The Continuing Evolution of Hedge Funds

Family Office Alpha Report

By Keith Danko

May 18, 2015

In their earliest days, they were an investment for well-connected high-net-worth individuals, particularly Europeans and others with access to offshore accounts. Today, hedge funds have evolved into primarily an institutional investment, with most high-net-worth investors funneled through one type of platform or another, or through a family office that follows an institutional framework.

A markedly elevated due diligence process has developed along with this trend toward institutionalization, one which has only accelerated in the wake of the 2008 financial crisis and the Madoff scandal. In fact, a formal checklist of minimum standard requirements has become de rigeur for most institutions.

Family offices have also followed this progression to a large degree. Originally closer to what could be called an “enlightened high net worth” model, many family offices have migrated toward a full institutional model.

In many respects, this movement is a good thing. In terms of investment sophistication, it mirrors a truth that has endured for the past decade: family offices have kept pace with the more established institutions in their ability to judge investment talent and opportunities. In some instances, often because of the specific business-building background of the founding family itself, this acumen may even be more refined at family offices than it is at other institutions.

But in their full adoption of formal checklists and standard requirements, have family offices and other institutions diminished their ability to discover, analyze, and invest in promising managers? Have they relinquished what was once their advantage—the connections to emerging talent and the ability to invest in it without undue delay—to institutions such as pension funds and endowments?

The reasons to be more “institutional” in approach have been driven mostly by demand for operational due diligence and security of capital. However, safeguards at almost all of the significant prime brokers and audit firms together with the general conservatism of risk management at medium and large hedge funds make the pre-2008 type anxiety about such private funds unfounded. The proliferation of single managed accounts (SMAs) has added further protection.

Modest hedge fund performance only validates this paradigm, given the mid- to low-single digit annual returns and low volatility generated from most hedge fund portfolios and in-house fund of funds. Family offices may be taking slightly more risk than other fiduciaries, but it still appears they are more conservative than they need to be, and are accepting a sub-par risk/return profile in their hedge fund investments.

Despite the heightened transparency and increased compliance and regulatory oversight implemented post-2008, emerging managers are under-allocated in this opportunistic environment. Emerging hedge funds, particularly those with unique or uncrowded strategies, warrant more attention. It is an opportunity for family offices to demonstrate some of the very instincts and savvy that created the family wealth in the first place.