Headlines about the ongoing crisis in financial markets have been difficult to ignore and problems at specific hedge funds have formed part of the unfolding story.
Headlines about the ongoing crisis in financial markets have been difficult to ignore and problems at specific hedge funds have formed part of the unfolding story. Indeed, large losses at two Bear Stearns mortgage credit funds were one of the catalysts for market volatility in July and August. It would be wrong, however, to conclude that 2007 has been a disastrous year for hedge funds.
For a start, the hedge fund industry now comprises more than 7,500 funds and 2,400 funds of funds, but it is still the small number of failures that grab most media attention. ‘The problems suffered in the summer by some credit funds were well-publicised. Less well-documented is that a handful of funds were short sub-prime mortgages and were part of a group of funds that at the end of October were up more than 100 per cent for the year,’ says Ken Heinz, president of Hedge Fund Research (HFR), the alternative investment database and index provider.
The most recent performance data from HFR paints a relatively upbeat picture. The hedge fund industry attracted a record USD194.5bn in new investor capital in 2007, bringing total assets under management to USD1.87trn.
Inflows for 2007 outpaced the previous year’s USD126.5bn and represent a 54 per cent year-on-year increase. However, the fourth quarter inflow of USD30.4bn was well below the pace set in the first three quarters of the year, making 2007 the third consecutive year to end with a fourth quarter drop in the rate of new capital coming into the industry.
The HFRI Fund Weighted Composite Index returned 1.37 per cent in the fourth quarter and 10.24 per cent for the year. For the third year running, the HFRI Emerging Markets Index was the top performer on an annual basis, adding 3.89 per cent in the fourth quarter, and returning 25.03 per cent for the year. Short selling led all strategies for the quarter, returning 5.94 per cent, but was up just 3.98 per cent for all of 2007.
Relative value arbitrage and event-driven attracted the most new assets in the fourth quarter, bringing in USD9.9bn and USD5.3bn respectively. For the year, relative value arbitrage brought in the most new assets, totaling USD45.9bn. Equity hedge was next with USD41.5bn, although the strategy attracted just USD14m in inflows in the fourth quarter.
Funds of funds saw net new inflows of USD11.3bn in the fourth quarter and USD59.2bn for the year, compared with USD49.7bn in net new assets in 2006 and USD9.5bn in 2005. Globally, USD798.6bn is invested in funds of funds, according to HFR, with total assets invested in the category increasing by almost 22 per cent in the past year. Fund of funds performance was up 1.85 per cent in the fourth quarter of 2007, and 10.12 per cent for the year, according to the HFRI Fund of Funds Composite Index.
‘It was another record year for hedge funds when it came to attracting new assets in spite of the slower pace in the fourth quarter,’ says HFR’s Heinz, who confirms that there are now more than 10,000 hedge funds in the industry. ‘The trend in strategy allocations suggests investors are not chasing the best performers, and are anticipating continued opportunities in arbitrage and event-driven.’
Looking ahead, any outflows appear likely to be more than offset by continuing strategic inflows. ‘If market conditions remain difficult in 2008, which we think they will, then inflows will remain strong,’ says Thomas della Casa, head of research, analysis and strategy at Man Group.
Barry O’Brien, director of business development at fund administrator LaSalle Global Fund Services Europe, also noted an optimistic outlook among hedge fund providers. ‘It is very much business as usual,’ he says. ‘Of course some individual funds have lost their shirts, but that is a cyclical phenomenon. In the late 1990s emerging market funds suffered in the Asian crisis, which was followed by the technology crisis. Certain discrete areas have been severely affected this year, but others are expanding.’
In 2007, market volatility has resulted in a greater variance in the performance of both managers and strategies than in recent years, which for an industry that promotes itself on its ability to generate alpha is a good thing. ‘The hedge fund industry fee model has attracted a lot of mediocrity, but the fees are set at levels that are not synonymous with mediocrity,’ says Robin Bowie, chairman of Dexion Capital. ‘It is now an ideal environment for hedge fund managers to exploit opportunities and show their worth.’
With this greater variation in performance, manager and strategy selection will be even more important than usual in 2008, and there is a renewed belief in the benefits of diversification. ‘Achieving a return of Libor plus 500 basis points with a fund of funds is a much better bet than investing in credit at the same level,’ says Bowie.
Both Man Group and LaSalle Global have noted a trend towards a greater relative focus on fund of funds rather than hedge funds. ‘In 2008, we will see a revival of the diversified fund of hedge funds. In recent years investors wanted high returns, more leverage and specialised exposure. Now they are starting to value diversification more highly again,’ says della Casa.
