Hedge Funds and the Active Management Industry

Abstract

The significant growth of hedge funds has garnered substantial attention—and concern—amongst observers of, and participants in, the investment community. In this article it is argued that hedge funds are not sui generis, but are part of the broader “active management industry.” Three broad conceptions are discussed. First, as part of the broader active management industry, hedge funds still represent a relative minority of the risk taken with the expectation of generating alpha. Second, the important question for investors is the choice of governance models for generating alpha—the traditional active management model or the hedge fund model? While structural features of alpha generation do involve tradeoffs, on balance, the hedge fund form is more appropriate for alpha generation. Finally, while superior to a traditional model, the hedge fund format is imperfect. Therefore, mechanisms to make manager/investor outcomes more symmetrical (such as an appropriate level of co-investment), when combined with the current hedge fund governance structure, may further align incentives between managers and investors.

TOPICS: Real assets/alternative investments/private equity, manager selection, portfolio construction