Report: Institutions Influence Post-Crisis Reinvention Of Hedge Fund Industry

Jul 14 2011 | 12:56pm ET

Institutional investors are driving the evolution of the hedge fund industry and in the process are increasing the focus on fund transparency, liquidity and efficiency, says a new report from State Street.

“Hedge Funds: Rebuilding on a New Foundation” examines the industry, post financial crisis, and notes a new dynamic between fund managers and investors “as a result of growing concerns over liquidity, transparency, terms for fees and lockups and risk management approaches.” The State Street report says this new dynamic is fostering “a keener focus among investors and fund managers alike on operational excellence, third-party administration and risk management, transforming these considerations from ‘nice to haves’ into critical market differentiators.”

Citing industry research that shows institutional investors of all stripes—pensions, endowments, foundations, insurance companies—are preparing to increase their allocations to alternative investments, the report notes the effect they are having on the space:

“Institutional investors are increasingly taking great interest in how hedge funds manage operational infrastructure, choose administrators and provide for governance and best practices,” said George Sullivan, executive vice president and head of State Street’s alternative investment solutions group. “Escalating client demand for operational control and transparency is driving funds to outsource many responsibilities to administrators experienced in all asset types and investment strategies. By hiring administrators to assume a range of services, including data management, asset class coverage and portfolio risk analysis, fund managers can concentrate on generating alpha and distributing investment products.”

The report considers the role of technology in the post-crisis hedge fund world, particularly in meeting new regulatory requirements. New rules like Dodd-Frank in the U.S. and the EU Directive on Alternative Investment Fund Managers will increase the information reporting duties of hedge funds. “For large and small firms alike,” says the report, “third-party administrators with substantial technology, information-gathering and reporting infrastructure in place will be the best way to make this compliance reporting feasible.”

The report also looks at the role to be played by funds of hedge funds, which took a beating in the financial crisis and have yet to see their assets return to their 2008 peak of $826 billion. As of Q1 2011, however, funds of funds managed $673 billion and State Street believes they “retain a critical utility for institutional investors, helping them to navigate among thousands of hedge funds and to undertake due diligence and ongoing management of direct fund exposures.” The funds of funds that will succeed, however, are those that develop “an innovative, more flexible business model geared to providing client-focused portfolio solutions.” The report also suggests forward-looking funds of funds should be prepared to offer advice and expertise without necessarily being “the physical conduit of fund investment.”

While noting that enthusiasm for managed accounts, which surged in the immediate post-crisis period, has since stabilized, the report also suggests that institutional investors bothered by the varying risk tolerances of investors in a hedge fund may opt for a “fund of one.” Essentially, “a separate share class for a single investor.”

In its conclusion, the State Street report suggests that vehicles like funds of one and others that better answer the newly articulated needs of investors, represent the future of the industry.

State Street had $22.6 trillion in assets under custody and administration and $2.1 trillion in assets under management as of March 31, 2011.


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