After the crisis, industry adapts to new environment
The hedge fund industry has looked into the abyss and stepped back. After the depressing slump in performance in 2008 and the frenzied outflow of funds that followed, London-based managers are again breathing more easily, most off them buoyed by a resounding rebound in performance last year. Service providers too are returning to dealing with issues of growth rather than contraction. But the environment they are working in is not the one that existed up to 2007.
That’s not necessarily a bad thing. The hedge fund industry today is aware of and taking steps to deal with a wide range of risks and challenges that were barely on the periphery of its vision three years ago. In particular, the intervening period has been a spectacular education in the nature and scope of the risks that can arise within the hedge fund business, and the lessons learned have resulted in broad changes in the way fund management firms operate and the tools they use to measure and manage risk.
The hedge fund industry in London and other centres around the world has also gone through a period of creative destruction. Many managers that relied on massive amounts of leverage to amplify tiny market anomalies are gone, some of them spectacularly. Borrowing is grudgingly available in the new environment; on the other hand the return of volatility has made it much less necessary.
And into this new world are coming a stream of talented individuals who are leaving existing hedge fund firms and investment bank prop desks to test out their talents on their own. It may be harder than in the past to persuade institutions to back managers without an established track record, but on the other hand the newcomers do not have to struggle to return to daunting high water marks before they can start earning performance fees.
“Last year saw many hedge funds make their best returns for more than 10 years coming off the back of a very difficult 2008,” says Stephen Burke, a director and head of compliance with IMS Consulting, which describes itself as the largest independent compliance consultancy in the UK focusing solely on the asset management and securities industries.
“We saw a real surge in the number of people seeking to launch hedge funds from June onward, and new ones continue to come steadily to the London market. A lot of those are very credible propositions with good people, with seeding deals that are pretty much secure, although new launch activity is at lower levels than the heady days of 2006-07 and assets are generally much smaller.
“That is markedly different from a year ago, when many people who were hoping to get seeding in a fairly uncertain market were unable to make much progress. They may well be coming back now. In those dark days of a year ago there was retrenchment everywhere you looked. A significant liquidation of funds and redemptions was an undercurrent through much of last year.
“That all seems to be behind us as net inflows return. The indications we get from the prime brokers are that a lot of good managers are in the wings waiting to launch their funds. The vibrancy of the industry is beginning to return, and existing managers are not only growing their funds again but beginning to get past high water marks that at one time looked unattainable.”
One of those is specialist quant boutique Sabre Fund Management, which suffered along with the rest of the industry two years ago but is now enjoying a return to vigorous performance and renewed asset growth. “After all the shocks of 2008, last year turned out to be a year of opportunity,” says managing principal Melissa Hill. “Our final NAV put us up 22.5 per cent, the best year the fund’s ever had in live trading.
“It wasn’t wholly unexpected because the environment was favourable for all the component parts of our strategy – good volatility levels for our stat arb models, investors focusing on styles that might make money in a recessionary world, and then rational rotation of investment themes throughout the year. Also there’s been less competition in the quantitative space with many prop desk activities having been curtailed. So we got our high water mark back by the third quarter, which put us ahead of many hedge funds, and we had more money to start developing the business again. Most of our investors have returned, albeit in some cases with smaller assets.”
Hill says Sabre is now in a position to push ahead with plans that had to be shelved temporarily when the crisis struck. “Last year was one of recovery and stabilisation, but 2010 is when we put back into effect the business plan that we had in 2008,” she says. “We are looking at areas including Europe-domiciled funds, Ucits funds and diversifying our investor base. Like most hedge fund managers, we are looking at alternative types of distribution.
“The beauty of a market neutral strategy is that it’s relatively easy to implement within the sophisticated Ucits rules. I see this as an area of considerable importance for our business development because it will give us the opportunity to approach some of the IFA platforms and thus the mass affluent, not just high net worth qualified investors. In addition, it will enable us to meet the standards that are looked for in distribution in Asia, where Ucits funds are very popular.”
Like other managers, Sabre regards Ucits funds not only as a ‘hedge’ against the still-uncertain rules coming with the European Union’s planned Directive on Alternative Investment Fund Managers but as a vehicle that can reassure nervous investors after shocks such as the Bernard Madoff scandal. There’s an element of box-ticking about this, Hill acknowledges, but Ucits provide for significant checks and balances including liquidity that must be at least bi-monthly and the presence of an independent custodian responsible for safekeeping of the assets.
