Are Hedge Funds Drowning In Flood Of New Money?

Investors Offshore.com, London

19 November 2001

Randolf Warsager, Director of Education at the Center for International Securities and Derivatives Markets, University of Massachusetts, has written an article about hedge fund capacity which may help investors to understand whether the rush of new money into the hedge fund sector will reduce the returns available by flattening out trading opportunities with too much money. Investors Offshore reprints the article as a service to investors.

What is the current capacity of hedge funds, in general terms? The answer to that question is not as straightforward as it seems. The various elements that determine capacity at any given time must be addressed individually. Broadly speaking, the capacity of a particular manager depends on the depth of the firm's resources and, perhaps more importantly, the strategy it employs. This is because the markets in which the strategy requires the manager to trade may or may not be deep or liquid.

"Capacity issues are extremely important", says Amy Hirsch, Chief Executive Officer of Paradigm Consulting Services, adding, "We look at this issue all the time, constantly evaluating the different levels and kinds of capacity constraints. It's a very multi-layered issue."

"You can't separate capacity from strategy", she points out. "You can't address capacity in a vacuum. For example, merger arbitrage managers have recently found that their range of opportunities has narrowed. Similarly, at the beginning of the year, there was a big flow of convertible bonds that created opportunities for convertible arbitrage managers, but that flow has slowed down. Keep in mind that there is no single capacity situation; it depends on the specific strategy you talk about and when you talk about it. Managers themselves don't necessarily know exactly what the capacity of their overall strategy is. And the situation is fluid. Further, every strategy is being affected to some degree by the tragedy of September 11th. Even in the absence of such equilibrium-shattering events as the attack on the World Trade Center, macro economic forces have a direct impact on the capacity of various strategies. They affect liquidity, volatility, and other factors."

Some industry professionals will generalize in saying that the capacity shortage is severe. Others think marketers have exaggerated the situation, hoping to justify higher fees. This article features opinions from industry participants who are on both sides of the issue, skeptics and believers.

The conventional wisdom seems to be that although the number of hedge funds has grown, the actual capacity they provide has not kept pace with assets. Many of the new managers are too small or inexperienced to absorb much of the asset expansion. Some excellent new managers emerged from the major hedge funds that dissolved themselves in 2000. Some of these quickly grew as large as they wanted, while others continue to nurture their small asset bases.. But investors and consultants alarmed about a capacity shortage believe there are simply not enough good managers to go around.

Ms. Hirsch is concerned about capacity mainly in terms of niche strategies. These are the hedge fund styles most constrained by the relative illiquidity of the instruments and markets in which they trade. They are also the styles that provide the most non-correlated performance.

Ms. Hirsch says, "One of the most frustrating things about the capacity issue is when people ask me if we can help them get access to closed managers. My response is this: If a manager has decided to close because accepting further assets could hurt performance, why would you want to invest in that fund under these conditions?" She feels that an investor should consider how large the manager's trading volume is as a percentage of the average daily trading volume in the markets. If it is a significant percentage, then there is a good reason for the manager to close.

According to Ms. Hirsch, investors do not necessarily understand the damage it can do to all the investors in a fund if a manager who is closed for good reasons decides to allow additional assets in. The exception is when the new assets are replacing those of an investor who has redeemed. She says, "We do have long term relationships with managers who eventually closed. We don't try to get clients into those funds unless someone else has redeemed. This way we're not concerned about diluting returns to us and the other investors."

Richard Papert, Chief Investment Officer of The Lira Organization, cautions investors to be aware that being invested in a fund that subsequently closes does not mean the investor is protected against the problems that constraints at the strategy level can cause. He says, "A manager, no matter how good he or she may be, may be adversely affected by capacity at the level of the instruments traded. " Too many dollars pouring into a strategy with limited capacity can adversely affect even the investors already in established funds.

Capacity at the manager level is a concern for many investors. In recent years the prevailing view has been that "small is beautiful." Investors have favored newer, smaller managers (defined, roughly, as those with AUM of less than $300 million). This has increased concerns about capacity. Managers are generally reluctant to accept an allocation that would represent a sudden, large percentage increase in assets under management and they prefer not to have one investor represent a disproportionately large percent of the fund.

