Of the 20 biggest daily upswings in the S&P 500 since 1980, 10 have occurred in the last five years. Similarly, of the 20 biggest downswings, 13 have taken place in the last five years.
Rarely have the markets been so wild. In fact, the last four years have been the most volatile in the history of markets. Price fluctuations of 4 per cent or more in intra-day sessions have occurred six times they did on average in the previous forty years.
Indeed a recent survey from CREATE-Research shows that markets are now in a prolonged era of heightened volatility until substantial progress is evident on the debt front in the US and Europe.
No wonder, pension funds worldwide have shown growing interest in alternative investments as a part of holistic solution to achieve uncorrelated absolute returns: positive investment outcomes irrespective of market conditions.
The 2008-09 bear market savagely exposed the scale of the funding crisis and damaged the reputations of many pension funds. Their focus on bonds and equities landed them with big deficits in their funding ratios. In response, they are scaling back on retirement benefits and raising the retirement age.
These measures are necessary but not sufficient. They also need decent returns on their investment portfolios. Even the most cautious public sector pension plans in the US and Europe are now making allocations to alternatives in general and hedge funds in particular. But their allocations come with some questions marks.
Two in three pension funds believe that high returns on hedge funds depend upon: fresh inflow of new talent, rapid innovation, as strategies go out of fashion and ability to commercialise the new strategies. There are doubts on each of these factors in the wake of the 2008 crash. Hence, those investing in hedge funds prefer to have high liquidity that permits them to move in and out, as and when market conditions change.
Nor are pension funds convinced that hedge funds managers can scale their business without sacrificing performance; or that regulation can prevent periodic blow ups. Although their allocations to alternatives have been rising, alternatives face a stiff competition from other – more manageable – sources of good returns. Six in every ten pension funds who are staying out of alternatives feel that they can meet their liabilities – requiring an average return of around 7 per cent on all their assets – without resorting to alternative investments.
For example, equity market increases of over 35 per cent in the last ten months indicate the challenges that alternative investments in general and hedge funds in particular face in an environment where investors display zero tolerance towards mediocrity.
Resolving the paradoxes and raising the bar
There is nothing new about these challenges. Hedge funds have weathered them during the period 2004-07. The most pressing challenge stems from the uniqueness of hedge funds. Like physics, hedge funds have no impossible frontiers.
But they have to grapple with three paradoxes. You need to have a critical mass of assets to attract new money, but without money, you can’t build the required mass. A sustainable hedge funds business needs scale, but size can be the enemy of high return. You need a rigorous investment process to attract institutional investors, but process can stifle creativity.
Doubtless, institutionalisation will professionalise the hedge fund industry beyond recognition by 2015. For example, pension funds want independent valuations based on transparent pricing models. They also want to receive valuation reports directly from the administrators, not via hedge funds managers. They want a fee structure that delivers value-for-money. Finally, they want all the regulatory and risk controls in place.
Things that made the hedge funds industry great – talent, individualism, enterprise – are the very things that will change. The challenge is to deliver uncorrelated returns in a changing landscape.
Cayman Alternative Investment Summit
It is this challenge that the Cayman Alternatives Investment Summit will address on 1-2 November. Its basic premise is that the industry is at an inflection point: A point where the future ceases to be different from the past. It’s a point at which the best way to predict the future is to invent it via a set of purpose actions that can create a more vibrant alternatives industry.
The speaker line up includes industry leaders like Peter Clarke, CEO, MAN Group, Harvey Pitt, former SEC Chairman, Matt Botein, Head of Alternatives at BlackRock, and some 40 other thought leaders. Each of them will address a unique challenge and suggest the way forward.
The emphasis will be on who needs to do what in order that the Alternatives Industry develops a new narrative on what it stands for and what it can deliver after a perfect storm. In their keynote addresses, President George W Bush and Sir Richard Branson are expected to set the tone and share their insights into actions that will create businesses of enduring value in the years to come.
The Summit will especially focus on three questions that will assist the industry in setting a clear agenda for this decade: how to create new opportunity sets for investors in the alternatives space, how to drive the alternatives into the mainstream space so that they become a big component in investors’ asset allocation and how to create an alignment of interest so as to create a win-win for investors and their managers alike.
We expect over 500 participants from numerous geographies who will also help to shape the industry narrative as it embarks on its next wave of growth.
Both authors are on the program committee of the Cayman Islands Alternative Investment Summit.