DUBAI, 8 November 2004 - The investment management industry is at the beginning of a new paradigm shift. The segmentation of the industry into traditional market-based, or beta strategies and alternative skill-based, or alpha, strategies has become increasingly evident.

As a growing number of investors gain a better understanding of these investment approaches they have begun to recognize the limits of traditional investments and gain a deeper appreciation for the benefits alternative investments, such as hedge funds, can offer.

This is already being reflected in demand for alternative investment products like hedge funds.

Figures from hedge fund research group TASS show that a record $72.2 billion in new money flowed into hedge funds in 2003, $26.8 million in the fourth-quarter alone, lifting assets under management to around $750 billion. Much of the new money came from institutions. TASS estimates that there were about 6,700 hedge fund managers at the end of the year.

Separately, a survey by industry magazine “Alternative Fund Services Review” and data management firm “Correctnet” claimed that assets under management by hedge funds and funds of hedge funds had swelled from $745 billion in mid 2003 to $1.16 trillion by May 2004.

The TASS figures show that, by the end of the year, long - short equity funds were in greatest demand, attracting $6.2 billion in new money in the fourth quarter of 2003. Event driven strategies raised $5.8 billion, global macro and convertible arbitrage both raised $3.3 billion in the quarter. Only dedicated short bias and equity market neutral strategies saw net redemptions in the quarter, down $20.7 million and $169.6 million respectively.

Another recent characteristic of the industry has been the strong shift toward funds of hedge funds. Hedge Fund Research calculates that assets under management by funds of hedge funds grew by 124 percent over the two years ended 2003, to $317 billion - or from roughly a sixth to over a third of hedge fund assets.

Traditional Mutual Funds

It is a well documented fact that traditional mutual funds under perform their benchmarks over time, even if they claim to be actively managed. That is because mean returns will tend to trend towards the index that the funds track over time, while trading costs and management fees will pull returns slightly below that mean.

So-called “active” traditional mutual fund managers are finding it increasingly difficult to differentiate themselves from products like index funds, exchange traded funds, index futures or equity swaps that provide similar beta exposure at significantly lower cost.

Investors have become increasingly aware of the constraints that traditional asset managers face which undermine their ability to generate better returns across all market environments. Not only are they limited by regulations that impose restrictions on the type and quantity of securities that they can invest in, but investment strategies are also foregone by the inability to conduct short selling and employ leverage.

While these serve to lessen the range of opportunities for traditional asset managers to benefit from, the benchmarking mentality itself imposes implicit shortcomings. Not only is herd behavior endemic, but having to stay fully invested in securities regardless of fundamental evaluation is not conducive to successful or even prudent asset management. Buying and holding stocks that you have no faith in is neither sensible nor desirable.

Hedge Funds

Conversely, hedge fund managers are unencumbered by the sorts of regulatory and methodological restrictions that characterize traditional fund management. Returns are dependent upon the skill of the hedge fund manager and their ability to identify and exploit market inefficiencies.

The mandate of the manager includes judging whether the opportunity set in his field of expertise is rich or poor. They have freedom to invest in a range of assets and instruments employing a variety of investment styles and techniques in a diverse range of global markets. The ability to use derivatives, arbitrage techniques and, importantly, short selling — selling assets that one does not own in the expectation of buying them back at a lower price — affords hedge fund managers rich possibilities to generate growth in falling, rising and volatile markets.

As performance is not exclusively a function of the underlying markets, strategies generating alpha are becoming increasingly important for a portfolio. As a result, investors’ emphasis is shifting towards absolute and sustainable returns. These strategies depend on various criteria: Complexity (high), transparency (low), market access (difficult), information (scarcely available), segmentation (high), and liquidity (lacking). The skill level is measured by return quartiles, i.e. the difference in realized returns between the best professional in a specific discipline versus the worst participants. The performance characteristics of the different alpha strategies can vary quite significantly, whereas beta strategies have proved to be highly homogenous.

This performance imperative is already leading investors to shift away from ‘actively managed’ portfolios of traditional stocks and bonds to a blend of passively managed index-funds and alpha-generating strategies such as hedge funds and private equity.

Global Hedge Fund Trends

As we have already noted, there has been a strong shift toward institutional investment in hedge funds and sharp in-flows into funds-of-hedge-funds.

Hedge funds have been operating since 1949, but these early products were largely restricted to wealthy private investors. Now, institutions and less wealthy retail investors, with very different goals, are buying into the asset class and increased weight is being placed on repeatability of returns and strong risk management and slightly less emphasis on pure performance.

This is increasingly driving demand for fund of hedge funds products and innovative product structures, such as capital guarantees.

Investors are also becoming more sophisticated in their requirements, and as the investor base widens, there is a growing demand for transparency and product liquidity. While a wealthy investor may sit on an investment indefinitely, smaller retail clients will want the ability to trade in and out of funds.

At the same time, the success of hedge fund industry is attracting more players into the market, particularly among traditional asset managers, so sourcing outstanding management talent is likely to become even tougher.

That is bad news for the smaller hedge fund players, as increasing regulatory oversight, more demanding investors, and competition for industry resources will create economies of scale, that will benefit the larger players.

As a result, the industry is likely to see major consolidation going forward, with smaller and underperforming funds absorbed or closed. Funds of hedge funds are also likely to achieve dominance in the industry, as they offer easier access to clients.

(Antoine Massad, is head of Middle East and Asia at Man Investments. He is based in Dubai.)