Adrian Durrant examines the outlook for 2004 in the light of growing allocations
from institutional investors.
Will the proposed European Union-wide passport for hedge funds be a driver for
encouraging the industry to move onshore? Possibly. Will new rules go some
way to coaxing European investors back onshore? Possibly.
Both are most unlikely to have any direct impact on money flows during 2004.
The more likely scenario is that any regulatory reform will have to be
implemented hand-in-hand with well-considered tax reforms. Getting the
incentives right here, for all stakeholders, including investors, managers and the
taxman, will be key.
Within the European regulatory field, Germany has taken a bold step forward
with the modernisation of its investment law, which came into effect on 1 January
2004. The government body which is responsible for the implementation of the
ideas coming out of Berlin, the BAFin, is in active courtship with stakeholders
within the local hedge fund community. These are positive moves for an industry
that has, rightly or wrongly, been thought of traditionally in terms of lack of
transparency and offshore tax havens.
Furthermore, hedge funds complying with Germany's transparency rules will be
taxed in line with normal investments. Hence, it would appear as if legal and tax
reforms here are indeed being worked hand-in-hand.
The Right Measure
The bear market of 2000-2003 has left its indelible mark across many investment
portfolios. What is clear is that 'rainy day' money requires improved downside
protection going forward.
Professor Harry Kat, Director of the Alternative Investment Research Centre in
London, is specific when it comes to the impact of hedge funds on portfolio
performance. Kat's research leads him to believe that in order for hedge funds
[and commodity trading advisers] to have any meaningful impact, portfolio
allocations of in excess of 20% would be required.
Compare Kat's figure to the current European allocation of around 1-3% and the
gravity of his message becomes clear. A concerted move on institutional grade
capacity would be hard, if not impossible, to absorb within the 'niche' sized hedge
fund industry [of around USD 700 billion]. Hence there is a capacity dilemma to
be faced, especially for hard hit pension money. The saying, "if you are going to
do it, do it right… else don't bother", could become a bitter pill to swallow.
So, what will 2004 hold for the European institutional hedge fund investor?
Two things are for sure - hedge funds offer both investors a compelling source of
risk adjusted returns and suppliers with an attractive source of revenues, when
other investment classes appear to have run out of steam.
First time institutional investors tend to invest via third party fund of hedge fund
managers, as a direct route to diversification. This comes at a cost; the additional
fee layer directly impacts a product's return. Fund of hedge funds on average
posted poor returns in 2001 and 2002, with many struggling to be in the absolute
return space, whereas last year they presented a significantly better picture - up
10%, on average.
Over the above period, it has been interesting to note an increasing number of
fund of hedge fund managers that have started to apply leverage to their
portfolios. This year could well put the robustness and added value of this
approach to the test.
The big European banks are already rolling out their proprietary hedge fund
platforms into the institutional market. However, with the exception of the Man
Group, and possibly GAM, there hardly seems any European household brand
names out there in the hedge fund space.
Whereas building keeps the money and the revenues close, the cost of
acquiring, and maintaining, competence and infrastructure is prohibitive to most
European mid-tier intermediaries such as the private banks. Outsourcing to the
best money managers appears to be their most pragmatic way for getting into,
and staying in, hedge funds.
A good sign is that the past couple of years have witnessed a greater emphasis
being placed by investors on the business risk in hedge fund due diligence and
selection. Whereas the investment risk is more easily quantifiable, soft issues
such as possible fraud are considerably harder to assess at the outset. Going
forward, it would appear that accurate, and independent, fund pricing will become
another major issue on investors' agendas in 2004.
As far as the more recent regulatory initiatives are concerned, it is encouraging to
see a significant level of active dialogue between the hedge fund industry and the
respective regulatory bodies. As a general statement, inclusion has always
triumphed over exclusion.
Another good piece of news is that the hedge fund attrition rate appears to have
eased off, down from 13% in 2002 to 7% in 2003. Could this be yet another sign
of an industry that is starting to mature?
Talking aside, accessing capacity in the 'best of breed' funds will continue to be
the name of the institutional investor game in 2004.
Adrian Durrant, ehedge
The opinions expressed in this article are those of ehedge AG. eHedge is an
independent adviser to European institutional hedge fund investors, and is based
in Frankfurt, Germany. For more information please visit www.ehedge.info .