Funds In Search of New Frontiers Fall 2006
The Vanishing Frontier funds no can longer roam freely and prosper 1890 US Census: The Frontier is closed Frederick Jackson Turner: the frontier gave rise to the American ideology of freedom and endless bounty. The closing of the frontier presents issues for this way of thinking. Funds during the frontier days of the 1990s Managers prize freedom to trade, use leverage, go short, derive outsized returns from an range of arbitrage opportunities Freedom from compliance, office politics, suits, commute to Wall Street Funds today All known investment strategies are now overcrowded, returns are dampened There are no longer wide open spaces of investment opportunity Fund managers seek new investment frontiers, as regulatory pressure impinges upon their freedom to run businesses as they please and centripetal pressure draws the business back towards Wall Street 2
Why Head Out to the Frontier? Investment Goals A disconnect between two viewpoints creates tension around hedge funds 1. Stated Fund Investment Goals Absolute Returns Low Volatility Non-Correlation with markets 2. Prevalent Investor Attitude Funds offer dramatic, outsized returns 3
Population Growth: Funds Settle the Frontier 10,000 Estimated Number of Funds 1990 Q2 2006 9,000 8,661 8,825 8,987 8,987 8,000 7,436 7,000 6,297 Number of Funds 6,000 5,000 4,000 3,325 3,617 3,873 4,454 5,379 3,000 2,383 2,781 2,990 2,000 1,514 1,945 1,000 610 821 1,105 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Q1 2006 Q2 2006 Source: HFR Industry Reports, HFR, Inc. 8/21/06, www.hedgefundresearch.com. 4
Assets Migrate to Alternatives Estimated Growth of Assets / Net Asset Flow Fund Industry 1990 Q2 2006 $1,300,000 $1,200,000 $1,100,000 $1,105,385 $1.2 Trillion $1,225,094 $1,181,699 Assets (In $MM) $1,000,000 $900,000 $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $0 ($100,000) $95,720 $38,910 $58,370 $27,861 $8,463 $185,750 $167,790 $167,360 $36,918 ($1,141) $256,720 $367,560 $374,770 $490,580 $456,430 $539,060 $625,554 $91,431 $99,436 $57,407 $55,340 $14,698 $23,336 $46,545 $4,406 $820,009 $972,608 $70,635 $73,585 $46,907 $42,132 $24,040 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Q1 2006 Q2 2006 Estimated Assets Net Asset Flow Source: HFR Industry Reports, HFR, Inc. 8/21/06, www.hedgefundresearch.com. 5
Growth at the Top Rapid consolidation of assets draws hedge funds back towards Wall Street Top Ten Funds by Assets: Year over Year 1Q 2005 $ Billions 1Q 2006 $ Billions 3Q 2006* $ Billions Farallon 12.5 Goldman Sachs 21 Goldman Sachs 29.5 Bridgewater 11.5 Bridgewater 20.9 JP Morgan 28.8 Goldman Sachs 11.3 D.E. Shaw 19.9 Bridgewater 28 Citadel 11 Farallon 16.4 D.E. Shaw 23.2 Caxton 10.8 ESL 15.5 Farallon 18.1 D.E. Shaw 10.8 Barclays 14.3 Barclays 17 Och-Ziff 10.7 Och-Ziff 14.3 Och-Ziff 17 Vega 10.7 Man 12.7 ESL 15.5 Tudor 10.4 Tudor 12.7 Campbell & Co 13.8 Perry 10.3 Caxton 12.5 Tudor 13.6 Sum 110,000 Sum 160,175 Sum 204,500 Source: Alpha Magazine Fund 100, 2005 & 2006; Absolute Return, 2006 6
Many Strategies for the Fruited Plain Estimated Strategy Composition by AUM Q2 2006 Relative Value 11.90% Regulation D 0.23% M erger 1.68% M arket Timing 0.38% Sector (Total) 4.70% Short Selling 0.27% 3.28% 4.60% Emerging Markets (Total) 4.24% M acro 10.71% FI: MBS 2.35% FI: High Yield 0.77% FI: Diversified 1.67% Equity 29.97% FI: Bonds 0.08% FI: 2.83% Event- 13.79% Equity M arket Neutral 2.18% Equity Non- 4.38% Source: HFR Industry Reports, HFR, Inc. 8/21/06, www.hedgefundresearch.com. 7
