By Marianne Scordel – When Hedgeweek decided to compare the US to the European hedge fund market a year ago, we found it pertinent to address the question from the perspective of an industry analysis, in order to provide new managers with inspiration and insight around how to position their businesses.
Understanding the environment, which includes the competitive landscape and the various trends and forces within it that continue to shape the industry in a dynamic way, is paramount when it comes to establishing long term success. Now is a time when, on both sides of the Atlantic, the industry is undergoing important changes, making this exercise all the more relevant.
At the time of writing last year, we had found a striking contrast between US and European hedge funds, the visible aspect of which mostly came out in terms of performance: we had then made the point that “the top performers worldwide are managed from the US”1, in spite of the apparently global nature of our industry.
We split our findings into three main categories – respectively: different approaches to equity strategies, regional split in relation to the need for liquidity, and diverging regulatory frameworks – to explain the fact that, to some extent, two separate markets existed, and to nuance – and warn against – the pitfalls inherent to some possible comparison. However, due partly to the economic situation in Europe and to capital market events over the past twelve months, we have more recently found points of convergence in the three areas previously highlighted.
The following therefore recalibrates and puts into perspective what we had said last year, along three lines:
- The US is still the home market to skills in the management of equity strategies. In the past twelve months, this played out particularly on the short side, with US managers with a short bias delivering a performance in sharp contrast with that of their European counterparts and becoming even more vocal, thus reinforcing what we had observed last year. In spite of this happening, some form of rapprochement has also taken place, some of which has to do with immediate trends, while others pertain to differences in the real economy.
- While we had previously said that US investors had not followed European ones in demanding more liquid products on the alternative side, the rise of the 40 Act fund in the US can be looked at as a parallel to the demand for UCITS in Europe. This points to a certain form of convergence, including from a regulatory perspective, albeit coming from opposite directions.
- Finally, investment in hedge funds depending on size or via funds of funds are still subject to debate. While the former is now influenced by regulation – and costs incurred – as much as anything else, the history of the latter on either side of the Pond still provides for two diverging models.
The future of investment: Strategic and tactical shifts
When, based on investors’ responses, we wrote last year that equity long / short was a strategy of choice when it came to allocating to US managers, little did we know that our theory was going to be put to the test in the following twelve months. The spectacular rise of equity markets2 providing fertile ground for the purpose of evaluating in practice the validity of two ideas our respondents had put forward.
Historical, cultural and geographical reasons all concurred to provide investors with the idea that US managers were technically better than their counterparts elsewhere in the world, especially on the short side. Over the past twelve months, the following has confirmed, or at times nuanced, that point:
- The long… When asked what he believed the trend for US equity hedge funds had been over the past twelve months, Keith Black, PhD, CFA, CAIA, Managing Director of Curriculum for the CAIA Association, naturally pointed to an increase in allocations, towards the directional side, which confirms what we had anticipated in a recent survey3. US funds may have attracted more capital than hedge funds elsewhere due to the fact that they have a wider ranging reach to invest in equity markets worldwide, a trend which we highlighted last year and which, in turn, may have compounded positive performance in an up markets. Additionally, Dr Black points to the fact that the recent period has seen US hedge funds and traditional asset managers coming closer together, with the trend of US hedge fund managers offering long only products accelerating; again, this, combined with the direction of equity markets, would have resulted in positive performance. It is unclear, however, whether these changes are the result of skill or are driven by other factors – investor’s backward looking bias4 in the former case, possible structural change in the latter. Besides, the results for the past twelve months do not shed much light insofar as top performers in each equity category do include mostly US hedge funds, but several of these categories also include some hedge funds from the rest of the world. In many, return figures are rather concentrated around the mean, which, again, makes identifying managers that stand out from the crowd somewhat difficult. Are any of these managers “swimming naked”5?
- … and the short of it Dr Black insists that US managers in the “activist” category have been “making more noise than usual” over the past twelve months – particularly as far as their short positions were concerned. Indeed, there seems to be a case for emphasising the fact that, while more US funds have rebalanced their positions in favour of the long side, thus becoming closer to traditional (or European?) management style, those with a short bias have continued to become “more vocal”, as an investor put it last year. This polarisation has been useful in testing what we had put forward last year: that shorting stock was more of a US speciality. To draw on Warren Buffett’s metaphor, it does take an excellent swimmer to manage to cover some distance when going against the tide, and in that sense, the performance over the past twelve months of managers with a short bias provides one with better substance when it comes to gauging a manager’s skill. Contrary to other equity categories, the top performers in equity categories where a short bias may be the norm are more firmly from the US, with European managers reporting mostly negative performances and coming well below their US counterparts. Even among the US managers, returns are distributed unevenly. It is not completely clear whether the above are strategic or tactical shifts. While the recent rise in equity market is obviously a temporary factor, such factors as the convergence between hedge fund and traditional managers, in the US as well as in Europe, seem to be more influenced by demand and supply and other such factors that impact the industry’s competitive landscape. And, while hedge funds with a short bias have had a more erratic or uneven distribution of returns over time6 as well as between themselves, the fact that no nationality other than US ranks among the top performers supports the point we made last year and points to a regional gap apparently untouched in spite of changes within the industry.
