Tue, 01/04/2014 - 14:17
By Marianne Scordell (pictured), Bougeville Consulting – “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness”, famously wrote Charles Dickens at the start of one of his novels, the title of which we borrowed last year1. While those words were seeking to describe another epoch, the sense of movement, upheaval and uncertainty they convey somehow echoes the array of changes currently impacting the hedge fund industry, in Europe especially.
From regulation to redistribution of investment allocation and of returns between asset classes, at a time when better performance is, in fact, more than ever required, the European alternative investment management industry is feeling some pressure from all directions.
While the current changes are bound to reshape the industry and to redefine new markets in which players will continue to compete, those who will do well will have anticipated trends and adapted their businesses strategically, rather than tactically, to an environment which, simply, will no longer be the same again.
In the following, we will try and understand recent trends which have emerged in Europe and which we believe are here to stay as part of this industry reshaping exercise, in Europe more than elsewhere. They stem from trends which, recently, have materialised as follows:
• Performance is being “reallocated”: while strategies that had done well in the past are going through an existential crisis (e.g. CTAs), equity strategies have simply mirrored direct equity investing, with some (upward) adjustment for those able to select stocks on the basis of value. Those with a long bias have done well, but those with a short bias have naturally suffered – in Europe more than elsewhere.
• The idiosyncrasies of the European regulatory developments are already starting to impact the industry from various angles: we are learning how to live in a post-AIFMD world, not only from a cost perspective, but also insofar as relations between hedge fund managers and their investors are being redefined – within Europe as well as across the Directive’s perimeter, allowing an enhanced level of competition between Europe’s national markets along the way.
• Funds of Funds (FoFs) in the broader sense – including those part of more diverse operations such as wealth management companies that select outside alternative managers as a step towards their overall portfolio construction process – have suffered more in Europe than anywhere else. With current AUMs 50% lower than they were in 2007, new investment channels have appeared. Education – of those new to direct hedge fund investment, in some cases with the assistance of those who have lost their customs – has been an interesting winner.
Performance: “The superlative degree of comparison only”2
When we wrote about the US hedge fund industry a year ago3, we pointed out the fact that while some trends were global rather than limited to a single region, the strategy for which investors would specifically choose to look at the US market for managers was equity long / short. This was especially true when it came to the activist subcategory, for which there is more of a tradition in the US. However, while the results of the European study concurs with these findings at present, looking at equity markets overall provides a different perspective.
A year ago, the main two points supporting the thesis according to which US long / shorts do better than European ones were:
• A culture of shorting stocks, a geographical concentration in and around New York, a pool of talent that reproduces itself by learning from each other were all vague but nonetheless tangible points most respondents had been keen to put forward to explain why their search for equity long / short funds would intuitively result in them looking at the US rather than Europe. The long history of US hedge funds – since the 1940s – meant US long / shorts got to critical mass sooner than funds from other regions, hence their global reach, access to international markets, and, consequently, their information advantage, resulting in a positive impact on performance.
• Investors also said that US managers were much more active than their counterparts elsewhere in the world on the short side, that they expressed greater divergence between themselves, and that they were more vocal. Investors said they decided to invest in US, rather than European, long / short funds because they offered a management style they did not see on offer elsewhere.
In keeping with those findings, the top performers in each category throughout 2013 are often from the US, however, in most cases, it is possible to find strong European managers; activists and short bias are the only subcategories in which the gap between Europe and the US is so profound that no clear European winners emerge, on a pure performance basis.
Merger arbitrage, conversely, is well established in Europe, with a few continental players making their marks in a European industry of which London is still the vastly unchallenged centre. This makes sense if one considers a recent Hedgeweek article4, in which the following quote appeared: “In a lot of respects, shareholder activism can almost be thought of as the antithesis of merger arbitrage. In merger arbitrage, companies are doing well and different people compete to acquire them. Shareholder activism is the opposite where something needs to be done to improve shareholder confidence; the focus is on taking on companies that are not worthy of mergers5”.
While one could debate over the merits of opposing Europe and the US – “it is the wrong approach” says an investor, who simply wants managers to be located in a financial centre, no matter where – looking at performance in the context of capital market developments over the year brings a useful perspective. And, in a year when equity markets rose dramatically throughout the developed world, the fact that European long only strategies fared relatively better than activist funds, or than those with a short bias, may only reflect market exposure rather than specialist skills, at a time when investors are paying for enhanced returns.
The fact that some US managers with a short bias have had positive returns, while virtually none in Europe did in 2013 still points to differences between the two regions, with the idea of shorting pertaining more to the American side of the Pond not being so farfetched after all. Few US activists did well in 2013 though, which illustrates the point according to which regional specificities do exist, however they are somewhat less relevant than first thought when put in the perspective of a dominant market theme.
