Milestones on the road to recovery
By Simon Gray - The second edition of the Hedgeweek Awards for excellence among hedge fund managers and service providers comes at a time when the outlook is starting to look brighter for the hedge fund industry following the difficulties of the past few years. Performance in 2010 was in most cases unspectacular but solid, delivering on the industry’s promise to provide consistent returns and protect capital whatever the state of traditional asset markets, and it appears that this pattern is continuing into the early months of 2011.
The results of this year’s Hedgeweek Awards are conditioned by the increased focus on transparency, consistency and depth of expertise in the new investment climate, but also the industry’s recovery from the slump in confidence it suffered in 2008 and early 2009. The renewed stability of performance has been rewarded by capital inflows, especially from institutional investors, that in turn have helped assets under management to return to the record levels seen nearly three years ago.
Last year hedge funds returned just over 10 per cent, according to most established industry index providers, after the roller-coaster ride in which the sector lost roughly 20 per cent in 2008, then gained a similar amount the following year. Their 2010 performance also enabled many managers who had not done so before to resume earning performance fees, an important step in restoring stability to their business.
The return to ‘normal’ levels of performance has encouraged investors to bring their capital back to hedge funds after the upsets of 2008-09. Following that period of substantial outflows – accompanied by sudden illiquidity of assets that forced many managers to restrict redemptions through gates and suspensions – institutions in particular have renewed their faith in hedge funds, particularly as other types of investment have disappointed or delivered particularly volatile returns.
In the final quarter of last year total industry assets under management grew by nearly USD150bn to end the year at USD1.92trn, according to HFR. Barring an unexpected upset, assets are poised to overtake the previous peak recorded by HFR, of USD1.93trn at the end of June 2008, if they have no already done so. Assets have grown by 44 per cent since their nadir just over two years ago, and with large volumes of institutional capital still waiting on the sidelines, the potential for growth over the next few years remains substantial.
There is always room for quibbling about the precise level of hedge fund assets – in particular, surveys of hedge fund administrators rather than managers tend to come up with significantly higher totals – but the underlying trend is inescapable. According to HFR, investors committed USD13.1bn in net new capital in the final quarter of 2010, bringing the annual total to USD55bn – the largest figure since 2007.
The news is not so good for everyone. Anecdotal evidence from industry members around the world suggests that much of the money flowing back into the industry is going to established managers and funds. Start-up businesses are taking longer to raise capital and to launch their funds, and the squeeze can be tough at a time when compliance and regulatory costs have risen. The golden age for new managers in the mid-2000s now seems a distant memory.
Still, there are factors that suggest that for all the difficulties, the industry is in line to experience an injection of new talent. The introduction in the US as part of the Dodd-Frank Act provisions of the Volker rule, requiring a separation of publicly-guaranteed traditional banking business from proprietary trading and other activities deemed to be particularly risky, has prompted many investment banks to hive off in-house alternative investment businesses into independent units.
The industry ranks have also been swelled by talented managers striking out on their own, in some cases because of difficulties at existing hedge fund management businesses that have found it harder to recover, especially in business terms, from the travails of 2007-08. And investors may be wary now, but most will have in mind a series of studies suggesting that new managers deliver on average significantly better returns than their longer-established counterparts managing much higher levels of assets.
Meanwhile, the supporting infrastructure for hedge fund managers is seeing changes of its own. In part that’s down to consolidation, especially among alternative fund administrators, although there is a parallel trend toward the emergence of niche players expanding from offshore jurisdictions into new markets.
The cards have also been shuffled by broader upheavals in the financial industry, most notably the collapse of one of the leading prime brokerage players, Lehman Brothers, but also the disappearance of one of the top names in fund administration, Fortis. More turbulence may be in store as depositary banks digest the implications of new European rules prompted by the role of feeder funds, and the supposed failings of their custodians, in investor losses resulting from the Bernard Madoff scandal.
In the first quarter of 2011 the industry has demonstrably changed considerably since the heady days of 2006 and early 2007. Even the newest managers today are being asked to show proof of institutional processes and operations before investors outside the ranks of friends and family will commit money. Topics such as risk management, transparency and reporting are on everyone’s lips; due diligence is the watchword for investing institutions, and these days the diligence is rather more evident than a few years ago. Service providers too are under the microscope.
The pressure is not coming from investors alone. Over the past two years the regulatory landscape has changed dramatically round the world, starting in the US, where the Dodd-Frank Act is now set to bring most managers under the supervision of the Securities and Exchange Commission. Nearly five years after the SEC’s first attempt to regulate hedge fund investment advisers was struck down by the courts at the behest of Philip Goldstein, the argument is no longer whether managers should be regulated but how.
