Are US hedge funds more attractive? A tale of two markets
By Marianne Scordel – Summer in London brings with it a whole new wave of would be hedge fund managers, who have either left their employers as part of a pre-bonus cost-cutting exercise, or are planning to do so once they have been paid the sums they will then use as the required investments to start up their new ventures.
Those currently involved in drawing up business plans, as well as incumbents taking a look at where they are within the industry in order to monitor levels of profitability, all have an interest in reviewing the competitive landscape. While the former need to know what they are up against before making the “big jump”, the latter also have to keep an eye on how the forces that shape the industry1 are evolving, to be able to forecast revenue and make the necessary adjustments to their business strategies, be it their product offerings, approaches to marketing, or the structuring of their operations.
As consultants, Bougeville assists hedge fund managers with their business strategies. In order to provide sound economic advice aiming at long term and sustainable commercial success, we ground our approach in a combination of involvement with academia2 and active presence in the market3.
As it turns out, defining the market with a view to analysing competition provides those from the European side of the pond eager to make their mark in the hedge fund industry with a striking starting point: this is a global industry in which the top performers worldwide are managed from the US.
• Indeed, if one looks at the top three performers within each of the 11 categories of investment strategies (as defined by the CAIA Association), only one – convertible arbitrage – contains no US managers
• Besides, the top three performers in six categories – activist, distressed, volatility arbitrage, fixed income arbitrage, relative value multi-strategy and market neutral – consist of US managers exclusively
• Finally, one European fund only is present in just three among the remaining four categories: macro, merger arbitrage and event driven multi-strategy (from Switzerland, France and UK respectively)
Over the past few weeks, we have spoken with hedge fund investors, managers, prime brokers and academics to try and understand the reasons behind the apparent success of one region versus the rest of the world, and to try and anticipate developments – towards discrepancy or convergence – for the months to come.
The results of this research can be split into the following themes:
• While the top performing hedge funds are managed from the US, a closer look reveals an uneven split among investment strategies: equity long/short and distressed debt seem to pertain firmly to the US; however, factors relating to size, history, risk appetite and market access may also explain – as well as nuance – the results
• On the revenue side of the equation, the change in the investors’ landscape has had an impact on due diligence and on investor’s need for liquidity. On that front also the regional split can be observed
• Finally, diverging regulatory frameworks on either sides of the Atlantic will be imposing costs which are likely to accentuate differences rather than bridge a gap
Ultimately, the findings may provide some indication on how the industry is being shaped, with long-term strategic impact.
The performance of US hedge funds is higher than elsewhere
When asked what they go to the US for, European investors’ typical answer includes equity long/short as a strategy of choice. Some also wonder whether distressed debt might be the next highly performing strategy, and if so, would be more comfortable accessing it in the US, due, in part, to better established bankruptcy laws.
While not all the respondents agreed on the performance of distressed debt funds in the near future – “the year of the distressed debt strategy was announced ages ago, it is yet to happen”, says one investor – equity long/short seems to benefit from a ringing endorsement in terms of differentiating US hedge fund managers. The following support this view:
• Tarun Ramadorai, Professor of Financial Economics at Said Business School, University of Oxford, points out that the first modern hedge fund was created in the US by Alfred Winslow Jones as early as the 1940s. While saying that this does not, in principle, mean US managers have more expertise over the area, he concurs with most other respondents in acknowledging this may have had an influence. 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, are all vague but nonetheless tangible points most respondents have been keen to put forward. The long history could also explain that fact that US long/short hedge funds got to critical mass sooner than funds from other regions: it is possible their global reach and access to international markets provides them with an information advantage, resulting in a positive impact on performance
• Another reason investors cited both supports the previous point and nuances the overall picture according to which US hedge fund managers may be more attractive as a result of their better performance. Investors say that US managers are much more active than their counterparts elsewhere in the world on the short side, that they express greater divergence between themselves, as recent cases have illustrated, and that they are more vocal. They decide to invest in US long/short funds because they offer a management style they do not see on offer elsewhere. This argument may relate to the previous point insofar as history and culture are possible explanations for the fact that US managers are more active on the short side. However, it also nuances the overall thesis according to which US hedge funds are absolute top performers, in the long/short category and as far as other strategies are concerned: as Professor Ramadorai points out, risk may be an explanation for the overall better performance by US funds. If that is the case, US hedge funds would also be among the worst performers, making the case for the attractiveness of US hedge funds relative, rather than absolute, in the sense that it would depend on investors’ appetite for risk
• Finally, the liquidity of the investments made by the funds and the sophistication of the US market may be a reason for the over-performance by US managers. Volumes traded are larger, markets are more efficient, the resulting information being reflected in the price of the investments faster than elsewhere. Due to their sizes, US funds are more able to invest worldwide than their counterparts; however, they would typically invest in US-listed stocks first, which are covered by more research analysts around the globe than non-US stocks. Shorting stocks in other parts of the world sometimes proves more difficult (e.g. in Asia), and this ease of trading, within one jurisdiction and under one regulatory umbrella, also contributes to the fact that, currently, 40% of hedge fund investments are targeted at the Americas, 10% at Europe and Asia, and 45% at global funds
The above features, as epitomised in the case of equity long/short funds, contribute to explaining why US hedge fund managers, who invest in the US as well as elsewhere, have tended to over-perform relative to their counterparts from other regions.