Investors' pursuit of 'star' managers may worsen whatever capacity problem exists. When many investors chase a particular manager at the same time there is bound to be a capacity problem at some point. But if investors seek to gain access to the returns from a particular strategy, like long/short equity or convertible arbitrage, there are generally good managers available who can provide the risk/return pattern that is characteristic of that strategy.

A January 2001 survey of the hedge fund industry, conducted by The Hennessey Group, suggests that the manager capacity problem is not as serious as some think. The survey, which included questions on capacity, elicited responses from 667 managers with assets totaling $180 billion, accounting for more than 25% of most estimates of industry assets. According to Hennessey Group President and CEO Charles Gradate, the survey suggests that the industry's managers, who currently have assets under management estimated at $408 billion, could absorb substantial additional assets within their current funds, growing by almost 90% collectively, to about $770 billion. The question is not so much one of capacity but of timing, arising from what Mr. Gradate calls the "funnel effect." That is, there is room for growth as long as the assets are allocated incrementally. It is a matter of asset flow over time, not strictly the dollar amount of the assets. He suggests that a growth rate of about 10% per quarter might be appropriate for many managers.

Not everyone believes there really is a capacity problem. James Hodge of Permal Asset Management argues that the capacity issue is essentially a creation of hedge fund marketers who would like investors to believe that they had better hurry up and get their money in before it is too late. Mr. Hodge says, "I have been doing this for nearly 15 years and have dealt with over 1000 managers. I only know one manager that may truly be closed. Established fund of funds can offer ready access to managers claiming to be closed."

The capacity issue at a practical level boils down to whether and when an investor can invest in the particular managers he or she wants to, regardless of whether the industry as a whole has room for growth. So the institutional investor seeking to allocate $50 million immediately to a manager with total assets of $200 million could indeed have an access problem. For private investors who wish to allocate a far smaller sum, there may be no capacity problem at all, even with a smaller manager.

The capacity issue involves other things besides money. Knight and Buchanan at PAAMCO point out that from a manager's point of view, all investors - and all assets -- are not equal. They observe that, "Sophisticated managers prefer sophisticated investors. Managers generally prefer to have investors who have the right reasons for wanting to invest in the fund, who truly understand the strategy and the investment cycle of the strategy, as well as the market environments in which it works and does not work. Part of this is a desire to have investors who will not panic during difficult times." Investors stand a better chance with popular managers if they thoroughly understand the manager's strategy and investment philosophy.

Peter Fletcher, head of a Geneva-based family office, observes that capacity has become a greater concern as institutions have begun to invest in hedge funds, joining European private investors who have invested in hedge funds, in some cases for decades. "The flow of institutional money has changed the game quite a bit", says Mr. Fletcher. He adds, "With nearly every European bank forming a fund of funds and raising assets through their traditional networks, there is a large pool of money knocking on popular hedge fund doors," but "the business is not scalable," he adds. "In many cases, at some of the banks and fund of funds it becomes less a matter of selecting managers than of allocating the assets under pressure to get the funds invested. Sometimes this means that second tier managers are funded quickly. Previously they would not have been", says Mr. Fletcher.

In previous years, he says, "Investors could allocate a small amount and then get to know the manager, adding in increments as the relationship developed. Now everyone's in a rush to invest and the dynamics have changed."

Mr. Fletcher adds, "We pay attention to who our fellow investors are in a fund. We prefer not to be in with hot money. Preemptive redemptions can cause huge problems." He points out that the rush to get into new funds before they close reduces the time available for thorough due diligence, adding that a frenzy like this means a lot of people are going to get hurt. He adds that, "Many fund of funds and banks are competing with each other, afraid they won't get access to the hot new managers. Sometimes they sprinkle their assets around so they can be guaranteed the opportunity to add later if a manager does well."

Mr. Fletcher also reminds investors of the law of unintended consequences. "Many investors don't realize that the huge inflow of funds can increase volatility in the underlying markets. Some investors have irrational expectations of their hedge fund managers," failing to take in to account the constraints that growth can impose on managers' performance An alternative investment official at a major endowment, speaking off the record, agrees and points out that too many assets in a strategy may drive the margins down and affect performance directly.

