Institutional investors force hands of hedge funds, Moody’s says

A shift in the investor base of hedge funds away from wealthy individuals and their advisers to institutions such as pension funds, will force a lowering of fund fees, changing of business strategies and reductions in risk tolerance, Moody’s Investors Service believes.

In a paper on the $1.9trn industry the ratings agency said the downturn and post-crisis environment has resulted in structural shifts among several hedge fund industry stakeholders, particularly banks and pension funds.

Although net industry inflows were marginal in the first half of 2010, they accelerated to $19bn in the third quarter, then $13bn last quarter.

Moody’s said the change in the investor base underlying this has occurred primarily because investor sentiment changed in light of economic conditions since the crisis, and a change in conventional wisdom, away from substantial allocations to equities.

“This shift in thinking and the need for alpha-producing strategies, in addition to investors’ improved understanding of alternative investments, has increased the attractiveness of hedge funds versus traditional long-only investments,” Moody’s report said.

However, the shift in its investor base also poses several risks for hedge funds.

Moody’s says managers will need to increase investor relations teams and improve reporting systems, likely stretching existing operational staff.

Hedge funds may also be forced to tone down risk tolerance to attract and retain institutional investors, but this could change the flexible and entrepreneurial nature of the industry, Moody’s added.

Over the last two years the balance of power has shifted in favour of investors and many managers had to offer better terms, including lowering fees.

“This has affected all hedge funds (regardless of size) and even those with good performance,” said Moody’s. “This is a trend that looks set to continue in the near term.”

The report also predicted the rise of managed accounts. In 2010, several large institutional investors announced they would invest in those offered through large platforms, rather than directly in funds.

However, the report concluded the proliferation of managed accounts also poses risks, such as concentrating operational risks into fewer counterparties – in the case of the large platforms – and increasing the costs of managing investments and causing further fragmentation of hedge funds.

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