In Europe, members of the industry may well feel they have dodged a bullet after seemingly seeing off draconian proposals to inflict a one-size-fits-all straitjacket on the alternative investment industry as a whole. Last November European Union member states and the European Parliament agreed on a compromise to end more than a year and a half of deadlock over the Alternative Investment Fund Managers Directive, whose first draft was rushed out in April 2009 at the height of the global moral panic over financial market stability.
At some points in the interminable legislative process some drafts of the directive proposed barring non-EU managers and funds outright from access to European investors. Last autumn’s compromise will allow them to seek access to a new EU single market for sophisticated funds from 2015, albeit two years later than EU managers and subject to rules that have not yet been written.
There is plenty to complain about in the final AIFMD provisions, and plenty of room for concern about the devil in the details that the new European Securities and Markets Authority is charged with drawing up. A number of offshore jurisdictions are wondering out loud whether they might attract managers of funds that are not targeted at European investors and are neither domiciled nor serviced within the EU.
Still, it could have been a lot worse. For the fact that it is not, thanks are due to the concerted campaign by industry organisations and individuals who worked tirelessly to educate European lawmakers about the facts, as opposed to the myths, about the alternative fund industry and ensured that some of the most unworkable and damaging provisions were removed or watered down.
The final outcome of the European certainly benefited one part of the industry that had much to lose, the offshore fund industry and financial centres stretching from the Isle of Man to the British Virgin Islands. The obituary of the offshore world has been written many times, especially in the past three years, but it has survived the onslaught by its willingness to co-operate on tax issues with the world’s big economies, a condition accepted even by jurisdictions that in the past have been renowned, rightly or wrongly, as bastions of financial secrecy.
The many months of uncertainty over the European legislation did increase significantly the number of hedge fund managers ready to consider using onshore structures and comply with onshore regulation. Most notably, it gave wings to the trend toward so-called Newcits, involving hedge fund strategies shoehorned into vehicles that comply with the EU’s Ucits regime for cross-border retail funds.
The managers are taking advantage of measures incorporated into the Ucits III legislation, finalised in 2002, that allow investment in derivatives and the use, within certain limits, of modest amounts of leverage. Their adoption of the highly-regulated Ucits regime as a vehicle for hedge fund strategies meets some of the needs of institutional investors in particular, but it also reflects the long-observed convergence of traditional and alternative investment.
In addition, Newcits funds are starting to make the benefits of hedge fund strategies available to a broader investor base – although the implications of this development have yet to be fully thought through. In traditional European centres for retail funds such as Luxembourg and Dublin enthusiasm for the new business they bring is tempered by concern about the risk of damage to the Ucits brand, especially in new and fast-growing markets across East Asia, the Gulf and Latin America.
Alongside the offshore centres, the other great survivor – so far at least – is London, which remains the dominant centre for alternative fund management in Europe. Despite lurid reports to the contrary, the hedge fund management industry has not lighted out en masse for Zug or Pfäffikon – proof if it were needed that there are other important considerations for managers besides their income tax rate or non-domiciled resident status.
Over the past year the hedge fund industry has continued to face verbal assaults from politicians and others on its modus operandi and impact on global markets. Two years ago, it provided a convenient scapegoat for politicians who sought to pin on the industry much or all of the blame for the credit crunch and global economic downturn.
A great deal of what was said and written at the time was demonstrably nonsense, but its impact lingers to this day. Aside from changes in direct regulation on both sides of the Atlantic, managers are facing restrictions on short-selling and/or disclosure requirements that could be equally damaging, the latest being the European Parliament’s proposal to impose tough conditions on ‘naked’ trading of credit default swaps linked to sovereign debt.
The EU’s new short-selling rules are supposed to come into force by 2012 – although, as we have seen, deadlines can slip – and the industry faces a renewed fight to convince legislators that short-selling is a vital component of market liquidity and price discovery rather than just a tool for speculators to make money from the misfortunes of others.
Sometimes the industry contributes to its own problems. The trial that has just opened in the US in which hedge fund manager Raj Rajaratnam is accused of industrial-scale insider trading has tarred the industry as a whole with an association with financial crime that may be hard to shake off. Nor does it help that barely a week goes by without news of the uncovering of another Ponzi fraudster passing himself off as a hedge fund manager, unfair though the link might be.
The frustration for many in the industry is that rational argument often seems to have little impact on broad sentiment about hedge funds in political circles and the media, in the same way that no amount of regulatory co-operation and exchange of information on tax matters seems capable of removing the tag of ‘tax haven’ from certain offshore jurisdictions.
However, the outcome of the long debate over the AIFM Directive does illustrate that the task is not entirely hopeless; it suggests that efforts to separate myth from reality and to provide insight into the complex role hedge funds play in the financial sector as well as the wider economy is becoming better understood, slow though the process might be.
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