Endowments, pensions drive hedge fund growth

While there has been a lot of talk among lawmakers and regulators about the so-called retailization of hedge funds, the one trend that has appeared to dominate the nearly $2 trillion hedge fund industry over the past decade has been the increased influence of institutional-class investors.

“The biggest change I’ve seen in the hedge fund industry is that it has become largely institutional,” said Stuart Feffer, co-chief executive officer at LaCrosse Global Fund Services, a New York-based firm that provides back-office services for 50 hedge fund clients.

“Even as recently as five years ago, most of the money going into hedge funds was coming from wealthy individual investors,” he added. “Now almost all of the new money is coming from institutions like pension funds, and most university endowments are making allocations to hedge funds.”

Depending on how one interprets inflows, however, it could be argued that institutional money ultimately represents individuals. That would essentially validate the argument that more retail-class investors are being exposed to hedge funds.

But that’s generally not what lawmakers have in mind when attempting to protect retail investors by increasing regulatory oversight or otherwise restricting access to hedge fund investments.

The hedge fund industry, which was calculated at less than $40 billion in 1990 and swelled to $375 billion by 1998, was little more than a cottage industry back when individual investors were responsible for most of the inflows.

Some market watchers point to the 1998 near-collapse of Long-Term Capital Management as the event that both sparked interest among regulators and convinced the hedge fund industry that greater transparency was the surest pathway to prosperity and the big money of institutions. The heavily leveraged Greenwich, Conn.-based hedge fund became the symbol of the risk associated with hedge fund investing when it lost $4.6 billion in less than four months.

“Since Long-Term Capital, investors have said they want transparency and they want to be able to look at and understand the drivers of performance,” said Lane Carrick, chief executive of Sovereign Wealth Management Inc., a Memphis, Tenn.-based multifamily office with $500 million under management.

In fact, some say the increased push for transparency and other basic business practice standards by institutional investors will work to police the hedge fund industry and supplant the need for increased regulatory oversight.

Early attempts to rein in hedge funds have failed, including a move by the Securities and Exchange Commission to require hedge fund managers to register as investment advisers. According to Hedge Fund Research Inc. in Chicago, through the first quarter, there were more than 7,600 individual hedge funds and nearly 2,600 funds of hedge funds. This compares with 530 hedge funds and 80 funds of funds in 1990, and 2,848 hedge funds and 477 funds of funds in 1998. The fund-of-funds market is considered by some to be a proxy for institutional-investor appetite, as many endowments and foundations require the added layer of diversity and due diligence that comes with the fund-of-funds model.

According to HFR, assets in funds of funds totaled more than $800 billion at the end of March, up from $395 billion in 2005 and $76 billion in 1998.

“It used to just be about some wealthy individual investors trying to find ways to add alpha,”said Adam Herz, founding partner of Hunter Advisors, a New York-based recruiting firm. “But hedge funds have become a real investment class, and the fee structures have influenced hiring the best and the brightest.”

E-mail Jeff Benjamin at [email protected].