One of the biggest drivers of change in the alternative funds market in recent years has been large institutions investing directly into large blue chip managers, concentrating 80 per cent of the industry's total AUM in the upper decile of fund managers. Consequently, it could be argued that hedge funds have morphed in recent years into something that no longer represents the original essence of what a hedge fund was meant to be.
Hedge funds used to be about making money. "Now it is about reducing volatility and generating risk-adjusted returns. The only ones really trying to make proper returns are private equity fund managers," postulated Mark Yusko (pictured), CEO and CIO of Morgan Creek Capital Management, in his keynote address at CAIS 2016.
Size is the enemy of alpha
Institutional investors, along with market regulation, have driven the alternatives industry down this road; one where the speed limit is a safe 30mph, rather than 100mph on the German Autobahn.
Pre financial crisis, hedge funds were more willing to embrace risk to produce stellar returns but over the last six years, continued institutionalisation of the industry has crowded out individual HNW investors. This has allowed the bigger fund managers to get bigger but as Yusko pointed out, size is the enemy of alpha; it's impossible to produce consistently high returns with large AUM without moving markets.
To compensate for this, the smarter institutions are looking to chase the returns that hedge funds used to generate by developing in-house capabilities, building their own alternative investment teams. They have realised that small, boutique managers are the alpha generators and are, to an extent, re-embracing the original spirit of what a hedge fund used to represent.
Spiros Maliagros is President of Tiedemann Investment Group, a private investment advisory firm with USD9 billion in AUM across the group. On the size issue, Maliagros confirmed that TIG takes an incremental approach to capacity. "We like to test the capacity of funds. We take a careful approach to our funds' growth, closing funds to new investors and then re-opening them," said Maliagros.
One investor that is also training their sights on smaller managers to improve returns is Adi Divgi, President/CIO, EA Global LLC, a single-family office he established in 2005. Prior to his current institutional investor role, Divgi oversaw the Opportunistic Fixed Income investment program at the New York City Bureau of Asset Management from March 2011 to April 2014.
Speaking at CAIS 2016, Divgi said that the smallest amount that would get allocated in the Opportunistic Fixed Income program was USD200mn. Given that there was a restriction to invest in managers where the program owned no more than 10 per cent of a fund's total AUM, this limited Divgi to managers with USD2 billion or more in AUM.
"Now, I invest in meaningfully smaller managers that can generate alpha. Large pension funds will have to continue investing in the largest managers unless they create a FoHF platform," said Divgi.
The evolution of customised solutions
As well as evolving to invest directly into hedge funds, SWFs and other large institutional investors are exploring funds of one, segregated managed accounts, as well as buying GP stakes in hedge funds; essentially taking a long position on hedge fund fees.
All of this, said Scott Soussa, Senior Managing Director, The Blackstone Group, is great news for the industry. "The evolution in hedge fund investing has been taking place for over a decade. We now call ourselves a hedge fund solutions provider. Investors who are the most flexible have done the best. And managers are now more willing to play. We do everything from managed accounts to funds of one, '40 Act funds, taking slices of managers' strategies to access consistent alpha generation; even if this means paying higher fees," commented Soussa.
Michael Rees, Managing Director, Neuberger Berman, DYAL Capital, made a similar point to Soussa, confirming the importance of becoming a solution provider not just a product provider.
"We are seeing more product innovation than ever before, largely because of fee pressure among investors. It's now about customising solutions for investors based on exactly what they are looking for. This is the next phase of institutionalisation as hedge funds deliver solutions," suggested Rees.
Embracing regulation
To help supercharge the industry brand, some alternative fund managers are beginning to embrace regulation rather than try to fight against it. Part of this is to enable them to expand their fund product range to include regulated funds to compliment their existing offshore structures. This is something that TIG has done by entering the European UCITS market with one of its fund strategies.
"We're now looking towards Asia. Rather than open offices locally we've found partners with the right distribution and legal and compliance frameworks to allow us to evaluate, incrementally, whether we want to go direct into those markets over time. Again, this is an incremental approach. I think UCITS has a place, and also the US '40 Act space," said Maliagros.
One prominent US hedge fund manager that has been quick to recognise the opportunities on offer under AIFMD regulation in Europe is AQR Capital Management. As Andrew Bastow, Vice President and Head of European Structuring and Regulatory Affairs outlined at CAIS: "Few US managers have set up as an AIFM in Europe. AQR is one of few that have and we are already seeing the benefits of that."
