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New York—A recent report from KPMG and CREATE-Research projects increased demand for alternative investment products, increasing convergence between long-only and hedge fund managers.  The study focused on two trends:  Convergence between long-only and alternative investments such as long-only managers adopting alternative techniques, and convergence between alternative investments, such as hedge fund managers adopting private equity techniques.  Active long-only managers are getting closer to the alternatives sector, which is itself witnessing the convergence of hedge funds, private equity, real estate, infrastructure and structured products.  Convergence is yet another factor driving the growth in demand for alternative research.

CREATE-Research and KPMG International recently released “Convergence and divergence: New forces shaping the investment universe”, part of a series of studies on the global investment management industry.  The study was conducted during 2007 and included surveys of 239 long only and hedge fund managers; 61 pension funds and 48 administrators.

Convergence: Long Only & Hedge

Long-only managers have three approaches to adding alternative type investment products. First, with regulatory support through UCITS III, they have offered hedge fund like products for retail investors. Second, using hybrid products like 130:30 and Global Tactical Asset Allocation (GTAA), they have tried to satisfy their institutional clients’ demand for greater absolute returns.  Third, via acquistions, they have purchased alpha generation skills.

Long only managers enjoy the greatest market share of pension assets, with 70% of pension assets invested with long only managers.  However, share has been declining: 

“But subsequent interviews showed that [the long only market share] had come down substantially over this decade, from a high of 85 percent in 2002. The decline accompanied an explosive growth in assets channeled into hedge funds, private equity, structured products and real estate.”

One competitive response from long only managers has been to create ‘high alpha’ products with broad investment mandates accompanied by high volatility and high tracking errors. Many asset managers include global tactical asset allocation funds in this category.  Global TAA funds use derivatives to switch between asset classes and profit from changes in macro economic conditions mimicking macro strategies deployed by hedge fund managers.

 Long only managers have also increased use of derivatives, leverage and shorting in the traditional equities and bond portfolios, including 130:30 products.  The study indicates that the adoption of 130:30 products has been “more limited than media coverage would imply. In the last two years, they have grown from zero to around US$100 billion.”  In some cases, long only managers have ramped up their quant capability to create a wider universe for targeting stocks for shorting and leverage.

Convergence within the Alternative Space

The study finds that more than two in every five pension funds have ventured into real estate, private equity and infrastructure investments over the past three years.  Strategies that invest in hard assets are popular because trustees can understand them and their staff can monitor them.   A further one in every three have also ventured into emerging markets, long-short equity, structured products and equity market neutral strategies.  The increased allocations to alternative investments from pension funds are significant.  The study suggests that around two in every three pension funds have diversified their asset base by up to 10 percent in the last 3 years, and a further 3 in 10 by over 10 percent.

The increased demand for alternative strategies from pension funds has led to convergence between alternative investment managers.  A number of larger private equity groups have expanded into real estate, infrastructure or hedge funds.   Hedge funds have expanded into private equity.  Real estate managers have moved into infrastructure, and a small number of real estate hedge funds have emerged.

Hedge funds have also added new investment strategies.  Besides private equity, the most popular among hedge fund managers have been long short equity and emerging markets.   According to the study, one in three investment managers has diversified within alternative investments, with just as many aiming to do so over the next three years.  To support their forays into less liquid asset classes, some hedge funds have created permanent capital through fund listings, added debt finance or instituted ‘side pockets’.  In addition, a small number of mega managers are emerging, with assets approaching US$100 billion and a full suite of alternative investment products. Some of these managers have begun to compete with investment banks, and some have raised capital in the debt and equity markets.

Convergence represents another factor which is increasing demand for alternative sources of research as alternative managers, and long only managers, seek investment ideas and analysis to support absolute return strategies.