Fund Strategy Returns Vary Cyclically 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 YTD Q2 2006 Sector 39.65% 37.54% Sector 30.68% Event- 24.84% 33.33% Equity 23.41% 28.59% 22.79% Sector 67.00% Equity 44.22% Merger 18.02% 14.50% 13.37% 13.28% 12.10% 9.05% 30.82% 29.56% 18.89% Event- 15.01% Equity 10.60% Fund 9.30% Merger 8.59% 8.22% Equity 31.04% 22.92% Event- 21.23% Equity 15.98% Fund 31.29% Relative Value 13.41% Event- 12.18% Macro 7.44% 28.67% 12.83% Sector 9.14% Event- 8.10% Macro 29.32% Event- 25.11% 22.74% Equity 21.75% Fund 21.10% 20.77% Macro 18.82% Fund 16.79% Merger 16.44% 12.00% 7.77% Sector 7.62% Fund of Funds 26.47% Event- 24.33% 23.54% 13.27% Equity 9.09% Event- 6.74% 9.40% Relative Value 8.92% Macro 6.87% Relative Value 5.44% 5.28% Fund of Funds 1.02% Sector 27.93% Event- 25.33% Macro 21.42% Sector 11.34% 10.86% Fund 9.03% 8.27% 7.56% Fund of Funds 7.49% Sector 7.43% Relative Value 6.37% 6.29% Fund 21.50% Merger 16.61% Fund of Funds 16.20% Merger 7.23% 21.03% Fund 4.98% Fund 4.62% Merger -0.87% Equity 20.54% Equity 7.68% Event- 7.29% Fund 6.16% 19.85% 19.73% 18.70% Merger 17.86% Relative Value 15.66% Fund of Funds 11.10% 14.56% Relative Value 14.49% Fund of Funds 14.39% 11.73% Macro 9.32% 3.35% Relative Value 15.93% 15.40% 14.16% 12.72% 9.87% Sector 5.21% Macro 6.19% Relative Value 2.81% Fund 2.62% Event- 1.70% -4.23% Fund of Funds -5.11% Macro 17.62% 16.94% Relative Value 14.73% 14.41% Merger 14.34% -2.40% Fund of Funds 4.07% 2.78% Macro 1.97% Sector 0.31% -9.09% -14.07% Fund of Funds 2.80% Merger 2.76% Equity 0.40% Sector -4.90% -11.85% -17.83% Fund -1.45% Event- -4.30% Equity -4.71% Sector -12.85% -21.06% -22.09% Fund 19.55% Fund of Funds 11.61% 9.93% Relative Value 9.72% Merger 7.47% 5.07% Fund of Funds 6.86% Relative Value 5.58% Macro 4.63% 4.54% Merger 4.08% 1.18% Macro 6.79% Merger 6.25% Relative Value 6.02% 4.91% 2.55% -1.86% Equity 5.51% 4.95% Fund of Funds 4.19% Macro 4.19% 2.71% -1.24% Source: HFR Industry Reports, HFR, Inc. 8/21/06, www.hedgefundresearch.com. 8
Fund Capacity is Tested 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 YTD Q2 2006 Sector 39.65% 37.54% Equity 31.04% Macro 29.32% Event- 25.11% 22.74% Fund 21.50% 19.85% 19.73% 18.70% Merger 17.86% Relative Value 15.66% Fund of Funds 11.10% Sector 30.68% Event- 24.84% 22.92% Equity 21.75% Fund 21.10% 20.77% Merger 16.61% 14.56% Relative Value 14.49% Fund of Funds 14.39% 11.73% Macro 9.32% 3.35% 33.33% Equity 23.41% Event- 21.23% Macro 18.82% Fund 16.79% Merger 16.44% Fund of Funds 16.20% Relative Value 15.93% 15.40% 14.16% 12.72% 9.87% Sector 5.21% 28.59% 22.79% Equity 15.98% 12.00% 7.77% Sector 7.62% Merger 7.23% Macro 6.19% Relative Value 2.81% Fund 2.62% Event- 1.70% -4.23% Fund of Funds -5.11% Sector 67.00% Equity 44.22% Fund 31.29% Fund of Funds 26.47% Event- 24.33% 23.54% 21.03% Macro 17.62% 16.94% Relative Value 14.73% 14.41% Merger 14.34% -2.40% Merger 18.02% 14.50% Relative Value 13.41% 13.27% Equity 9.09% Event- 6.74% Fund 4.98% Fund of Funds 4.07% 2.78% Macro 1.97% Sector 0.31% -9.09% -14.07% 13.37% 13.28% Event- 12.18% 9.40% Relative Value 8.92% Macro 6.87% Fund 4.62% Fund of Funds 2.80% Merger 2.76% Equity 0.40% Sector -4.90% -11.85% -17.83% 12.10% 9.05% Macro 7.44% Relative Value 5.44% 5.28% Fund of Funds 1.02% Merger -0.87% Fund -1.45% Event- -4.30% Equity -4.71% Sector -12.85% -21.06% -22.09% Source: HFR Industry Reports, HFR, Inc. 8/21/06, www.hedgefundresearch.com. 30.82% 29.56% 28.67% Sector 27.93% Event- 25.33% Macro 21.42% Equity 20.54% Fund 19.55% Fund of Funds 11.61% 9.93% Relative Value 9.72% Merger 7.47% 5.07% 18.89% Event- 15.01% 12.83% Sector 11.34% 10.86% Fund 9.03% Equity 7.68% Fund of Funds 6.86% Relative Value 5.58% Macro 4.63% 4.54% Merger 4.08% 1.18% Equity 10.60% Fund 9.30% Sector 9.14% 8.27% 7.56% Fund of Funds 7.49% Event- 7.29% Macro 6.79% Merger 6.25% Relative Value 6.02% 4.91% 2.55% -1.86% 9 Merger 8.59% 8.22% Event- 8.10% Sector 7.43% Relative Value 6.37% 6.29% Fund 6.16% Equity 5.51% 4.95% Fund of Funds 4.19% Macro 4.19% 2.71% -1.24%
Newer and Expanding Frontiers: A Sample Set Crimped returns drive hedge funds to allocate more to a range of strategies Emerging and other non-us markets Convergence of private equity / hedge funds (ESL, Cerberus, etc.) Activist investing Alternative finance: debt Institutional Credit Strategies (Direct lending, ABL, ABS) Consumer Finance (Subprime credit cards, auto finance) Insurance strategies P & C Catastrophe bonds & captive reinsurers (>$12 billion AUM) Life insurance senior settlements & life premium financing Energy hedge funds (525 funds, $67.4 billion hedge fund AUM) Credit derivatives (total $26 trillion outstanding contracts) Weather derivatives ($40-50 billion market) Shipping derivatives ($25-30 billion market) Direct investment in film, real estate Sources: Energy Fund Center, Weather Risk Management Assoc./PWC 2006 Survey, Reinsurance Assoc of America 10
