Eisenhart: Size still counts

Growing pains afflicting hedge fund managers continue apace as institutional investors allocate more capital to (and stipulate more transparency from) the sector, while long-only managers compete for arbitrage opportunities, and regulatory bodies consider whether to increase oversight of the industry. By Stewart Eisenhart

Investors' tastes and expectations tend to drive changes in how hedge funds operate just as much as the other, more thoroughly reported factors. Analysts and observers have noted signs of 'maturation' of the hedge fund industry for some time now – an inevitable effect of more institutional capital flowing into these managers' portfolios – and along with that maturation a tempering of the stellar growth and outsized returns long associated with them.

Findings in Deutsche Bank's hedge fund capital group's 2006 Alternative Investments Survey bear these forecasts out, but they also illuminate hedge fund investors' changing preferences in terms of allocations, investment regions and strategies.

Among the especially noteworthy findings, investors – particularly pension and endowment funds – plan to increase allocations next year to hedge funds active in the emerging markets of Asia and Japan, where they take an increasingly bullish view. At the same time, Deutsche expects a 7% decline in allocations to US-focused hedge funds, indicating a gradual yet significant decline in this most well-established market.

Investors also revealed changing attitudes in terms of which hedge fund strategies they favour this year, with convertible arbitrage gaining in popularity, while on the other hand, investors have expressed less enthusiasm for multi-strategy allocations this year following the collapse of Amaranth last September.

In addition, many investors taking part in the survey expressed interest in managers making more focused investments according to specific strategies going forward, which could result in fewer allocations to multi-strategy managers. The need for diversification has also accounted for investors' intentions to allocate more capital to convertible arbitrage funds, as well as merger arbitrage, credit and commodities.

Given these indications, we can anticipate at least on a high level, how hedge funds seeking to attract or maintain these investors' support will be impacted in terms of operational and infrastructure requirements.

Having explored the issues around hedge fund activity in emerging markets in the January issue of Buy-Side Technology, we can expect that managers with ongoing investment operations in Asian markets to be well-positioned to meet growing investor interest in these regions. For managers traditionally active in the US and Europe looking to set up operations in Asian emerging markets, though, a thorough review of current infrastructure and capabilities will be necessary before any such move can occur.

Similarly, managers running long-short funds but wanting to add convertible arbitrage and other more complex strategies will need to make sure their infrastructures can handle those additions before proceeding.

A familiar dynamic will play out: hedge funds with deeper pockets and ample IT resources will have a considerable advantage over smaller managers more beholden to their counterparties and third-party providers for their trading, risk and back-office technologies/systems.

Indeed, some of the players best-suited to adapt to investors' moves away from multi-strategy hedge funds are the multi-strategy hedge funds themselves.

In our conversation regarding the survey results, John Dyment, head of Deutsche's hedge fund capital group, told me as much: "There is investor demand for concentrated risk returns in certain types of strategies, and these managers have the infrastructure and technology to incrementally add single strategies to their arsenals, and we see that as a definite trend taking shape."

The big fish-little fish analogy – cliché that it is – nonetheless aptly describes the scenario. Before long, it may well supplant the traditional image one gets – that of the lone maverick trading from a converted Greenwich basement – when thinking of hedge funds altogether.

Maturation indeed.