Since the financial crisis, an interesting dynamic has been playing out in the hedge fund industry. Historically, economic scale has not been a critical differentiator of success in the business. In fact, since small, off-the-run investments have tended to generate the most attractive returns, larger funds actually found their size a hindrance to alpha generation compared to their smaller competitors. More recently however, larger funds seem to have adapted, instead, capitalizing on the value of their asset size to create sustaining and self-reinforcing competitive advantages.
It is Alvarium’s view that through the use of platforms, certain hedge funds are creating moats around identifying and hiring internal talent, creating robust internal systems for collecting, analyzing, and sharing data, and building tools for employees to do their jobs more effectively. As a result, we believe that launching a subscale single strategy fund will become increasingly difficult and this trend is just beginning to play out.
We have seen this type of market share consolidation in other industries, especially in retail, as department stores are losing share to businesses that are using platforms to create a competitive edge. If we are right, allocators need to rethink their process for investing in hedge funds.
Allocators’ disappointment with their traditional hedge fund investments can be seen in their actions. According to eVestment data, in the ten months through October 2019, investors have redeemed almost 90 billion dollars from hedge funds on a net basis, following close to 40 billion dollars of net redemptions in 2018. We think net redemptions are largely being driven by fund closures, which is a trend we expect to continue. However, we are seeing significant inflows into what we call multiple portfolio manager and opportunistic product platforms.
Multiple Portfolio Manager Platforms
Multiple portfolio manager platforms have separate and distinct portfolio management teams that trade their own portfolios as a subcomponent of a broader fund portfolio. The established platforms have been able to create a flywheel, where their internal analytical framework and market data access attract teams. This addition of new unique teams provides the platform access to more data to analyze, which in turn is used to further improve the analytical framework and market databases.
The analytical systems provide portfolio management teams with recommendations on how to optimally size positions, avoid behavioral tendencies, and manage risk. Most standalone operations lack these resources to build competitive systems, which puts their investment staff at a disadvantage. We are seeing this dynamic play out with increasing regularity as portfolio managers, who 15 years ago might have set up their own shop, are now opting to tuck into a platform.
"Over the next ten years, we expect the hedge fund industry to benefit from the trends that have played out in other industries"
Additionally, in an era of big data, artificial intelligence, and machine learning, access to market datasets has become increasingly important. Yet clean and unique databases are difficult and expensive to construct. Established multiple portfolio manager platforms have a clear edge with their years of experience identifying and collecting useful datasets. They can also spend more money on alternative data, because the cost can be shared across a large asset base and a broad number of portfolio teams. Finally, because the portfolio management teams use datasets in unique ways, any alpha associated with the data should be highly diversified.
Opportunistic Product Platforms
Opportunistic product platforms offer a series of standalone vehicles that are structured to capitalize on specific tactical investments. Product offerings typically have a defined lifecycle, and capital is returned to investors once the tactical opportunity plays out. Opportunistic product platforms that generate returns around specific themes can build a platform that creates the scale needed to create a self-reinforcing competitive edge. Platform growth creates a positive feedback loop by improving the firm’s access to deal flow, investment talent, and the capital needed to build infrastructure for executing complex transactions. Additionally, investor base growth makes the platform more robust, because there is a self-selected network of investors who are looking to invest in new tactical opportunities.
Tactical alpha has been difficult for allocators to access. Niche managers that can provide direct exposure to a specific opportunity typically have had inherent operational risk. Large institutional funds tend to be highly diversified, which often dilutes the benefit of tactical investments. Opportunistic product platforms can help solve for these structural issues that exist with more traditional funds. The platform model has the necessary scale to compete with the large institutional funds for resources, while their standalone vehicle structures provide investors direct access to targeted opportunities that can enhance their investment returns and more control over which investment risks are represented in their portfolios.
Over the next ten years, we expect the hedge fund industry to benefit from the trends that have played out in other industries. Today, for example, certain online retailers use scale, data analytics, and centralized oversight to create a constantly improving platform for sellers, while at the other end of the spectrum, highly specialized product platforms have been taking market share in the luxury market. As shoppers have moved in the direction of these platforms, the department store model has been a clear loser. We expect to see a similar stratification of success in the hedge fund business, with core allocations increasingly going to multiple portfolio manager platforms and high alpha tactical allocations to opportunistic product platforms.