Capital returns as investors regain confidence in hedge funds
By Simon Gray - Should one tempt fate? In May 2008, Deutsche Bank’s sixth annual Alternative Investment Survey forecast that despite the unfolding meltdown of the US sub-prime mortgage market and the bearish global economic outlook, cautious investors were poised to eliminate their cash holdings and pump more than USD200bn in fresh allocations into the industry over the coming months.
That was before a succession of catastrophic events across the financial industry culminated in the bankruptcy of Lehman Brothers in September (topped off with the uncovering of the Bernard Madoff fraud three months later), turning a year full of apparent potential into a rout and massive outflows from hedge fund managers that have taken more than two years to make good.
This year too any predictions must be subject to inevitable caveats about the impact of unforeseeable global events ranging from earthquakes across the Asia-Pacific region to political upheavals in North Africa and the Middle East. However, there is reason to believe that Deutsche’s ninth Alternative Investment Survey, conducted in January by the hedge fund capital group within the bank’s global prime finance business, may be on firmer ground in predicting an acceleration in the flow of assets back into the sector amounting to some USD210bn over the course of this year, boosting overall assets under management by more than 10 per cent.
The survey, whose respondents included public and private pension schemes, foundations and endowments, sovereign wealth funds, funds of funds, private banks, investment consultants and family offices worldwide with a total of more than USD1.3trn in hedge fund assets – around two-thirds of the industry total according to some counts – found that investors expect capital inflows to hedge funds in 2011 to be four times the level in 2010, a year in which confidence remained brittle and market sentiment skittish.
“Despite a challenging market environment over the past year, the hedge fund industry continues to trend upward, with investors predicting a fourfold increase in inflows into the industry in 2011,” says Barry Bausano, co-head of global prime finance and head of equities in North America. Inflows of the scale predicted by the Deutsche survey would bring total assets under management in hedge funds to USD2.25trn by year-end, the bank’s researchers say.
There are already signs that investors are putting their money where their mouth is. TrimTabs Investment Research and BarclayHedge have reported that the hedge fund industry posted an estimated inflow of USD2.9bn in January, the sixth straight month of inflows and one notable for the fact that the beginning of the year is historically a period of net outflows rather than inflows of new capital.
“This inflow is very bullish for the industry because January typically delivers a heavy redemption related to year-end,” says BarclayHedge founder and president Sol Waksman. “Additionally, February is historically a strong month for new fund subscriptions, and our preliminary data suggests that the industry took in as much as USD10bn last month.”
According to the Deutsche report, institutional investors are increasing their allocations and the size of their hedge fund teams, which indicates significant future growth. More than 70 per cent of pension schemes and more than half of all the consultants surveyed added numbers to their dedicated hedge fund teams last year, while more than half of all investors increased their hedge fund assets. “Investors’ responses indicate a sustained, strong recovery,” says Jonathan Hitchon, co-head of global prime finance. “Bullish sentiment on equities, flows, and industry dynamics were the clear messages conveyed by the respondents to our survey.”
Anita Nemes, Deutsche’s global head of capital introduction, says the investor responses indicate the extent to which hedge funds have become an established and central part of the industry. “Hedge funds now hold a widely accepted role within the overall asset management industry,” she says. “More than 50 per cent of investors increased their hedge fund assets under management last year, further cementing the industry’s place in the mainstream.”
The report sees a broad range of indicators that inspire confidence in the outlook for the industry. Again, investors are saying they plan to cut the amount of cash sitting on the sidelines, with respondents expecting to reduce their cash position by a cumulative USD29bn over the next six months and 75 per cent saying they expect to hold less than 5 per cent of total assets in cash by June.
In addition, the survey finds that consultants are increasing the number of clients to whom they provide advice on hedge funds, while 82 per cent of consultants expect their clients to increase the proportion of their portfolios invested in hedge funds this year.
An important factor is that most investors are no longer significantly weighed down by problematic investments that ran into trouble in 2008 and 2009; the majority of respondents have no, or relatively few, investments with managers that still have positions in side-pockets, or where redemptions are still gated or suspended.
Up to now the money flowing back into the hedge fund industry has gone disproportionately to well-established managers and large funds, but that may be changing, according to the survey, which sees significant growth opportunities for smaller and medium-sized funds. Deutsche reports that investors are no longer looking solely at funds with USD5bn or more in assets.
Other indicators point to increasing investor risk tolerance that is already reducing the concentration of allocations to the largest managers. While over 2010 as a whole more than 80 per cent of new inflows went to firms with more than USD5bn in assets under management, according to Hedge Fund Research, the industry’s largest firms accounted for only 51.6 percent of the USD13.1bn in net new capital inflows in the fourth quarter.
Sixty-five per cent of investors surveyed by Deutsche anticipate that the average size of hedge funds to which they will allocate this year will be less than USD1bn, suggesting that capital is poised to flow increasingly to managers with assets of between USD500m and USD1bn. Start-up managers, who have found the fundraising ground particularly stony over the past two years, could also benefit; more than 50 per cent of investors say they are prepared to invest on day one, compared with just 20 per cent in 2004.
