After the debt crisis of the late 1990s and the credit crunch and scandals of the late 'Noughties, the hedge fund industry is braced to enter the third phase in its development. To succeed, it must learn the lessons of these episodes.

The hedge fund industry has gone though three distinct phases over the past two decades, each with a significant lesson for family offices and other investors. 

The first ended with the failure of Long-Term Capital Management in the late 1990s, its demise serving to highlight the ability of a single fund to create systemic risk. The second era came to a close last year through a combination of the credit crisis and the Madoff scandal, providing a dramatic demonstration of the need for better transparency, due diligence, and risk management. 

The industry is now setting out to reinvent itself once more. The third wave of hedge fund investing is being defined by a new set of criteria, including major improvements in transparency and risk management technology, the ability to understand and identify true sources of Alpha within a portfolio, a much higher level of fiduciary responsibility, and better access to liquidity. For many family offices, these requirements can be met by moving away from traditional manager and fund of funds relationships and towards the newly emerging separately managed accounts (SMA) platforms.

Economies of scale

Though the industry has had its share of problems, most family offices cannot afford to ignore hedge funds. Consider that for the past ten years, domestic long-only equity returns have been essentially zero. Over that same period, the major hedged equity indices were up anyw here from 8-9 percent. Given the anaemic performance of traditional global stock markets, the need for Alpha is now even more compelling.

Historically, investors have used returns-based analysis and Modern Portfolio Theory (MPT) to build portfolios and manage risk. While useful for traditional strategies, this approach has proven to be unworkable in the hedge fund industry. Fund strategies are too opaque, often purposefully so. Fund managers increase or decrease gross and net exposures, shift geography and sectors, or employ active trading strategies.

Meaningful benchmarks are nearly impossible to establish. Monthly, quarterly and year-end reports are just snapshots and shed little light on what has actually transpired between reporting periods.

The next generation of SMA platforms are being designed as much as risk management vehicles as they are access funds, and have the intention of addressing many of the flaws in the current industry models. Such platforms incorporate a high level of portfolio transparency, sophisticated risk management technologies, and position-based analytics, among other features. The best ones combine this range of functionality in a holistic way, allowing investors to more fully understand and monitor sources of both risk and return on something approximating a real-time basis.      

The key to a family office accessing this functionality is the economy of scale available through the platform. In many cases, the technologies employed to track and manage risk are extremely costly, and have historically been affordable only to the largest institutional investors.  By spreading the cost over several users, including multiple investors in a specific managed account, family offices can take advantage of risk control benefits historically reserved for only the largest institutional investors.

Momentum

There is clearly momentum building behind this approach. A recent study by Deutsche Bank found that interest in managed accounts has more than doubled over the last five years, with 43 per cent of investors now considering using SMA platforms to access alternative investment managers. Family offices have historically been early adapters of both investment technologies and strategies.

The hedge fund industry has proven to be remarkably adaptive, demonstrating the capacity to learn from its mistakes. Managed accounts initially developed by investment banks were typically used to perfect collateral for the banks’ structured products to provide high frequency liquidity. These platforms, generally referred to as “access platforms,” have offered the investor minimal due diligence and little in the way of transparency, portfolio analytics, or risk management. This left the investors in these early-generation platforms unable to flag a host of potential problems including style drift, over-concentration in a single asset or sector (particularly when different managers unknowingly gravitated to similar strategies), and excess leverage.

Such information was available to the platform sponsor, whose interests may have differed from those of the individual investors. Often, if uncovered by investors at all, these issues generally surfaced after the damage had already been done.

These problems are being solved, and the future again looks bright with the hedge fund industry on course to exceed $2 trillion in assets under management in the not too distant future.  Having weathered the storm, the third generation of hedge fund investing has the potential to be the best one yet.