Traditional structures under challenge as industry looks to the future
One of the most striking changes that has emerged within the hedge fund industry in response to the upheavals of the past three years is a rethink of the structures through which managers offer their strategies to investors. The dominance of the offshore pooled fund model has been challenged, albeit certainly not yet overturned, by the growth of regulated onshore structures including European Ucits funds on one hand, and by a surge in the use of separately managed accounts both by funds of hedge funds and large institutional end-investors on the other.
In particular, the use by hedge fund managers of Ucits structures – regulated vehicles that can be freely sold to retail as well as other investors throughout the European Union and that are also increasingly accepted by regulators in Asia, Latin America and other markets – may help the industry to reconnect with individual investors, which have been slower than institutions to return to the market following the hefty losses and liquidity problems in 2008 and early 2009.
This is the belief of Max Gottschalk, senior managing director and head of European business at Lausanne-based fund of hedge funds manager Gottex Fund Management, who argues that individuals are increasingly attracted by more regulated fund structures. “We have seen the emergence of new products, in particular Ucits hedge funds and funds of funds, and we expect retail investors to come back via these investment vehicles,” he says.
Charlie Woolnough, European regional director at Fortis Prime Fund Solutions, sees a trend toward the domiciling of funds in the EU centres of Dublin and Luxembourg, which built their market position with retail Ucits funds but are seeing increasing success with more lightly regulated structures aimed at sophisticated investors. “We are certainly seeing a trend toward ‘onshoring’ in Europe,” he says.
“Historically we have had a long-only presence in Luxembourg, but we recently launched a specialised office dedicated to hedge funds, funds of funds and private equity to cater for the trend of managers to move more toward Luxembourg Specialised Investment Funds or Irish Qualifying Investor Funds, but also Ucits products as well. This is perhaps to cater particularly to investors looking for passport-regulated structures in the light of Madoff and one or two other unsavoury incidents that have occurred over the past couple of years.”
Chris Cattermole, sales manager for Europe, the Middle East and Africa for Advent Software’s hedge fund portfolio management, reporting and accounting software package, Geneva, says that amid a large influx of money from pension funds and other big institutions, he is seeing not only a surge in the launch of Ucits funds but many investors turning to the use of managed accounts.
He says: “The challenges that our clients currently need to address involve the capability to service individual investors rather than being able to bundle investors together with others in a single fund and provide fund-level reporting. It’s a much more high-touch environment, and the less manual that environment is for the managers, the more efficient they will be.”
Lyxor Asset Management has been running a managed account platform since 1998 and has been a major beneficiary of the demand by investors for greater liquidity, transparency and control over their hedge fund investments. “The managed account platform provides investors with a risk-free framework within which to invest in hedge funds,” says head of sales and marketing Christophe Baurand. “We eliminate operational problems while controlling the risks of the funds, providing superior transparency to investors and better liquidity terms than in the traditional hedge fund space. In addition, we have a very large offering and access to leading managers such as Caxton, Tudor and Paulson.”
Baurand notes that the Lyxor managed account business, which now has more than USD10bn in assets, has benefited from two high-profile industry debacles a decade apart. “We have had two catalysts in the development of the platform,” he says. “One was Long Term Capital Management – Lyxor was created as a response to the problems linked to operational issues that became evident back in 1998. The second is Madoff.
“Investors still very much appreciate the advantage of hedge funds in terms of risk-return profile and decorrelation benefits over traditional asset portfolios, but they are extremely cautious about the lack of transparency and liquidity, and about practices in the hedge fund space. Everybody has in mind Madoff, Amaranth, and all the operational issues that regularly emerge.”
The past 12 months have seen a wave of new providers of managed account platforms, including large banks, service providers and fund of funds management companies, but Baurand cautions that the barriers to entry are high. “A platform is a large operation,” he says. “You need systems and a lot of human resources if you want to control operations within the managed accounts. The first hurdle is the level of resources you put into the business. We currently have more than 100 people working solely for the Lyxor platform, which represents a significant investment. There’s also the issue of credibility, which comes with the passing time as you build up a business over the years.”
Baurand is convinced that demand for managed accounts will continue to grow and will be sustained even when the trauma of 2008 begins to fade. “Every time there is a new crisis, every time hedge funds fail, people remember that there are risks associated with the asset class, and that creates new momentum for managed account platforms and set-ups,” he says.
“The trend toward greater liquidity and transparency and more risk control is permanent. Ten years ago, investors in hedge funds were mostly private investors. Now the institutional world is investing massively into hedge funds, and their stringent criteria for investing makes it impossible to go back to the old days where you would allocate money to a manager simply because he had a great reputation. Those days are over.”
Advent Software, which won the Hedgeweek Award for Best Managed Account Platform Technology Provider, continues to see demand expand in this area, according to Cattermole. “Three years ago, there was very little demand for that kind of capability,” he says. “Having discretionary and fund management on the same platform is a major advantage for us. Coupled with the level of granularity we can go down to, plus the breadth of asset classes that we can service for individual investors, this represents a unique offering in the separately managed account space.”
Cattermole says the current environment is as demanding for a software firm like Advent as it is for managers and their service providers. “We have to remain at the leading edge of today’s requirements, because our clients span fund administrators, prime brokers and hedge funds,” he says. “Service providers need the latest technology to manage the new asset classes that are constantly appearing. We’ve always been multi-prime, multi-currency and multi-asset class, but we are now seeing new developments around the delivery mechanisms of reporting and slicing and dicing the information as the investor would like to see it.”