Gene Krinn, Managing Director at a Chicago-based a family office, agrees that marketing plays a part in the perception of capacity but that the problem goes beyond marketing. He agrees with Mr. Fletcher that there is a competition between fund of funds for capacity and these investors are sometimes in a hurry to deploy their capital. Mr. Krinn cited an old saying, "When the best are closed, the rest will be funded." On the other hand, he says, there are many new funds being launched each year. All in all, he does not believe the capacity issue is a significant problem for investors. "Capacity problems are a micro issue in the industry. The macro issue is that the industry continues to grow as new managers come on the scene to absorb new assets," he says.

Mr. Krinn believes, however, that several problems arise from the pressure on fund of funds to invest quickly. He observes that performance may be affected negatively if managers absorb more assets than they should, given the constraints of their strategy and capabilities. Also, Mr. Krinn points out that some managers have done well partly because they have deployed assets that were then locked-up for long periods. With banks and fund of funds negotiating more favorable redemption terms, Mr. Krinn wonders whether performance will suffer.

The "small is beautiful" philosophy has many believers. Mr. Papert of the Lira Organization shares this view: "We prefer smaller managers, other things being equal."

Jean Karoubi of The Longchamp Group, Inc., who runs his own family office, believes that capacity shortages are more a matter of declining liquidity in the underlying markets than of particular managers being at full capacity. Mr. Karoubi says, "This liquidity leads to a chance in the risk/return profile of certain strategies. This mainly occurs in the niche strategies. Investing in them becomes less rewarding as they get more crowded, as inefficiencies disappear. Profitability is reduced, but risk is not."

Terry Beneke, CIO of a family office in Dallas, notes that the impact of rapid growth on a manager's ability to be nimble in the markets is widely recognized. Many investors believe that greater size can degrade performance. Another aspect of growth that sometimes gets lost in the discussion is the issue of managers' developing the appropriate infrastructure as they grow, keeping pace with the inflow of assets. The back office demands can be considerable as assets grow.

In the past, Mr. Beneke says, "I'm closed" was considered to be 'the fourth greatest lie in the world." But over the last six months he has observed that managers are increasingly willing to close their funds. He says that some managers, depending on the strategy they run, are not only declining to accept new investors but are refusing to take additional funds from their existing investors. He reports that manager capacity is one of the most popular topics at family office gatherings.

Mr. Beneke, echoing Peter Fletcher's comment, says that there has been a compression of the due diligence period as a direct result of the pressure on investors to make their decisions faster. While institutions may be unable to speed up their process, families and fund of funds are feeling pressure. "The three year rule is buckling," he says, referring to the typical traditional requirement that a manager have a track record of that length before substantial investments are made.

Hedge fund capacity can be an issue at the level of a particular hedge fund strategy, when, for example, there is an interruption in the flow of new instruments on which managers depend as a source of fresh trading opportunities. Or if there are simply too many players in a strategy, resulting in fewer of the inefficiencies that once made the strategy profitable. Capacity can also be an issue at the manager level, as particular managers reach the limits of their staff resources and idea flow, or when they simply have attracted so many assets they lack the flexibility they need to sustain their performance level.

A survey of the industry earlier this year indicates that overall the industry can absorb substantial new assets if the assets are allocated incrementally, to avoid the funnel effect of too much money coming into the industry too fast.

Some asset allocators believe that there really is no capacity problem, and that very few, if any, managers are truly closed. They speculate that hedge fund marketers have used talk of capacity limits to justify higher fees or simply to pressure investors into shortening their allocation process. A European family office active in hedge funds contends that the dynamics of the allocation process has contracted and that there is a sense of the need to rush into the new, hot managers before it is too late.

It seems that the capacity problem is real enough with respect to certain strategies and certain managers. Timing is important, as well. Capacity shortages ebb and flow, depending on many factors internal to the markets. Not all strategies are equally vulnerable to capacity problems. A convertible arbitrage manager is far more likely, at certain times, to bump into capacity issues than a long/short equity manager who operates in deep and liquid markets. Individual investors might find themselves nudged aside by the inflow of significant assets from institutions, or at the very least find they have less time to make their decisions. In the end, if investors thoroughly understand not only the managers they like but the strategies in which they wish to invest, including the liquidity crunches to which those strategies are subject, they should be able to successfully navigate through capacity issues as they arise.

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