Some of these market specificities, alongside a somewhat related better performance overall, have contributed to the idea that two distinct markets may exist, at least as far as hedge fund investors are concerned. In our previous report, we argued the point that the situation was a little different in terms of where managers decided to invest, with US managers having more firepower to diversify globally than managers from other regions, as reiterated above. This asymmetrical positioning has been increased over the past twelve months.
- Are US hedge funds embracing investment in European markets? The global financial crisis has had some regional variations and the recovery stories play out differently across the Globe. With the stocks of European financial institutions performing well over the past few years, a regional landscape that still has national specificities (thus resulting in information being more difficult to get or to understand, creating inefficiencies), with, last but not least, whole countries still in relative financial distress, there have been high incentives for US managers, who come from a relatively more transparent and better researched environment, to invest in Europe. Last year, we said that 40% of hedge fund investments were targeted at the Americas, 10% at Europe and Asia, and 45% at global funds7. Considering the fact that there may be a limited amount of alpha available, managers have an interest in going where they are more likely to get it and will experience less competition for it, which is all in favour of US hedge fund managers setting up small operations in Europe with local analysts and traders, a trend we have observed directly.
- Increased marketing restrictions and lack of harmonisation have resulted in a slowdown in US managers talking to European investors – since AIFMD first coming into force less than a year ago, US managers and European investors have been like Romeo and Juliet, two lovers whose families somewhat shut the doors on each other, via the use of regulatory weapons as far as the financial world is concerned. With the new European regulatory framework leaving it to national supervisory authorities to each have their own marketing rules, the European landscape is becoming confusing for US (as well as for European) players. A recent survey8 showed that some European investors where slowing down their search for new managers, not knowing whether their responding to managers’ attempts to woo them, or even direct solicitation on their part in the form of reverse enquiry, might (or not) be acceptable under the new local variations (often still in the making). Rather than bring the US and Europe closer together, this is making the dividing line between the two markets stronger, making the global competitive landscape less free, which, ultimately, may not be all in favour of the European investors whose interests regulators were seeking to protect.
From a US perspective, barriers to entry into Europe have gone up, which could prompt managers from across the Atlantic to either avoid Europe or, on the contrary, to get more involved in it, not only to access distressed or otherwise undervalued assets as investment targets, but also to ensure they are established locally and can engage with Europe-based investors (and local regulators) to an extent they have not done before. Regulation is here to stay, however its constituting an obstacle to hedge fund investment may be a temporary disruption before the industry finally adapts strategically. Structures and products adapt over time, and recent product developments in the US have also included changes in the level of liquidity on offer as well and a pending question over AUM thresholds.
Liquid alternatives: Institutional vs Individual
When asked to compare and contrast US and European hedge funds, Dr Black is quick to point to what he calls “the rise of the liquid alternative in the US”, in the form of the 40 Act funds. Beyond the apparent contradiction with what was said last year – when some investors had somewhat disappointedly acknowledged the fact that one of the major downsides from their perspective when looking at the US hedge fund market was, precisely, the lack of liquid products9 – liquidity in the US is, in fact, of a very specific nature. Again, this raises the question of convergence, between retail and institutional this time, and makes one wonder about how this phenomenon (or lack thereof) compares across the Atlantic.
- Dr Black explains that 40 Act funds “started with high net worth individuals, then moved to institutional investors, and now are all the way back to retail. There is a tremendous rise of the retail product in the US”. The fact that this current trend now has to do with engaging with retail investors does not invalidate what investors had told us last year: being typically less developed than their US counterparts, European institutional investors in need of liquidity cannot turn to the US hedge fund market; they typically have a shorter time horizon and review their portfolio more frequently, leading to their choosing European liquid alternatives, in the form of UCITS. The 40 Act funds seem to have gone the other way, in the sense that they have brought retail investors to hedge funds rather than retail products to institutional investors; while UCITS once started with retail investors in mind, the 40 Act fund seem to be ending with them. Local rather than international in nature, US retail investors can, to some extent, contribute to making the US hedge fund market more, well, local, thus increasing the above mentioned asymmetry between where US hedge funds invest on the one hand, and where they get their capital from, on the other hand, and reinforcing the US / Europe split which the AIFMD has, to some extent, been able to trigger.
