Increased allocations to hedge funds by institutional investors (especially pension funds) could make hedge fund managers more conservative, according to the latest Industry Outlook from Moody’s Investors Service.
Moody’s says that, given the sheer volume of assets such investors control (U.S. pension funds alone managed assets worth $15 trillion as of December 2010), even a small increase in their allotments to hedge funds will be significant.
But increased institutional investment in alternative assets (including hedge funds) could also prove problematic—Moody’s warns that hedge fund managers may become more conservative to attract institutional investors. This, says the report, could “change the flexible and entrepreneurial nature of the hedge fund industry and would have far-reaching consequences.”
The same phenomenon will also put pressure on fees, says the ratings agency, as power shifts toward investors and away from hedge fund managers. Moreover, the need to expand their investor relations teams, improve reporting systems and adjust their procedures to meet the demands of institutional clients will raise near-term operational risks for hedge fund managers.
The report also suggests that some institutional investors will opt to invest in managed accounts rather than directly in hedge funds, something several large institutional investors did in 2010. This trend also poses risks, says Moody’s, such as “concentrating operational risks into fewer counterparties (in the case of the large platforms), increasing the expense of managing investments and causing further fragmentation in the hedge fund industry.”
Other industry trends discussed in the report include capital flowing to larger, more established managers; the consolidation both within the alternatives space and between traditional and alternative managers; and increased capital flows to “passive investment products” (like ETFs); and the effect of new regulations like the AIFM directive and Dodd-Frank.
Overall, though, Moody’s describes the credit outlook for hedge funds in 2011 as stable, with signs of improvement.
The report highlights the strong performance of the industry since the latter part of Q3 2010, which has resulted in renewed market confidence and net investor inflow. Says Odi Lahav, a Moody's vice president and senior credit officer explains, “The current economic environment and the likelihood of a protracted recovery in the US and in Europe favor flexible investment mandates, and as such, hedge funds are well positioned to increase their respective share of global investment capital." Although the environment is likely to remain volatile, Moody's believes that barring a major market event, this trend looks set to continue in the short term.