Ospraie's Fall Indicates Consolidation, Not Industry Shrinkage

I had the pleasure of attending a breakfast meeting yesterday morning during which several hedge fund luminaries (and myself, the token non-luminary) were tasked with selecting the recipients of one of the industry’s many annual awards.  With the announcement of Ospraie’s crash still hot off the press, the discussion inevitably turned toward the ailing state of the industry as a whole. 

While it’s easy to assume that hedge funds are falling out of the sky, the news this week is actually somewhat mixed as usual.  In fact, in its usual annoying way, the hedge fund industry continues to defy easy characterization.

First, there’s the issue of hedge fund closures.  Reuters reported last week that:

Running a hedge fund was long considered the crown jewel in finance but this summer a growing number of managers have called it quits, unable or unwilling to keep going during one of the industry’s worst-ever years.

One might easily be excused for assuming that less funds equals a shrinking industry.  But as we’ve discussed several times on these pages, consolidation is a necessary stage in the maturation of any new industry - particularly one with such dramatic economies of scale.  Smaller funds are being snapped up by larger players as they fail to achieve orbital velocity, and in cases where funds are simply mothballed instead, their assets are just as likely to end up in other hedge funds as they are back in traditional investments. 

Like previous shake-outs in the banking or telecommunications industries, this one will make the lives of suppliers (fund managers), not the customers (investors) difficult.  As a result, it will not dramatically impact the underlying industry demand.

Are institutions canceling their dates with hedge fund managers?  Not really.  This week, the Conference Board reported that institutional demand remains healthy with plenty of room for growth:

Pension funds have been increasing the investments they make in hedge funds during the past three years. The report shows the largest 200 U.S. employee retirement plans with defined benefit assets in hedge funds. The amounts invested in hedge funds by these pension funds rose from an insignificant amount in prior years to $29.9 billion for the year ended September 30, 2005, to $50.5 billion for the year ended September 30, 2006, and then to $76.3 billion for the year ended September 30, 2007. This actually represents a fairly small percentage of total assets for these pension funds - 0.7 percent in 2005, 1.0 percent in 2006 and 1.4 percent in 2007. Thus, while increasing rapidly, hedge fund investments remain a small portion of the total defined benefit plan assets invested by these pension funds.

With the World’s top 300 pension plans now managing $12 trillion (up 14% year over year), this segment alone could carry the entire industry.

Are hedge fund investors losing their collective shirts?  Not really.  Sure, Ospraie investors will need to visit a good haberdashery.  But as Reuters pointed out last week, hedge fund returns to the end of July were about 7% ahead of the S&P 500.  Early returns from August suggest the gap has narrowed somewhat, but hedge funds remain well ahead of equity markets.  Put another way, the S&P 500 has seen two days in the past 2 weeks when the percentage daily loss roughly equalled the year-to-date loss in the Credit Suisse/Tremont Hedge Fund Index.  And this year is generally considered to be the worst in recent memory for hedge funds.

Some industry participants seem to realize that shut-downs and lay-offs don’t necessarily indicate industry shrinkage.  Investment consulting firms know that hedge funds represent an alpha source not unlike the alpha sources their clients have owned for decades - only separated off into its own fund rather than being mixed with market betas in the form of traditional active mandates.  As a result, they are actually entering the industry right now.  Reports Pensions & Investments today (new: free registration required):

Client demand and higher fees are luring more investment consultants into money management, particularly hedge funds of funds…Consulting firms are managing at least $2.3 billion in discretionary alternatives portfolios, mostly focused on hedge funds. The total most likely is much larger, because many consultants do not report their assets under management.

Why run back into the burning building just as everyone else is stampeding out?  Because the smoke is just coming from a turkey (osprey) burning in the oven - not a 5-alarm propane explosion.  In fact, it turns out that some institutional investors have been hounding their investment consultants to start funds of funds.  P&I reports that some consultants’ clients “…have been so persistent in asking for discretionary management that executives there were pushed into finding a way to provide it.”

Sure, Ospraie copycat funds may be next to fall.  But the result is more likely to be greater due diligence by investors, more regulation, more conservative funds, and the avoidance of commodity funds, not an all-out flight to passive mandates.  While there’s no question that competition in the hedge fund industry is intensifying, that doesn’t mean that the amount of assets dedicated to active management and deployed in the form of “hedge funds” is destined to shrink. 

The hedge fund industry may indeed wax and wane.  But if it does, it will be taking its cue from the active/passive management debate, not from the sickly cries of a wounded osprey.