Don Lindsey, President and Chief Executive Officer of the University of Toronto Asset Management Corporation
Investment Darwinism: Hedge Funds and the Evolution of Investment Management
Over the past two and a half years, the investing public has lived through a post-bubble economic environment of historical proportion and significance. The extraordinary gain in technology stocks in the late 1990's and subsequent obliteration of share prices around the world since March 2000, however, is not unprecedented. Whether it is the South Sea Bubble of the 1720's in Great Britain, the U.S. stock market crash of 1929, or the American Gilded Age, these periods in history all share common characteristics, such as easy access to debt, complacency of government, a rapid increase in corruption, and a blind acceptance and permanence of the status quo.

The two decade-long bull market that ended in early 2000 created the status quo of investment management. The lucrative consulting business convinced institutional investors of the need for equity diversification across value and growth styles, capitalization sectors, and top-down and bottom-up stock selection. Then the hot debate became active management versus inexpensive indexation. By the end of the run, it did not matter because there was enough flow of funds into the equity markets to forgive mediocrity and unrewarded tracking error. Only those who were willing to compromise assets under management in order to pursue undervalued and unrecognized opportunities were penalized.

If a low equity risk premium environment persists over the next several years, the hedge fund structure is likely to eclipse the current mutual fund and investment advisor model. The owner-agency conflict can only persist in a bull market. The traditional business model rewards assets under management rather than risk-adjusted performance and does not appropriately align the interest of investors and firm management.

The pension industry has been obsessed with manager performance at the expense of diversification. The problem today is that it is virtually impossible to obtain the appropriate degree of diversification in a three-asset world of stocks, bonds and cash.

The traditional hedge fund model developed decades ago by Alfred Jones goes a long way in eradicating the owner-agency problems faced by investors. Hedge fund managers are expected to invest the majority of their liquid net worth in their fund. They seek absolute returns, which alleviates the tying of benchmark risk to business risk. Freedom from benchmark risk gives them the flexibility to exploit a wide range of opportunities. This requires, however, that plan sponsors and institutional investors develop a complete and thorough understanding of risk that goes beyond traditional mean-variance analysis.

As in any new industry, there has been a rush of participants trying to play survival of the fittest. This means more frequent hedge fund catastrophes are likely to happen, but the evolution of the investment management business is firmly in place.

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