The Evolution Of The Offshore Hedge Fund Industry

The offshore hedge fund industry has attracted increased interest over the past number of years. This is, in part, due to hedge fund investments becoming more "mainstream" and a wider range of investors including hedge funds in their investment portfolios.

The hedge fund industry experienced exponential growth since 1990, as can be seen in Figure 1 below. According to HFRI Research Inc, the current size of the industry is estimated to be around $1.8 trillion. Last year was, in fact, the best year ever for hedge funds with inflows in excess of $190 billion.

The rapid growth can be attributed not only to the increase in size of the industry, but also to the growth in the number of hedge funds and fund of hedge funds (FoHF's) as the trend continues with the movement of talented and experienced investment professionals from the traditional investment space into hedge funds.

Why the growing interest?

The main reason for the growing interest in hedge funds is investors' ongoing desire for opportunities to diversify their investment portfolios. Over the years, hedge funds have demonstrated their "value" in investors' portfolios. Attractive risk/return characteristics, low correlation to traditional asset classes, stability of returns, ability to deliver positive returns in different market cycles and the ability to provide an alternative source of alpha are some of the compelling reasons for the phenomenal growth witnessed in the hedge fund industry.

The above should come as no surprise as traditional offshore investment managers only invest in conventional equity, bond, property and cash strategies. In contrast, an offshore hedge fund manager generally combines the traditional investment strategies of equities, bonds, commodities, currencies and listed property with alternative strategies such as short selling, arbitrage and leverage, to name a few. Thus, the wider "tool set" available to hedge funds managers allows these managers to better exploit inefficiencies in offshore markets.

"Hedge funds are a dynamic collection of alternative strategies that derive their returns from active management of other asset classes"

Who is committing to hedge funds?

Towards the end of the last century, the majority of commitments made to hedge funds originated from high net-worth individuals. As a result of the market performance during the past number of years, in particular since the bear market in the US during the early part of 2000, increasingly more institutional investors and advisors are "buying" into hedge funds.

Accordingly, the investor base of hedge funds has broadened substantially over the past number of years with institutional investors representing the largest "slice" of the total hedge fund industry when considering assets under management.

"Pension plans have been and continue to be the fastest growing source of institutional capital for hedge fund managers" – Preqin Hedge 2007.

The institutionalisation of the industry

The increased involvement of institutional investors has undoubtedly improved overall accountability and governance within the hedge fund industry. Why? Institutional investors have been "schooled" in traditional investments with an inherent obligation to follow stringent processes in order to manage their investments that include the selection of hedge fund managers and fund administration.

SEI, one of the world's largest traditional multi-managers, recently published a white paper entitled "Five Critical Challenges for Hedge Funds Taking Aim at the Institutional Market". The paper identifies five challenges for the industry, as institutional investors are getting "tough" on what they require from their investment managers and require a better understanding before making an allocation to hedge funds. These challenges include:

*Good infrastructure – investors ranked quality infrastructure and operations as the most important selection criterion for potential investment managers. The administration should be performed by an independent third party and the investments should be valued independently;

*Reporting & transparency – hedge funds will have to comply with investors' demands. It was stated that insufficient information is provided on hedge funds at the strategy or sector level. One of the barriers currently experienced in investing in hedge funds is the lack of position level transparency. Interestingly however, only 11% of respondents said they sought position level transparency;

*Stable management teams;

*Investment disciplines – more concern was expressed regarding process and risk management than high absolute returns; and lastly;

*Keeping abreast of public policy and regulatory trends – the paper urges the industry to commit whatever resources are needed to ensure that hedge fund managers meet the highest possible standards for compliance and general business practices.

For these reasons, we have seen an increased investment into FoHF's by institutional investors rather than investing directly into single hedge fund managers. Most institutional investors do not have a dedicated hedge fund team whose sole mission is to source, select and conduct due diligence on managers. FoHF's have a number of advantages such as portfolio diversification, access to new or closed funds, professional due diligence, performance monitoring and risk management.

What does the future hold?

"Whenever an investment approach enjoys success, it is natural to ask whether it will continue or whether its best days are behind it" – cfapubs.org (June 2007)

Independent surveys conducted by reputable firms show that institutional investors around the world are poised to increase their allocation to hedge funds at a moderate pace over the next several years. We believe that virtually all institutions will ultimately invest in hedge funds in the years ahead.

However, "barriers" to invest in and or increase allocations do exist. The institutionalisation of the hedge fund industry is leading to many of the barriers such as fees, regulation, liquidity and lack of transparency, being progressively addressed by the various role players. For example, the UK's largest hedge fund managers recently established the Hedge Fund Standards Board (HFSB) with the aim of setting a benchmark of best practice within the industry, whilst simultaneously promoting self-regulation.

If one analyses the "product life cycle" of the hedge fund industry, then it is clear that hedge funds are still a long way off from their maturity stage. Typically, the growth phase of the cycle, which the industry currently finds itself in, goes together with new and stronger competition. We have witnessed the introduction of replication strategies, investable indices, long-only managers launching 130/30 strategies and hedge fund managers continuously coming up with different type of hedge fund strategies or funds in an attempt to differentiate themselves from increased competition.

Thus, exciting times lie ahead for hedge funds and only time will tell how long it will take the hedge fund industry to progress to the next phase of its life cycle.