As the level of convergence continues to rise amongst traditional long-only fund management houses and hedge fund managers, the liquid alternatives space has emerged to become one of the most dominant structural developments in the funds industry.
In Europe, the alternative UCITS space continues to attract managers yet as James Jardine-Paterson, Business Development at Dalton Strategic Partnership observes, this is still very much a young industry. "There's a lot that can still develop. For example, we've launched an enhanced UCITS fund that offers the same strategy as our flagship Melchior European Absolute Return UCITS Fund but with almost double the leverage.
"When we first entered this space, low leverage and low volatility appealed to investors. Over the last five years, we've noticed a rising interest among investors for a higher return profile and greater tolerance for risk. Generally speaking, that requires more sophisticated clients who understand how that fits within their portfolio," says Jardine-Paterson.
Lyxor Asset Management bided its time before exploiting the liquid alternatives trend but in the last couple of years it has enjoyed significant traction in the Lyxor Alternative UCITS platform, which offers alternative UCITS funds in a managed account format to institutional investors. The platform now has EUR1.6 billion in AUM. There are nine funds in total, six of which are external managers including the likes of Winton Capital, Chenavari, TIG Advisors and Canyon Capital Advisors.
"ARMA 8, a multi-strategy fund, and Epsilon Managed Futures fund are both internal single managers and we also have an internal multi-manager fund called Lyxor Select Edge," says Daniele Spada, Head of Lyxor MAP. "UCITS is the area today where we are focusing our selection process and putting a lot of effort into our onboarding capabilities. We have another US equity manager in the pipeline with a focus on special situations, which will launch by the end of Q3 2015, and we also working to onboard a global macro manager."
For Europe's alternative UCITS industry to consolidate its growth, managers who are running strategies in the EUR100 million to EUR1 billion range need to attract assets. Currently, the likes of Standard Life Investment's GARS fund, which has approximately GBP25.9 billion in AUM, dominate the market. However, as mid-sized hedge fund managers continue to build strong track records and larger funds start to soft close, the opportunities could be substantial.
London-based Skyline Capital Management launched the Skyline UCITS Fund in 2011 on the MontLake Plaform, managed by ML Capital. The fund, which pursues a global emerging markets long/short equity strategy, has grown its AUM to USD180 million. Since inception, the fund has generated total returns of 47.4 per cent compared to 10 per cent on the MSCI EM Index.
Obviously there were significant headwinds in 2014 given the Russia crisis in Ukraine, which impacted Skyline's Eastern European book; both in equities and FX.
"FX was a driver of negative performance in the fund during 2015. The Russian Ruble and the Brazilian Real caused large movements in emerging market currencies through the course of the year. Then, specifically in the second half of the year, we had to deal with the crude oil sell-off, which hit emerging market oil exporters," explains Harinder Hundle, Partner at Skyline Capital.
This led Skyline to make adjustments to the strategy to further protect the downside. This was achieved by reducing the fund's gross and net exposure through an adjustment in beta calculation, which has meant that realised volatility in the strategy is now less than half the index on a YTD basis – 7 per cent versus 15 per cent.
"We've basically dialled back risk in the portfolio to 2010-13 levels," says Hundle. "The other big change we've introduced is event risk currency hedging on EM currencies. We started doing that from 1st January 2015 and it has made a meaningful difference to volatility and returns."
Hundle says that despite recent volatility there is significant upside potential in emerging markets, noting that it is important for investors not to take a homogenous view of the asset class. "We are paying close attention to the big rotation out of commodity export-driven economies to domestic consumer-driven economies. China has seen a huge movement of labour from farming to urban but that supply is reducing.
"This has led to wage inflation and increased the level of conspicuous consumer spending. Outbound EM travel is a big theme with the portfolio.
"We also like the automation sector in China as it becomes more robotics-focused and productivity improves. We are investing in robotics companies going into China," confirms Hundle.
India is actually the biggest single country weighting in the fund. According to Hundle, India will move to a higher level of growth than China and will be more of an infrastructure story – essentially what China has been doing the last 30 years.
"India is still playing catch-up. It offers plenty of upside," adds Hundle.
The beauty of liquid alternative funds is the ease with which they can pull out of markets during periods of dislocation.
In 2014, there were four significant sell-offs when equity markets dropped sharply, during which the Melchior fund did not participate, which was a function of net exposure management and short alpha. Whilst being largely market neutral during 2014, straight after each of the sell-offs the fund built a net long position to benefit from the subsequent rebound.
"It was about being flexible with the net which is something we`ve always believed in," says Jardine-Paterson.
Currently, the fund has a 13 per cent net short exposure to the market.
"The fund's net exposure is as much a function of single stock opportunities as it is a wider expression of our macro views. For example, our net short position at the start of June 2015 was as much a reflection that the portfolio manager, Leonard Charlton, had concerns about global markets as it was that the number of short ideas we were finding suggested significant alpha opportunities from our shorts," adds Jardine-Paterson.