- Another feature of the past few months in the hedge fund world across the Atlantic has been the new advertising rule for hedge funds. There used to be a restriction for funds exempt from the 40 Act to advertise publicly, however this was lifted recently. Dr Black says that this “has not yet had a big impact”, and trying to forecast what the impact will be “is tricky because it is still the case that those funds can only accept money from accredited investors”. The extent to which this new – and itself well publicised – rule applicable to the US hedge fund industry can contribute to any industry changes – such as the “retailisation” of hedge fund products as discussed above – is therefore uncertain at this stage. While the 40 Act funds – that were always able to advertise their products – were able to adopt, and to adapt to, some of the hedge fund strategies – it may make sense for managed futures for instance – other strategies – such as distressed assets – may not be able to adjust to requirements for frequent valuation and high liquidity. Is this a reason for funds of hedge funds to have fared better in the US that elsewhere?
Accessing US Hedge Funds: Two idiosyncratic models
In addition to mentioning an increase in the allocation to equity products and “the rise of the liquid alternative” as defining features of the US market at the moment, Dr Black says “large funds are getting larger” – in the US as well as elsewhere, and reveals that US FOFs have not suffered much over the recent period, especially if compared to their European counterparts, the AUMs of which have halved since 2007.
- As of the third quarter of 2013, HFR’s Global Hedge Fund Industry Report shows that 17.5% of hedge fund firms manage over $1 billion, which adds up to 89.9% of industry assets. On the other side, the smallest 66.1% of hedge fund firms manage under $250 million, which combines to manage only 3.3% of industry assets. According to Dr Black, this is one of the effects regulation is having worldwide, “because larger funds stand better to comply with the rules, and they can prove that they can afford to spend resources on compliance.” While we acknowledge this broad direction of fund sizes, a question mark remains over the market for smaller hedge fund in the US versus Europe:
- A year ago we had said that the problem or regulatory costs arose in the US, but that those costs were even higher in Europe, thus penalising smaller funds even more, due to different regulatory approaches.
- We had also said that US investors could prove more adventurous and less risk averse, again making the case for smaller funds, from Europe as well as from the US, given the fact that smaller funds provide potentially higher returns (and higher risk)10.
- Finally, on the positive side, Dr Black adds that even though costs are high, now may be an interesting time to launch a fund in the US, paradoxically as a result of the new regulatory environment, which drives proprietary trader away from banks and into the hedge fund world. This, ultimately, is likely to benefit hedge fund performance as they inherit competent staff who will work for them rather than in competition with them. “If alpha is finite,” says Dr Black, “then it will go to hedge funds – rather than to banks”, which echoes the point we made earlier relating to the reasons why US hedge funds may be more interested to invest in, and expand into, Europe now.
- The reasons why the FOFs industry has been more stable in the US than in Europe are also up for debate, however few respondent mention the fact that retail access may have a lot to do with this. The utility function of those product may be higher in the US; it remains that what jumps to mind when asked about this is more the limited downside in the US, versus the fact that European FOF, whether operating independently or from within a private banks, “got burnt so badly”, as a Swiss investor put it. Other investors venture an explanation in relation to the FOFs industry’s historical development: because it appeared sooner in the US than in Europe, US investors have a longer track record, which includes more positive years and balances holding period return overall. He adds that US FOFs have historically serviced institutional investors in the US, whereas in Europe typical “consumers” of FOFs are smaller, have historically been less educated and hence are more prone to decision risk. It remains to be seen to what extent and in what ways this, as well as some tendency for some investors to “take the matter into their own hands” and build in-house capability, will affect the industry worldwide.
The US hedge fund world has remained in relative good health over the past twelve months. Momentary trends, such as market movements are not redefining the industry, but reversals can reveal genuine skills or lack thereof and change the number of incumbents. Ultimately, a strong and stable business model can make a difference and it is important that it is able to sustain and to navigate the long term transforming tides.
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.
2. Between January and December 2013, the FTSE rose by about 14%, while the S&P500 almost gained +30%. Source: Bloomberg.
4. The CFA Level III curriculum says: “The usefulness of historical hedge fund data is subject to controversy. (…) Research has also shown that the volatility of returns is more persistent through time than the level of returns.” CFA Level III, Volume 5, p.70.
5. “After all, you only find out who is swimming naked when the tide goes out” famously wrote Warren Buffett in his 2002 Chairman’s Letter to investors in Berkshire Hathaway.
6. The CFA Level III curriculum says that the annual standard deviation for the strategy they call “short selling” is 19.39%, the highest among their nine categories and higher than the HFCI’s standard deviation of 5.71% over the same period of time (1990 – 2004). While standard deviation may not be the best measure for the risk of hedge funds, this still provides some broad indication in support of the point we have observed. CFA Level III, Volume 5, p.67.
10. The CFA Level III curriculum says: “On average, large funds underperform small funds”. CFA Level III, Volume 5, p.76.