Expanded Operational Frontiers funds continue to upgrade technology and rethink business strategies Trading desk/prime Brokers: A wide range of technologies are reshaping the trading process: OMS, DMA, FIX, Algorithmic trading Financial Engineering the number of graduate programs in Financial Engineering over the last decade has grown from 8 to 40, fuelling the growth in quantitative trading Automation of fundamental valuation models as well as classic quantitative strategies Continuously expanding strategies, especially foreign investment, drive a need for new processes and platforms Outsource everything? Client management demands and brand control challenge the old mantra that hedge funds should focus on investing and outsource everything else Both Institutional and HNW channels push funds towards more robust enterprise data management, reporting and web services 11
Distribution Trends: Institutional Institutional allocations rise in volume and import Institutional hedge funds continue to increase hedge fund investments. A new study from Casey, Quirk & Associates revises the estimates of institutional hedge fund assets shown below up to $360 billion for 2006. Endowments have led, followed by pension funds Institutions drive a trend towards larger funds: Typically cannot comprise more than a certain amount of a fund s holdings Demand greater transparency and infrastructure from funds Over the long term, the secular shift in retirement savings from defined benefit to defined contribution plans will limit institutional inflows Source: Casey, Quirk & Associates Institutional Demands for Funds, 2004 12
Distribution Trends: Retail Asset managers are bringing alternative strategies to the mass affluent Asset managers seek to differentiate their product suites with alternative offerings, which may help them acquire or maintain relationships with affluent accumulation and consolidation stage investors, even if the assets secured are not high margin Product Trends Funds of funds still dominate, but single manager placements are rising Low-minimum alternative products are structured compete with mutual funds Hedging mutual funds offer alternative strategies to mass market Channel Trends Wholesalers market hedge funds to retail channels funds can be found on discount brokerage platforms and in IRAs Source: Cap Gemini/Merrill Lynch World Wealth Report 2006 13
Regulatory Trends fund regulation remains an open question There is no clear direction after SEC Registration was defeated in the Goldstein decision: Will there be more regulation? Should funds stay registered? A limited trend towards deregistration appears in late summer 06 (about 4% of registered funds have deregistered) The fear of Retailization lingers Exposure of retail investors via pension plans is the SEC s biggest fear (i.e. San Diego County Retirement Plan in Amaranth) SEC and the Managed Funds Association urge that Accredited Investor asset threshold be raised from $1 million to $1.5 million, or perhaps higher Regulatory Balkanization Connecticut Department of Banking founds hedge fund unit Utah outlaws naked short-selling 14
How We Add Value Princeton helps hedge funds thrive in changing business conditions What Funds need to prosper Automation of complex processes Transparency Scalability (no spreadsheets!) Web services for investors, intermediaries Integration with service providers Administrators Multiple distribution channels Key person risk mitigation Business Continuity Princeton Consultants Founded 1981 Princeton and New York IT Strategy and Implementation 15
Funds In Search of New Frontiers Fall 2006 Clark Troy Senior Consultant Alternative Investments Practice Princeton Consultants (609) 987-8787 ctroy@princeton.com