The strategy mix is also shifting to reflect a less benign macroeconomic outlook for 2008. Distressed asset trading, for example, is definitely on managers’ radar. Parts of the credit market, such as the industrial segments of the corporate credit market have come under pressure from long liquidation, despite company fundamentals – such as interest cover and cash flow – remaining sound. This creates opportunities for hedge funds to exploit the difference between intrinsic value and oversold market valuations.
Andrew Lodge, managing director of Nedgroup Investments, a fund of hedge funds, aims for a wide distribution of assets across different strategies, but says, ‘we do make some tactical asset allocations and we are expecting distressed debt trading to do well in 2008. We are also optimistic about the prospects for funds getting involved in providing mezzanine financing: the banks have pulled back and so the deal flow and value opportunities are improving.’
As well as taking the place of traditional financial intermediaries, hedge funds look set to benefit from greater economic uncertainty. For example, the continuing stress in money markets is a possible threat to strategies in fixed income relative value, but also creates opportunities. ‘There are currently very varied opinions about the macroeconomic outlook, which means that price action after central bank policy changes is quite marked,’ says Man’s della Casa. ‘This movement in yield curves creates opportunities to both take profits and enter new trades. Twelve months ago yield curves just weren’t moving.’
There has also been a shift of emphasis within specific strategies, such as credit. ‘There are three launches that we are aware of in December from managers looking to exploit opportunities in the credit market,’ says O’Brien. ‘Some areas, such as CDOs have diminished, but other credit-focused strategies have expanded significantly.’
Opinions are more divided on the prospects for quantitative funds, after the very poor performance of several high-profile funds in the first half of August. ‘There’s an inherent inflexibility in those funds,’ says Andrew Lodge. ‘There is very little human intervention in the models and they may have had their time.’ In November, however, when many hedge fund strategies recorded losses, equity market neutral – in which there is the highest concentration of quantitative funds – recorded a modest gain for the month.
One new area of quantitative investment, however, gained traction in 2007: hedge fund replication. Just as passive index tracking has become an important part of the mutual fund industry, as the hedge fund sector matures interest is growing in low-cost index-based products, which use proprietary algorithms to replicate the performance of hedge funds. Goldman Sachs, JPMorgan and Merrill Lynch have already launched hedge fund ‘clones’ and the market has also attracted new entrants such as New York-based Index IQ. By definition a passive investment strategy can only replicate beta not alpha. But gaining access at a lower cost to the alternative betas offered by hedge funds – the risk premia earned by isolating asset characteristics that are rewarded – has obvious appeal.
‘Passive indexing accounts for about 17 per cent of the mutual fund industry,’ says Adam Patti, chief executive of IndexIQ. ‘We won’t get to an equivalent level in the hedge fund industry next year, but that is the kind of future market growth we are thinking about.’ If hedge fund replication does gain widespread popularity, it could lead to downward pressure on fee structures at those hedge funds whose performance is not exceptional.
While it is clear that fund providers are relishing the prospect of more turbulent markets, there are also indications that investor demand remains buoyant – at least for the right kind of hedge fund investment. At the start of December Dexion Absolute, the biggest UK listed fund of hedge funds, raised GBP 460m from investors, which was more than double its original target. ‘There is strong demand for good quality funds, which are large and liquid,’ says Dexion’s Robin Bowie. Some smaller funds, however, have struggled to raise as much capital as they had hoped and there is definitely an element of ‘size begetting size’ in the current fundraising environment.
It is perhaps unsurprising that in a year during which illiquidity – the inability to sell an asset at the expected price – was the main cause of market distress, investors should show a preference for large vehicles offering ease of entry and exit. However, given the greater variation in performance in 2007, the best managers are finding themselves able to demand tighter, not easier redemption terms. Indeed, some have put forward the argument that very short notice periods added to the summer’s volatility by allowing panic withdrawals.
Increased volatility has also prompted a demand from some institutional investors for greater transparency from hedge funds. O’Brien, for example, notes an emerging trend towards managed accounts rather than funds with a unit trust structure. For hedge fund managers there is a fine balance to be struck between meeting clients’ requirements and protecting the proprietary nature of trading strategies. It is, after all, difficult to create alpha if everyone knows the exact details of the strategy being followed. In the aftermath of the August turmoil there has also been a greater demand for evidence of sound risk management and valuation processes.
Interest in risk management and transparency was also apparent among policymakers in 2007. Germany used its presidency of the G7 in the first half of the year to press for increased transparency at hedge funds and proposed a global database of hedge fund investments. Recommendations from the Financial Stability Forum, an international grouping of central banks and financial regulators, however, stopped short of calling for tighter regulation.
Germany and others pushing for action, such as the ECB, were mollified by efforts instead to establish a voluntary code of best practice.
The Hedge Fund Working Group, established by 14 leading hedge fund managers based mainly in the UK, this month published best practice standards for hedge fund managers following consultation with the industry and other interested parties.
