Asset Flows Move from Long-only Equities to Hedge Funds and Active-Extension Funds in Heightened Search for Alpha, Says TABB Group

According to TABB Group in a new benchmark study, “Alternative Investments 2007: The Quest for Alpha,” actively-managed US equity mutual funds, the largest segment of the mutual fund industry as measured by assets under management (AUM), will remain relatively flat at 3%, “but assets in 120/20 and 130/30 active-extension funds will explode from $140 billion in 2007 to nearly $2 trillion by 2010, a 141% CAGR.”

“A major change is underway at alpha-seeking firms,” says Larry Tabb, founder and CEO, TABB Group, co-author of the study with Jeromee Johnson. “They are becoming more creative, moving overseas and towards frontier markets, moving up and down the capital structure, moving toward shorter-term, event-driven strategies and longer-term holding strategies that resemble private equity-type investments. And shorting and leverage, used by the first hedge fund as early as 1949, are becoming more sophisticated and mainstream, proven by the explosion in AUM in enhanced active, enhanced long and short extension equity strategies.”

Ninety per cent of the fund managers interviewed believe that the growth of active-extension funds will increase as the pressure for increased yield and increased fees push traditional managers into this new area. This shift in AUM, explains Tabb, “cannot happen by itself. It must be driven by the clients of today’s asset-management companies, from pension plans, trusts and foundations, to corporations and high net worth individuals. It also includes the most massive of mutual funds that cater to the mass-market retail investor. As these firms reposition themselves, expanding and transforming to cater to their clients, other changes must happen as well.”

New products and strategies such as absolute-return strategies, portable alpha vehicles and multi-alpha funds will affect the investment value chain. As managers expand their search to be more global, they must expand asset selection strategies and become more nimble about moving
in, out and between different risk and capital structures. This will affect how firms are serviced and brokered, technology infrastructure is implemented and operations are structured, all in pursuit of alpha. “This will also affect investors,” adds Tabb, “because track records do not yet exist and these complex strategies have few services to vet them or ensure their fidelity. But with opportunities come adventures and as long as the oyster doesn’t close on a finger, the quest to find the pearl can be exhilarating, the rewards enormous.”

TABB Group interviewed 67 portfolio managers, chief investment officers, heads of research and senior managers of hedge funds, funds of funds and traditional long-only asset managers with a particular focus on traditional equity managers who had started active-extension funds. Collectively, they manage $12.3 trillion with the over 90% of those assets managed by large fund companies (over US $50B for traditional managers and $2B for hedge funds).

Key findings also include:
• Nearly half of all fund managers believe their greatest source of new alpha will be generated by new geographic markets.
• Research continues its shift from a sell-side function to one performed by the buy side.
• By 2012, the buy side will generate 63% of its research internally with spending on broker research declining to $3.42 billion.
• More than 50% of funds reported they would increase their spending on independent research providers, who are expected to grow their revenues from $1.0 billion in 2002 to $2.4 billion in 2012, a 9.15% CAGR.
• 40% of funds believed that trading costs were the most significant cause of lost alpha.
• In aggregate, only 35% of the firms believed brokers helped them capture alpha. However, size and satisfaction were linked as larger firms were overwhelmingly more satisfied by their brokers’ ability to capture alpha.