The mixed fortunes of CTAs relative to the previous track record for the strategy, in Europe as much as elsewhere, was also a feature of last year. In the face of such developments, hedge fund investors, who have complained about the poor returns of their allocations to alternatives, whether to CTAs on the basis of time series or to equity strategies relative to the return of indices, are bound to be confused: in a somewhat backward looking move, 50% of the respondents to a recent survey said they wanted to increase their exposure to equity strategies, while over 25% of the same sample was planning to decrease their exposures to CTAs in 20146. They would like to rely on current trends as if they were here to stay, to believe in an age of wisdom versus an age of foolishness; they are, by the own admittance of many, unable to work out whether this is the spring of hope or the winter of despair.
The impact of regulation on industry forces
Dickens’ novel was taking place during “the year of Our Lord one thousand seven hundred and seventy-five”, and was about two European Cities one of which was on the verge of experiencing its big Revolution. If we consider that, at the level of today’s financial markets, the Global Financial Crisis was also some sort of a revolution, the full impact of which is yet to unfold, the new regulatory regime, then, is the world’s New Order, in Europe more than elsewhere, in the same way as the impulse for freedom and democracy that swept continental Europe at the end of the 18th century was quickly followed by the rule of unity and an attempt to create an Empire.
With the stated objectives of bringing some discipline into financial markets – i.e. of addressing perceived, or real, market failures – of harmonising the European landscape and of protecting consumers of financial services – investors, in the case of hedge funds – the evolving European regulatory framework has already had some impact in terms of reshaping the hedge fund industry7:
• Keith Black, PhD, CFA, CAIA8, managing director of curriculum and exams for the CAIA Association, says: “Regulation is a global trend. One of the consequences of it is that large funds are getting larger, because they stand better to comply with the rules, and they can prove that they can afford to spend resources on compliance. As of the third quarter of 2013, HFR’s Global Hedge Fund Industry Report shows that 17.5% of hedge fund firms manage over USD1bn, which adds up to 89.9% of industry assets. On the other side, the smallest 66.1% of hedge fund firms manage under USD250m, which combines to manage only 3.3% of industry assets9”. This is particularly relevant to certain types of investors, as Dr Black continues: “Pension fund and endowments are process oriented, and, as part of their due diligence, they need to show unambiguously that resources for compliance are there. This applies as a result of AIFMD and Dodd-Frank alike”. Somehow, one cannot help but think that regulatory developments have become an additional barrier to entry in a sector that used to pride itself for being more seamless and flexible, as a trade off for the fact that its products were, and still are to a vast extent, distributed to qualified investors.
• The fact that market movements may no longer be obeying their previous logic is having an impact on asset allocation, however this may be a short term tactical adjustment – prior, perhaps, to some product improvement or some changes in terms of who the new players are once competition has allowed for a thorough selection process. European investors currently hesitating to access hedge funds on the grounds of the uncertainty surrounding the marketing rules under the AIFMD, is, on the contrary, a transition towards the establishment of a new dynamic in the way products are being distributed and bought. Supply and demand thus become more difficult to identify and to meet; the competitive landscape is also directly affected by the variety of obstacles in the way of incumbents depending on their location (“level playing field”). Additionally, the market for others within the industry – investors, service providers (including “cap intro” services) – is also being redefined.
• Finally, Dr Black points out the fact that there is an instance where regulation has accompanied and responded to, rather than triggered, changes in the demand. He says: “Alternative assets in UCITS format were EUR40.9bn in 2008, 84.9 in 2009, 125.3 in 2010 and EUR156.7bn at the end of Q3 201310, which addresses a demand for liquidity, particularly in Europe”. While we have discussed elsewhere possible reasons why European investors are more interested in liquidity than their US counterpart11, the point here is to highlight a specificity of the European market, and one that seems to be part of the long term market redefinition.
From the above, it is easy to infer a major underlying feature of our industry, which, as a result of its complexity, has had to organise itself in silos: “regulation” has all too often been confused with “compliance”. This may, to some extent, be justified in a stable regulatory environment; however, at times of “revolutions”, which is also when the industry structure is being reshuffled, repositioned and rethought, it becomes necessary to have a more strategic approach to try and understand what the market may look like in the future, and where the new opportunities might be, as the result of environmental factors (including regulation) that play a part in triggering the required changes. This is a matter of costs as well as opportunities, and of informing one’s decisions to adapt businesses by way of anticipation and careful planning.
Finally, no matter how strong the strength or harmonisation may be, Europe, unlike the US, is still relatively fragmented when it comes to hedge funds. While London has been, and remains, the centre of the European hedge fund market, regulation is, again, an opportunity, as well as a constraint, when it comes to individual states:
• An investor, for whom the most important question in terms of location is whether the manager is located “at the centre of things”, said he was reluctant to look at managers who have decided to move elsewhere. In Europe, he would not look at funds “whose location is more focused on optimising tax and regulations rather than returns”. In his mind, this would exclude Switzerland, but include such countries as Norway, for instance, since there may, in certain cases, be a rationale for that presence (e.g. being close to the energy markets).
