/or also adopting multiple strategies, hedge funds clearly need the appropriate systems and controls to demonstrate to the increasingly sophisticated institutional investor community that they are pitching to. There is a need to build in systems, controls, proper market practices, and consistent approaches to risk and collateral management – all the areas that a typical money manager needs to consider,” says Kirby.
Without such controls and processes, Kirby warns that hedge funds may still be regarded warily by institutional investors. Moreover, they also face more regulatory scrutiny, escalating from site visits, to close and continuous monitoring through to full-blown investigation. The costs and time involved could prove a significant distraction from the business of generating alpha. “For the funds, it is not just a question of cost, it’s a question of the drag on senior management time,” says Kirby.