On the long side, stocks such as Pandora, a Danish jewellery company, have done well whilst at the sector level, the food and beverage sector contributed to some good shorts in 2014, according to Jardine-Paterson. As well as generating alpha on the long and short side, the Melchior European AR fund also uses a tactical trading overlay.
A good example of this was Shire, which became the focus of a potential takeover in Q3 last year.
"Having held as a long position for fundamental reasons since November 2013, when the bid was announced we significantly reduced our position and took profits. A month later the bid collapsed and at that point we bought the stock again as we believed the fundamentals remained intact," recalls Jardine-Paterson.
Over the last four years, there's been little for the eurozone to shout about.
Earnings revisions have been largely negative but according to Stefano Girola, who co-manages the OYSTER Market Neutral Fund with Giacomo Picchetto at SYZ Asset Management (Suisse) SA, there are early signs that this trend is turning.
"Q1 showed some very encouraging earnings potential," says Girola. "There are a number of stocks in southern European markets that we didn't touch before but are now recovering and becoming part of our investment consideration. Retail banks feature strongly in the portfolio for example. We are long banks such as KBC, a Belgium bank, and short Irish banks.
"Another theme that has worked well this year is asset gathering businesses. In Italy, 10-year government bonds have fallen to low levels and this has led to a huge amount of money flowing into mutual funds. Companies such as Anima and Fineco Bank are collecting a lot of new assets from retail investors and we've done well out of these trades," comments Girola.
The OYSTER Market Neutral strategy looks to identify alpha opportunities by focusing on stocks where the team believes that consensus earnings are too low (and therefore expect a future upgrade) and shorting stocks where it believes the earnings numbers on the Street are too high.
As part of the investment process the team uses various models that score companies listed on the STOXX 600 Index based on three factors:
∑ The change in consensus earnings over three months
∑ P/E multiples
∑ Price momentum.
"We prefer stocks whose price has gone up over the last three months together with earnings. We never buy stocks where consensus earnings have gone up in the last three months but the stock has gone down. We need to see a correlation in place between price movement and earnings expectations movement," says Girola.
Currently, the fund is up 2.5 per cent. However, like Dalton Strategic Partnership it also runs a higher octane, leveraged version of the strategy, which has an 8 per cent (rather than 4 per cent) volatility target. This fund is up 6 per cent YTD.
"Historically, we've made 40 per cent of the alpha on the short side since the fund's inception," adds Girola.
Growth in the liquid alternatives space is not limited to Europe, where the market is being driven by single manager funds. In the US, the '40 Act alternative mutual fund market is also growing rapidly – indeed with more than USD300 billion in AUM it has overtaken Europe's alternative UCITS market – and is largely dominated by blue-chip asset managers such as BlackStone, Fidelity and Neuberger Berman offering multi-manager products. These typically comprise 10 to 15 hedge fund strategies where each manager is appointed as a sub-advisor.
These products are targeting the retail market – unlike alternative UCITS which are still the preserve of institutional investors – and whilst they are a fantastic opportunity for regular investors to get hedge fund exposure, these products are watered down, `hedge fund-lite' versions of offshore strategies.
"Fee compression is happening due to the growth of liquid alternatives," says Brad Balter, CEO of Balter Capital Management, which is disrupting the '40 Act alternative mutual fund space by targeting institutional investors – not retail investors – who want genuine hedge fund performance in a more liquid format.
"When a hedge fund goes to 1.5 and 17 if you do the math it is still too one-sided in favour of the hedge fund manager. So the way fee compression has to happen is through liquid alternatives. When you construct one of these liquid alts how do you ensure that you are offering the same thing to the end investor? That's where we come in.
"Our determination when entering the market was this: we can't do this unless we've got a minimum of USD100million in each fund. Second, the manager has to agree to pari passu the strategy or convert their fund. We started our first fund in 2014 – Balter Long/Short Equity Fund – which focuses on the small-cap market," says Balter.
The fund comprises four managers – Apis Capital Advisors, Madison Street Partners, Midwood Capital Management and Millrace Asset Group – but the plan is to launch a series of single manager alternative mutual funds going forward.
Indeed, on 27th May 2015, the firm launched the Balter Discretionary Global Macro Fund, which is sub-advised by Willowbridge Associates.
"The fund is unlevered. It is such a low volatility strategy that Willowbridge opened up a 3x leveraged version. That's what most of their hedge fund investors want. So our pitch to Willowbridge was, `Listen, the unlevered version is perfect for the liquid alternative market and if prospective investors want to get more juice out of the strategy they simply invest in your offshore strategy'.
"That's a nice symbiotic relationship. It allows Willowbridge to justify having both the hedge fund and the liquid alternative. It took us three years to source and implement this strategy.
"What is particularly interesting is that some investors are asking if they can put say USD20million in the hedge fund and another USD30million in the liquid alternative. That's fine with us," comments Balter.
If others decide to pursue a similar strategy to Balter and bring true hedge fund products in a '40 Act liquid wrapper to the US institutional market, it could mark the next evolution of its funds industry.
Watch this space.
