Ray Soudah – the former Cedel executive who now heads the Swiss-based fund management merger consultancy, Millenium Associates AG -says that, despite recent scepticism, there are still both good reasons and opportunities for traditional fund managers to get into the hedge fund business.
Speaking at the at the IFM 2003 Geneva conference today, Soudah said the hedge fund investment alternative is still extremely attractive to high net worth individuals and wealthy families and increasingly to institutions as well.
Noting that in 2002 through August the CSFB/Tremont hedge fund index was up 0.8% while the S&P 500 was down 20 percent and the World Index down 17 per cent, Soudah highlighted the low correlation of hedge funds with traditional investment strategies, thanks to their reliance on skills-based strategies rather than traditional market-based investments. “In times of bear markets, hedge funds consistently outperform major market indices and traditional long only equities and fixed income managers,” says Soudah.
Soudah identifies several keys to having the right business model to build and grow a successful hedge funds business. Key factors include a business head with hedge fund, marketing and management experience; staff with excellent trading and fund management experience; superior technical and operations infrastructure; appropriate risk management systems and processes; adequate capital (seed money and set-up costs); access to a solid distribution network; appropriate compensation structures and an investment performance track record.
Soudah pointed out that there are still significant risks associated with hedge fund investments, including fraud, when proper operational controls are not established. But fraud, he argues, is not top of te list of risks. Major losses like the Beacon Hill disaster – with losses of over $400 million – are not only possible but to be anticipated, says Soudah. The market, he says, has reacted aggressively by offering funds-of-funds to diversify the inherent risk of a single manager. These fund of fund managers, says Soudah, help diversify portfolio volatility and reduce exposure to a single major risk event within one organisation.
Soudah says that although hedge funds remain a risky business, growth can still be seen as strong in the future. He expects 20-25 percent annual growth for the foreseeable future. Soudah articulated that this offered opportunities for traditional managers to enter the hedge fund industry and gain market penetration in a growing business.
However, while the overall assets entering the investment class will grow, the number of funds is likely to shrink by close to 1,000 during the course of 2003. Based on current fund number estimates, this could be as much as a 20 per cent drop year on year. Soudah says this is being caused by an increase in consolidation caused primarily by the need for better distribution capabilities, better brand identities, limitation on capacity and the trend for investor transparency. Such a dynamic environment, offers opportunities for those firms wishing to enter or expand their hedge fund offering.
Entering or growing the business, however, needs to be well thought out and clear alternatives measured and the best implemented. Soudah pointed out that there are five primary alternatives available to traditional managers: organic growth, white labelling, joint ventures, mergers or acquisitions. Each alternative has distinct advantages and disadvantages but Soudah believes that acquiring firms along side organic growth is the best strategy for achieving scale within a reasonable timeframe.
Further, he notes that fund of fund managers will become more important in the industry and allows entering and/or growth with lower risks. He notes the example of Man Group and their tremendous business model change since the mid-1990’s. They built their alternatives business through initially leveraging their internal know-how and then bolting on key acquisitions. Man Group’s most recent purchase of FRM depicts the growing importance of fund of fund managers versus direct hedge fund managers.