The current environment is extremely fluid, according to industry members. For example, Steve Kass, co-managing principal of accounting firm Rothstein Kass, points to the high turnover of managers. “A lot of people who have been in the industry are exiting it, but others are leaving large financial institutions to create their own entrepreneurial businesses,” he says. “Although we’ve seen some closures, we’re seeing a lot of new opportunities as well.”
Spinning off from an existing business is far from an easy option, suggests Woolnough. “Raising money is terrifically difficult right now, and launch sizes are down,” he says. “Managers today are launching with perhaps USD50m, whereas someone with the same credentials might have raised USD300m to USD400m three or four years ago. A lot of investors are sitting on the sidelines, asking why they should invest on day one and take that new manager risk and operational risk. Why not wait six to 12 months, see how they perform, let everything bed in, and invest then? So managers are having to incentivise investors to invest on day one, in areas such as liquidity or fees.”
As they becomes more important to investors, risk structures are developing a higher profile within hedge fund managers, according to Paul Compton, head of product management at SunGard’s alternative investments business. “Greater importance is being given to the risk role within hedge funds, which now have more chief risk officers than they did five years ago, more risk committees and generally more management oversight of the risk within portfolios on a day-to-day basis.”
This emphasis is reflected in SunGard’s product development plans. “We’re always interested in making our products fit better into customers’ workflows and making it easier for hedge funds to use our risk products,” Compton says. “We’ve invested a lot in the area of scenario analysis, enabling fund managers to run their portfolios through historical scenarios and to come up with their own scenarios. We’re also looking closely at the area of integrated risk attribution and performance attribution.”
In this environment, fund of hedge funds managers in particular are under pressure to justify the value they add for investors, but GAM investment manager Kier Boley is convinced that the best managers will continue to be rewarded with investors’ business. “The main qualities we bring to fund of hedge funds investing are our rigorous investment process and risk management,” he says. “The approach we’ve applied for at least 15 years is very rigorous in terms of identifying managers, but also once we’re invested in how we monitor the managers, when we decide to increase our allocations or indeed when we decide to redeem.
“The past two years were among the toughest times ever for investing. In 2008 we outperformed our peer group by a significant amount because we focused on liquid strategies, we didn’t believe in leverage, and we wanted to keep in areas where investments were really marked to market, rather than marked to model. So we did well in the very difficult times, which was important for investors, but also when things improved and we could start taking risks again in 2009.”
Boley says that continuity within an investment team is among the most crucial criteria when selecting underlying managers. “The most important thing, even for a new start-up, is that the team has worked together before in a previous environment,” he says. “The hedge fund might be new, but they will have worked together at another fund or a proprietary trading desk.
“The real deciding factor is that they’ve been through at least one major crisis and they’ve stuck together, because it shows there’s an emotional bond between them. You see with a lot of groups that if things go badly or tough times arise, they separate. That’s not a group we want to be with, rather with people who stick together for at least five to seven years.”
Boley argues that the crisis has highlighted how many managers have depended for their returns on passive beta, and that this approach is no longer viable. “Many funds have tried to generate their fees out of just being long the market, long credit or long equity,” he says. “That’s not what investors want going forward. For investors returns are still important, but it’s much more about the level of beta or correlation that the fund demonstrates. They’re not willing to pay hedge fund fees for what is essentially just being long the market.”
He remains confident that the industry’s rebound is sustainable, although the period of explosive growth seen in the middle of the past decade is unlikely to be repeated. “We’ve passed the low point in terms of asset shrinkage,” Boley says. “In 2010 we expect probably about 5 to 6 per cent growth through new money coming into the industry, and at least 7 to 8 per cent compound growth. The industry will develop at a much lower rate than between 2003 and 2006, but there are plenty of opportunities for capital to be raised.”
Gottschalk is also positive about prospects over the next two years. “Hedge funds did phenomenally well in 2009 on the back of a poor 2008, and the environment is still very favourable,” he says. “We believe hedge funds will be able to generate very strong performance over the next 12 to 24 months as capital flows come back into the markets and as leverage gets reapplied to some strategies. Hedge funds have a tail wind behind them.”
He argues that the above-average performance of the Gottex Market Neutral Plus Fund in 2008 and 2009 maintained investor confidence at a time when other fund of funds managers were struggling. “The portfolio is constructed to be conservative as a diversified portfolio of hedge funds,” he says.
“We also make sure that the underlying managers have very little exposure to markets, which dampens losses on the portfolio in times of dislocation, as in 2008. In fact, a lot of the strategies that were affected in 2008 performed extremely well in 2009, and we were able to position the portfolio accordingly. The defensive nature of the product demonstrated its credibility over the two-year period.”
According to Gottschalk, the way hedge fund managers treated investors during the crisis is now an important consideration in selection of underlying managers. “We look for established managers with a track record and the ability to generate consistent performance over a period of time, full transparency, and obviously the integrity of the product,” he says. “But while performance is a key factor, there are a lot of other things to take into account. The crisis has enabled us to differentiate even further good managers from bad, not only in performance but also in the way they behaved through the crisis.”
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