One aspect of regulation, however, that needs to improve is for countries like the US to introduce tax efficient wrappers to help improve investors' abilities to invest in real assets including infrastructure.
Domestic pension plans could be far better utilised, as is the case with Superannuation funds in Australia, especially when one considers the US has a USD2.3 trillion infrastructure shortfall. It is estimated that in the US, retirement plans amounted to USD26.5 trillion in 2015. Even if a 10 per cent allocation were to be made, that would go a long way towards bridging that fund gap; and, crucially, would allow pension funds to generate yields of 8 to 12 per cent in long duration assets: something that cannot be underestimated as the world grapples with punishingly low interest rates.
"A lot of sovereigns are holding dollars that could be used to invest in US infrastructure. That highway of investment needs to open up," suggested Rodrigo Real, Director, Cindat Capital Management. Michael Underhill, CIO, Capital Innovations LLC, added that within the US water sector there are infrastructure opportunities in desalinisation plants in California, as well as in wastewater, utilities, energy and transportation.
Product innovation
Managers wishing to diversify their product offering to supercharge their brand and push the innovation button might do well to consider China. It is estimated that USD7 trillion could enter China's stock markets as Chinese pension funds are allowed to increase their allocations under regulatory reform. "Private companies in China will be listing A shares on the mainland's stock markets and that is where the investment opportunities will be," suggested Charles Mautz, CEO and Founder of Chinus Asset Management.
The demand is certainly there among investors. Mark Makepeace is Group Director of Information Services and Chief Executive of FTSE Russell Group, London Stock Exchange Group. He said that access to China was on a short list of issues "that I would estimate are on the agendas of 75 to 80 per cent of large asset owners that we speak with."
Indeed, Vanguard recently received, on 29th January 2016, a renminbi qualified foreign institutional investor (RQFII) quota of USD3 billion – the largest quota to be issued to date – to invest in China's A-shares markets. Hong Kong-based CSOP Asset Management Limited, quick to tap in to demand among foreign investors, became the first ever Chinese asset management company last March to list an ETF – the CSOP FTSE China A50 ETF – on the NYSE Arca.
The rise of marketplace investing
Alongside the burgeoning ETF market, as fund sponsors respond to the gradual opening of China's capital markets, one of the clearest examples of where disruptive technology is propelling product innovation is the rise of marketplace investing. What used to be referred to as peer-to-peer lending, allowing investors the opportunity to invest in chunks of consumer loans on platforms such as Lending Club and Prosper Marketplace, has evolved such that institutions can now buy whole loans that match their duration objectives.
Speaking at CAIS 2016, Ron Suber, President, Prosper Marketplace, said that marketplace investing represented a collision of Wall Street and Silicon Valley. So fast has been Prosper's growth that there are now Prosper bonds in the market, rated by Moody's and Standard & Poor's.
"Our platform is still yielding 6.3 per cent net every year, paid monthly, even as the economy changes, interest rates rise. Investors have moved from buying fractions of loans to what we call `whole loan passive', where they ask for an equal slice of whole loans on the platform.
"Marketplace is in every part of credit market, not just consumer loans. We're only in the second innings," said Suber.
Suber stressed that Prosper's model works such that the left leg (capital), which represents investors looking for loans for a particular duration, has to balance the right leg (product), which represents the borrowers. Assuring that lenders and borrowers are aligned on the balance sheet allows Prosper to run a highly transparent, disciplined business model.
"At Deutsche Bank, we have looked to develop a platform where marketplace loans can be traded on the secondary market. Transparency is crucial – these platforms have all the necessary data, skin in the game, underwriting skills etc. We forecast that the short duration securitisation market will grow so long as platforms maintain their standards of underwriting," said Nicole Byrns, Director, Deutsche Bank.
Prosper is also the first platform to have done a securitisation. The `S' word may still haunt some investors. But things have moved forward substantially since the financial crisis when nobody really knew the inherent value of the underlying mortgages that were being sliced and diced.
Looking ahead, Suber commented: "Retail investors will eventually be able to click on a symbol and buy marketplace loans from their JP Morgan or Charles Schwab account and invest internationally in consumer loans. The platform marketplace will look very different going forward."
There are countless ways for alternative fund managers to innovate and remain relevant to investors. The challenge for managers is to understand how to innovate in the right way without losing sight of their core values. Either way, this is a fertile period for the alternatives industry to evolve the brand
