Hedge Funds Strive to Satisfy Transparency and Liquidity Demands

Terry Flanagan

Hedge funds of all sizes, in the shadow of the market meltdown of 2008, continue to field demands from investors for more transparency and liquidity, which consequently affects funds’ operational infrastructures, overhead costs, and, to some extent, managers’ choice of investment strategy.

“There are two trends, really: the need for more transparency and for more liquidity,” said Greg Horn, chief executive of Alpha Hedge, which specializes in providing investment platforms customized for investors who seek to access smaller long/short equity hedge funds via separately managed accounts. “People are concerned because of what happened in 2008, and that’s exactly what’s driving [these trends], no question.”

For funds with less than $100 million in assets under management, such investor-friendly structures are key. While the effects of “institutionalization” are weaker at the emerging manager level, a May hedge fund survey conducted jointly by KPMG and the Alternative Investment Management Association (Aima) reveals that “65% of [emerging managers] indicated an increase in pension fund assets as a proportion of their overall assets under management since 2008, while 60% said ‘other institutional’ assets had increased in the same regard”. Family offices and, to a lesser extent, fund of funds were also a notable presence, though high net worth individuals dominated at the emerging fund level, according to the study.

Indeed, transparency is regarded with utmost importance, and technological tools are more crucial than ever. “I think [separately managed accounts] are wonderful for smaller funds,” said Patrick Morris, chief executive of Hagin Investment Management, a $60 million, market-neutral quantitative fund based in New York. “If you’re a high net worth client or a family office and want the ultimate in transparency, it’s the way to go.”

Horn at Alpha Hedge added: “Obviously part of [the trend] is the technology that constantly improves its ability to give ways to trade these portfolios and manage them in smaller bite sizes across a group of accounts. We’ve built a scalable platform in the past in managed accounts in long only, and we’re doing the same thing now for long/short fundamental equity.” For investors seeking the greater alpha rewards historically found in smaller funds, the control and transparency provided by SMAs are vital.

The rise in regulatory, transparency and liquidity requirements are negatively affecting emerging funds’ operational costs, as managers add employees, service providers and technology tools to their roster in order to meet investors’ needs, according to the KPMG/Aima report. The study also reveals that funds with over $500 million in assets under management are undergoing a similar sea change, albeit at a magnified level.

“Managers have significantly increased headcount to respond to both increased regulatory compliance requirements…increased investor demand for transparency and due diligence,” the study said. “Respondents almost unanimously (98%) reported an increase of at least one employee in the area of regulatory compliance.”

For funds of all sizes, the very methods by which they develop and execute ideas are also under greater scrutiny. “There’s a big push toward research transparency now too, what with the ‘expert network’ falling apart after 2008,” Morris at Hagin Investment Management said. “Things have now changed dramatically: theoretically, you should be able to look into every position in your portfolio, explain why it’s there, and be able to pull specific research or a specific forensic link as to why you own it and when you bought it.” Morris also points out that certain quant strategies are more given to research transparency than others: for example, a quantitative, fundamental strategy is naturally transparent, while an algorithm-reliant HFT manager will be less likely to share. “Those algorithms are predicated on very few people using them,” said Morris.

Investors’ calls for liquidity are now playing an increasingly influential role in fund strategy. “Because there’s a greater demand for liquidity, hedge funds have to play in the proper space,” Horn said. “Managers have learned their lesson—the music stopped in 2008 and their illiquid holdings became even more so—now, they have to be more focused on liquidity in the instruments that they invest in.”

Trends toward institutionalization, transparency, liquidity, regulatory compliance and greater operational costs aside, the bottom line remains the same for hedge funds, no matter what size: returns.

“You can have the transparency, the robust operational structure, the good liquidity terms, the compliance…but it all comes down to performance,” Morris said. “All the robustness of those structures have to come after performance if you’re an investor.”

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