The publication of the standards has been welcomed by the Alternative Investment Management Association (Aima), which will be involved in implementing them, and follows the issuing of a consultation document by the group last October.
The body of voluntary standards includes recommendations for managers to adopt an independent process for valuing portfolios and to put in hand robust governance of funds, in order to handle conflicts of interest between managers and investors.
The report also recommends enhanced disclosure to investors and urges managers to create a comprehensive risk management framework, an important consideration in the context of financial stability.
The Hedge Fund Working Group was set up last year in response to concerns about both the growing impact of hedge funds and financial stability. The standards aim to address these and other issues through increased disclosure to investors and other counterparties.
‘Our final report is the result of extensive consultation within the financial industry, which has helped us to refine the standards and in some important respects make them more rigorous,’ says the group’s chairman, Sir Andrew Large
‘Now it is up to investors to help take this forward. This is a voluntary, market-led initiative based on disclosure. It is the investors who can provide the market discipline to ensure these standards are widely adopted.’ Compliance with the standards will be voluntary and will operate on a comply or explain basis.
A Hedge Fund Standards Board is being set up to act as custodian of the standards. The board’s trustees will be responsible for updating the standards in the future and for encouraging convergence with the similar initiative currently being taken by the President’s Working Group in the US.
Members of the group will initially act as interim trustees of the new Hedge Fund Standards Board and Sir Andrew Large will be interim chairman until permanent trustees are appointed. Aima chairman Christopher Fawcett will become a trustee.
According to the working group, Aima will also have a key role in developing aspects of the recommendations included in the report and in acting as a channel for guidance for the industry as well as consultations on future changes.
The association has welcomed the publication of the report, describing it as ‘a substantial undertaking by leading hedge fund managers [that] offers high-level thought leadership on key issues surrounding the industry.
Aima notes that the report endorses its own work in defining and promoting best practice standards for the hedge fund industry and says it will work with the Hedge Fund Standards Board to mesh the standards with its own recommendations.
The association shares the working group’s desire to see convergence of the various sets of standards drawn up for the hedge fund standards and has expressed its commitment to leading these efforts, while not underestimating the challenges inherent in doing so. It will consult with its members on the development of the standards by the board and may develop guidance on them if called upon to do so by its members and investors.
‘This report is a substantial achievement by this group of leading managers, particularly given the time frame and the market conditions,” says Aima deputy chief executive Andrew Baker. We believe this initiative is the right approach for the hedge fund industry.
‘The working group’s endorsement of Aima’s leadership and its substantial body of work in industry practices is welcomed, and we are very much looking forward to working with the board and the rest of the industry to oversee convergence of standards.’
The working group was set up last July to address issues raised about financial stability by the G8 and the Financial Stability Forum as well as other concerns about the hedge fund industry. Its terms of reference were to explore a range of issues covering in particular valuation, disclosure of financial information and risk management.
The working group received more than 75 written submissions from interested parties in the industry, its investors and suppliers during the two-month consultation period and held 26 face-to-face discussion sessions.
The members of the group are Nagi Kawkabani, co-chief executive, Brevan Howard; Klaus Jäntti, chief executive, Brummer & Partners; Bernard Oppetit, chief executive, Centaurus Capital; Stuart Fiertz, president, Cheyne Capital; Michael Hintze, chief executive, CQS; Jeffrey Meyer, chief executive, Gartmore; Manny Roman, co-chief executive, GLG; Paul Ruddock, chief executive, Lansdowne Partners; Rob Standing, founding partner, London Diversified; Stanley Fink, deputy chairman, Man Group; Paul Marshall, chairman, Marshall Wace; Michael Cohen, managing partner and chief investment officer for Europe, Och-Ziff Capital Management; Michael Alen-Buckley, chairman, RAB Capital; and George Robinson, founding partner, Sloane Robinson.
The London-centric nature of the working group reflects the city’s dominant role for hedge fund management in Europe. According to EuroHedge, UK-based hedge fund managers had USD415 billion of assets under management at the end of June last year, some 80 per cent of the USD539bn in total assets managed or invested in Europe.
The FSF noted in October that, ‘The issuance of draft best practice standards…is a notable step towards improved transparency and discipline and a recognition by the sector of its responsibilities as a significant force in the financial system’
Importantly, the FSF has also recognized that this ‘significant force’ has not been the prime cause of financial market instability in 2007. At the request of the US government the FSF is now studying regulated financial institutions’ liquidity, market and credit risk practices.
At the end of a year in which a long expected return of market volatility has tested the resilience of most financial institutions, London’s hedge fund industry, with its focus on setting pragmatic best practice standards, is well placed to meet clients’ needs in a more challenging investment environment.