According to Hill, Ucits funds offering hedge fund-like strategies also represent an alternative to managed accounts, which have become a massive growth area for London-based managers in the aftermath of the crisis. “We’ve seen a big shift among investors away from the risks inherent in commingled vehicles toward managed accounts that follow the same strategies as the flagship funds,” she says. “This is a common theme across the industry. Managed account platforms provide robust infrastructure and risk reporting as well as enhanced liquidity. They also facilitate the deniability factor – being able to blame someone else if it all goes wrong.”
Simon Dinning, managing partner of the London office of the global offshore law firm Ogier, says that while the growth in managed accounts is undoubtedly a significant trend, it may not have reached quite the scale anticipated a year or so ago – in large part because investors must be substantial enough to absorb the extra costs involved. “Many commentators predicted a big rush to single-investor funds and managed account platforms on the back of the 2008 run on funds,” he says.
“While we have been involved in a number of these, in fact there hasn’t been the rush that everyone anticipated. The real reason for the slower uptake is the cost of set-up and maintenance. If you ask managers to set up a parallel portfolio investing in the same strategy as the main pool of assets, you’re bearing alone the cost of setting up that platform. This makes it an impractical solution for all but those investors with significant capital to commit.
“While managed accounts and single investor funds create a high degree of transparency, in allowing investors to trace assets exactly and see valuations, there is, however, an important secondary issue. Unless you are setting up an entirely separate strategy for your platform, there are obvious difficulties in ensuring complete segregation of risk. This is something to address at the planning stage to ensure that the real benefits of these platforms are achieved and maintained.”
His view is shared by Robert Mellor, UK financial services tax markets leader at PricewaterhouseCoopers, who says: “Post-2008 one response to the Lehman bankruptcy was to look to managed accounts, because they would provide segregation of and a clear line of sight to assets.
“However, I’m not convinced that will be the norm going forward, because of the extra administrative burden involved in managers running a managed account platform for investors. Institutional managers have added managed accounts to their range of products, but investors have to be prepared to incur the extra cost that comes with it.”
Size has been an important bulwark against the buffeting of the market over the past couple of years, according to Helen Bramley, product director for collateral at Lombard Risk Management, a software house specialising in risk and regulatory reporting software for institutions.“The past year was a tough one for everybody, but the larger hedge funds seem to be still relatively strong, and their investors are still there,” she says. “Their most important focus at the moment is rebuilding their assets, making sure their performance improves, and revamping operational processes to satisfy investor demands for more transparency.”
This has meant increased demand for Lombard Risk’s collateral management product, Colline, as well as other areas of the business such as valuation, liquidity risk and regulatory reporting solutions. “Reporting and accountability is now crucial,” Bramley says. “There may not be a correlation, but the hedge funds that avoided the worst of the storm seem to be the bigger ones that would have invested in collateral technology.
“They would have already understood the advantage of having improved control over their collateral process, whereas the smaller ones faced greater risks because they would not have had those tools when they needed them. It is difficult to defend margin calls and get quick payment. That is essential for all hedge funds, and this is where automated collateral management makes all the difference.”
Industry members believe that if anything transparency and accountability are more important to investors than a lowering of management and/or performance fees – another trend that was widely expected following the performance crash of 2008 but so far seems to have largely failed to materialise. “Investors are not necessarily looking for reduced fees, although they’ll take them if offered,” says Lachlan Roos, UK tax hedge fund leader at PricewaterhouseCoopers.
“They’re looking for transparency from their funds and more information about what they are doing. They’re looking for better due diligence from the funds themselves, especially at the fund of funds level, and there’s evidence that some investors are starting to prefer light regulation of their funds to the completely unregulated regimes they worked under in the past. This has prompted a few funds to move out of jurisdiction like Cayman to locations such as Ireland.
“Our clients are also telling us that investors are concerned with how managers communicated with them throughout the crisis and how open they have been, and it’s having a direct impact on how investors are responding now as money starts to flow back into the industry. Some clients have seen a lot of previous investors who have been happy to bring their money back because the managers treated the investors fairly. But others who threw up gates and suspensions straightaway haven’t done so well.
“As happened across all asset classes, losing money became a relevant concept. Clients who didn’t impose gates although they could have done became ATMs for investors, especially in the fund of funds market, but many investors appreciated that the managers kept liquidity open, and they seem to be getting assets back.”
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