• It is interesting to compare and contrast that view with that fact that certain EU countries, France for instance, have been adapting the new AIFMD rules in a way which several investors have found “industry friendly”. While the uncertainty over marketing rules still remains, obtaining authorisation under the new rules has been easier than anticipated in some countries within the EU, while rules within countries outside the EU (for instance Switzerland) have also become more stringent with a view, partly, to limit cross border arbitrage. Malta and the Netherlands have also been active to ensure their markets stay firmly on the European map, however in the latter country the push has come from the industry rather than from “market friendly” regulators.
Whether regulation fosters or impedes wisdom is a very broad debate. What is certain though is that no good regulation can be made without some level of knowledge, understanding and vision; likewise, the regulated community needs those very same qualities, be it to overthrow empires or to participate in a collaborative system in which they engage in a process from which they seek to gain collectively.
Education, education, education
When asked about the specificities of the European market, the first thing Dr Black mentions is the fact that the EU FoF industry has halved since 2008, whereas the US one has remained more stable in comparison. As a Swiss investor puts it: “the fact that European investors ‘got burnt’ more than US ones may be one explanation to this, however there are various responses: one is a move away from hedge funds by certain investors who choose to reallocate their assets elsewhere, to Private Equity for instance; another one is simply to improve their skill set in order to be able to select their hedge fund investments more carefully.” Indeed, many European investors at FoHFs, or in charge of selecting hedge funds for clients from within private banks, are saying that their businesses are slowly becoming endangered.
• Some of those providing dedicated services to medium size endowments, sovereign wealth funds or pension funds are reinventing themselves as “educators”: in some cases, they can win a temporary mandate on the explicit condition that they assist their client in building the in-house experience and knowledge base they will need to “do it themselves” in a few years’ time. While this does not arise with the same frequency in markets where pension funds traditionally viewed hedge funds negatively (and still retain some reluctance with respect to the asset class – e.g. Germany) other countries (for instance the Netherlands) have become particularly proactive in the space. Among other initiatives, let us mention the creation of an institute dedicated to pension funds’ education on alternatives in Amsterdam12.
• The fact that many private bankers are receiving more and more sophisticated questions from their clients, and are getting better educated to respond to the demand is also a case in point. This, in addition to the fact that many private banks are now recruiting former investment bankers, contributes to the demands for, and the relevance of, education and related service providers. Indeed, Switzerland is the biggest market for CAIA in continental Europe, a traditional country for private bankers and FoFs13.
The fact that the FoFs industry is undergoing consolidation is also a strategic response to the impact of the new environment. It is our belief that unless these strategic partnerships are carefully thought of and built with long term industry trends in mind, they will only constitute opportunistic and temporary fixes which will not survive, or benefit investors in a meaningful way.
At a time when the European hedge fund industry is undergoing major changes, which come from multiple sources and have happened in a sequential way that has so far seemed endless, parameters are being redefined. Perhaps in that context, wisdom would consist in embracing our diversity and proactively acknowledging that, while there is no certainty, continuing to learn and to adapt in order to create value is the best course of action. Long term performance depends on this.
Marianne Scordel founded Bougeville Consulting to assist alternative fund managers with their business strategies. This includes providing assistance to hedge fund managers in finding cost effective solutions to compulsory changes (e.g. those pertaining to the regulatory environment) and in enhancing commercial opportunities – adapting products, structures, or the marketing thereof. Prior to this, she worked for Nomura and for Barclays Capital. She is a co-chair of the Legal Issues Special Interest Group at CFA UK and an Alumna of St Antony’s College, Oxford.
1. See hedgeweek article http://www.hedgeweek.com/2013/06/23/186344/are-us-hedge-funds-more-attra....
2. End of the opening sentence to Dickens’ A Tale of Two Cities.
5. Quote attributed to Kenneth Heinz, President of Hedge Fund Research at a press briefing in London.
6. See hedgeweek article http://www.hedgeweek.com/2013/12/05/194165/conundrum-investing-emerging-....
7. This is a reference to “The Five Competitive Forces That Shape Strategy”, by Michael E. Porter, Harvard Business Review, January 2008. According to M. E. Porter, the five forces that shape strategy are: threat of entry, power of suppliers, power of buyers, threat of substitutes, and rivalry among existing competitors. http://hbr.org/2008/01/the-five-competitive-forces-that-shape-strategy/ Regulation is not considered a force in itself, however it will have an impact on one, or several, of the five forces.
9. These numbers are in keeping with the investor survey we published last year: http://www.hedgeweek.com/2013/12/05/194165/conundrum-investing-emerging-....
10. Dr Black is quoting data from the same source as previously: HFR’s Global Hedge Fund Industry Report.
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