The number of new hedge fund launches in 2010 exceeded the total in 2009, although Deutsche says a few headline launches attracted the majority of capital, and the highest-profile launches came in the final quarter of the year. The report expects the majority of new launches this year to come from former proprietary desk traders, in some cases cast loose by the Volker Rule in the US, as well as second generation managers from top-pedigree hedge fund firms. However, there is often a price to pay for managers in return for early investment; whereas 28 per cent of investors surveyed by Deutsche in 2010 would expect reduced fees for a day one investment, this year the proportion has almost doubled.
Both seeding activity and size of seed deals is expected to increase; it remains vital for the majority of new launches, whether in the form of a cornerstone investor or a true seeding deal. Competition for seed money remains stiff, according to the survey, with one European seeding firm in Europe receiving 250 applications in a single year, out of which they would allocate capital to 10.
The report says seeding is one area where fund of funds products come into their own for institutional investors, because on the whole the latter lack the resources, skill and experience required for seed investing, while due diligence is much more onerous and often calls for different skills. Meanwhile, returns on successful investment can be extremely attractive.
The report predicts that funds of funds that can offer compelling seeding products will be able to raise significant volumes of assets from investors that might not otherwise invest via funds of funds. Managers seeded in this way may also benefit in the longer term from direct investment on the part of end-investors that have already had exposure to them via the seeding vehicle.
In other areas the picture for funds of funds remain clouded, as the statistics for capital movements this year make clear. According to TrimTabs and BarclayHedge, funds of hedge funds experienced redemptions totalling USD3.6bn in January, the third straight month of outflows and the heaviest since January 2010.
Since the crisis, fund of funds firms have had to find new arguments to attract investors beyond their experience in picking managers, which overall did not spare them from the losses suffered by the industry as a whole, and their privileged access to managers, which became less compelling when industry outflows prompted some of the best-known managers to reopen their funds to investment and to contemplate hitherto scorned steps such as offering their strategies through managed account platforms.
Deutsche says the liquidity crisis of 2008, the Madoff fraud and an increasingly sophisticated investor community resulted in heavy outflows from funds of funds, especially in Europe, and raised questions about the continuing validity of their business model. According to the report, last year saw a bifurcation of the fund of funds world between a handful of mostly US firms that have been successful in raising new assets, while the rest, particularly in Asia and Europe, have struggled.
In response, the survey indicates, fund of funds firms have followed single hedge fund managers in seeking to institutionalise their investor base, focusing on longer-term institutional investors rather than high net worth individuals. For nearly 60 per cent of Deutsche’s fund of funds manager respondents, institutional capital now constitutes 50 per cent or more of the total, whereas only 40 per cent of firms reported this in 2008.
Despite much talk about institutions moving toward direct investment in single-manager funds, the report concludes that funds of funds’ efforts to attract more institutional capital have been largely successful, and that there remains a place in the industry for funds of funds that offer expert advice, due diligence resources, access to quality managers and bespoke or differentiated products.
While investors focus first and foremost on returns, the survey suggests that fund of fund managers can differentiate themselves through a focus on niche managers, as well as bespoke mandates that can provide institutions with investment solutions tailored in areas such as liquidity and comingling risk.
The findings of Deutsche’s survey of hedge fund investors echo the conclusions of a study of institutional investors published by SEI earlier this year, which found that while they were bolstering their commitment to hedge funds, institutions expected greater transparency and solid risk management infrastructure from managers.
The report identifies a need for hedge fund managers to institutionalise transparency policies to attract new capital, satisfy anxious investors, and protect their reputations. Its responses from investors indicated the importance of managers clearly articulating how their investment strategies add value to investors’ portfolios, enabling them to differentiate themselves through client service, reporting and education.
SEI also found that institutional investors’ confidence in hedge funds was growing, with 54 per cent of its survey respondents planning to increase target allocations in the course of 2011 – subject to concerns about transparency and risk management. Risk management infrastructure was the second most important factor in hedge fund among investors surveyed with 75 per cent of respondents deeming it very important, second only to clarity of investment philosophy with 79 per cent.
“The study confirms that investors are committed to hedge funds, but managers must get and keep investors comfortable with their investment decision,” says Phil Masterson, managing director for SEI’s investment manager services division. “Managers must differentiate themselves through increased transparency, enhanced risk management, and reporting as well as better overall client service to gain and retain assets post-financial crisis and post-Madoff.”
SEI reported that 70 per cent of investing institutions polled highlighted lack of transparency as their biggest worry, up from 56 per cent in 2009, and more than 75 per cent want risk analytics from managers, while 58 per cent named liquidity risk their biggest worry in hedge fund investing. Adds Masterson: “The hedge fund managers best equipped to compete will be those able to articulate clearly their value proposition and source of alpha, as well as demonstrate institutional-quality operations and risk management infrastructure.”
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