AIMA

The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Assessment of Hedge Fund Industry Challenges and Future

Commentary

AIMA

Q1 2008

In the midst of what is one of the most serious financial crises experienced in modern times, we take this opportunity to offer thoughts on how the hedge fund industry with it and how it will look in the future.

It is too soon to speculate on when the current financial crisis will end though end it will as have all previous crises. There is always a sense of “paradigm-busting” during times like these and, certainly, the financial world is pervaded by a sense of instability and a lack of confidence as well as strong feelings of anger and bewilderment by the general public who trusted governments, regulators, markets and financial professionals to secure their savings.

The hedge fund industry has been deeply impacted. The view that an industry which, in total, is smaller in size than the single largest global asset manager has the power to change markets so effortlessly is questionable. Measures taken by regulators to bring stability to markets by banning or restricting short selling have clearly not worked; most shares continued to tumble in value following the implementation of the restrictions. While we fully acknowledge the positive intention behind these restrictions, we seek their immediate cessation. There continues to be acknowledgement among the authorities that short selling is a legitimate and meaningful market tool; it reduces volatility and provides liquidity: two elements sorely needed at the moment.

The hedge fund industry has a vast body of work on sound practices spanning 10 years. It is subject to stringent regulation both at manager and fund level – onshore and offshore. It has engaged fully in the consultative processes affecting its operations over many years. It has shared in the pain inflicted by the market turbulence. And it continues to stand ready to work with all parties on finding the right solutions.

From a performance perspective, no part of the financial community has been untouched by this crisis. In addition to a downturn in asset valuations and performance, even hedge funds performing well are seeing investor redemptions driven by a need for cash. Some hedge funds are no longer able to trade their strategies in a world where short selling has been made so difficult, thus investors redeem. Redemptions lead to selling, which leads to further lack of confidence in the markets – and so it goes on.

With the hedge fund industry comprising such a broad range of strategies, there is a correspondingly broad spectrum of performance: short bias funds were up 21.40% in the 12 months to September 08 and macro stood at 5.48%. On the other hand, equity hedge stood at -14.91% while event-driven stood at -10.82%. 1 

We expect to see attrition both in assets under management and number of funds though it is still too soon to speculate to what scale. In the current market environment, some strategies – such as convertible arbitrage – struggle to exist; there will be some strategies that disappear and others that will thrive. From a manager perspective, one would expect to see greater contraction at the smaller end of the asset scale due to income comprising management fees only (rather than also performance fees) due to the current market challenges.

Investors are the ultimate deciders of the future of the industry. Where confidence has been knocked re-establishing trust and belief will be key. AIMA’s Roadmap to Hedge Funds is a 160+ page document, which addresses the myths and misperceptions about the industry. Written by investors and for investors, it will serve as a very helpful aide also to policy makers in increasing their understanding of the industry.

It is worth noting that, as we prepare the Journal, news continues to arrive detailing decisions by investors to begin or increase their allocations to hedge funds. This indicates clearly that the business model for hedge funds remains valid. The innovative and creative investment skills that have served hedge fund investors will continue. There will be changes across the way markets function and we should expect new and innovative strategies. We are in no doubt that there is a role for the vast array of hedge fund strategies in re-building market confidence, bringing stability where it has been lacking and serving as an invaluable tool to the replenishment of pension and other investment funds, which have been sorely affected in recent months.

1 Figures supplied by Hedge Fund Research and correct as at 24 October 2008.

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