While the results are based on hedge fund performance during the past 12 months, new entrants as well as incumbents have an interest in asking themselves to what extent these underlying explanations point to longer-term industry trends. To be more explicit, US hedge funds may represent a threat to their counterparts from elsewhere if they are found to be substitutes to the European offering. In a world where capital is mobile, one could presume investors tend to have more leeway over their investment targets, choose freely between products that meet similar needs, and are able to force hedge fund managers towards making improvements. A greater number of players within a global hedge fund market would contribute to a higher degree of competition and hence higher costs and less profit. Are US hedge funds offering a similar range of products to non-US hedge funds? Are they proving to be better at doing the same job?
Meeting investors’ requirements
Looking at whether hedge funds have adapted to meet investors’ requirements involves drawing a line between US and non-US managers, both from the perspective of the need for liquidity and that of the due diligence process.
Among the European investors surveyed, most say that US hedge funds do not fulfil need for liquidity in the post-crisis era. This lack of product adaption may be explained by the fact that the US investor base is more institutionalised than in Europe, with pension funds and other investors with long-term horizon reviewing their portfolios less frequently. This lack of liquidity from the fund to its investors certainly does not seem justified by the relatively high liquidity the fund has in relation to its investments; investors surveyed said that US equity long/short funds were more illiquid than in Europe, however, as mentioned earlier they invest in relatively more liquid markets.
With access to capital easier in the US than in Europe or elsewhere, it is possible that US hedge funds have not needed to adjust to demand elsewhere, be it via the adoption of the UCITS model or otherwise. Thus, it appears that US hedge funds may not be substitutes to their European counterparts after all, since they address different consumer needs in different markets.
European hedge funds’ increasing liquidity over the past few years has been the only way to compete for local investors. While they have been able to differentiate themselves to keep the European segment of the market, that strategic move does not seem to have forced US hedge funds to do the same. This would tend to argue in favour of the existence of two distinct markets: one in which liquidity is a necessary condition and the other one where investors are agnostic to this factor. If this is true, the advantage US hedge funds have would, in part at least, stem from a combination of better availability of capital and relative indifference to liquidity, two luxuries their European counterparts do not benefit from.
From a due diligence perspective, there also seems to be a split:
• As Keith Black, PhD, CFA, CAIA, director of curriculum for the CAIA Association, puts it: in the US, “as hedge fund assets have increased, institutional investors have become a growing portion of AUM. As such, the idea of an ‘institutional quality’ hedge fund has effectively meant that the due diligence processes of institutional investors have provided a more important oversight of operational risks than the regulatory authorities. This has led to increasing concentration of assets in large funds that have the asset size and processes in place that are needed to pass the institutional due diligence process”.
Here too, the investor landscape is somewhat defining the hedge fund offering and their relative performance; and here too, this results in different trends on either sides of the Atlantic. Due diligence being investor, rather than regulatory, driven would tend to infer that big funds are more likely to be successful in the US than elsewhere, a point which echoes the one made earlier on US funds reaching critical mass more quickly due to their longer history.
• In spite of this investor-led due diligence, which, in theory, ought to have raised the standards, investors are split. Some say that US hedge funds have more robust technology, and higher standards in terms of having the right software to allow for NAV reconciliation. Others, particularly from Europe, are appalled when they look at corporate governance of US hedge funds as compared with their European counterparts; they complain about the lack of voting rights and the fact that there are more hidden charges in the US; they also mention a greater possibility of abuse of soft dollar – “we, the investors, should not be paying for US hedge fund managers’ Bloomberg machines”, says one.
So in spite of US hedge funds and hedge funds from elsewhere abiding by different sets of standards, the former remain successful. They are performing better and they are getting bigger, without an apparent need to increase the liquidity of their offering to investors or improving the quality of their operations to meet demand from outside the country.
It has been said above that regulation may have an influence on investors’ behaviour – or, in Porter’s speech, on “consumer power” – resulting in large US hedge funds becoming even larger. However, a brief look at the table of best performing funds shows that their sizes may be small. This may be as a result of what Professor Ramadorai calls “the capacity constraint” larger funds are now facing, with its associated cap on performance. The combination of the relative over-performance by US hedge funds and smaller funds showing up in the performance raking table may also point to the idea that barriers to entry in Europe may have a part to play in explaining those results.
The long term regulatory game
It has been written that regulation is not, in itself, “a force that shapes the industry”4. Rather, regulation has an impact on the competitive landscape because it modifies the strength of the five forces that shape the industry. In that sense, we described above how regulation has had an influence on how investors perform their due diligence, resulting in large US funds becoming even larger.
Regulation has an impact on barriers to entry, which, according to respondents, is likely further to increase the divergence between the US and other markets, especially Europe. The following are all reasons why the impact of regulation is likely to be lighter in the US than elsewhere, resulting in relatively lower barriers to entry in the US:
• As Keith Black said: “The US takes quite a different view of hedge fund regulations, focusing on investors rather than fund managers. For most of the history of hedge funds in the US, hedge fund managers were not required to register with the SEC. However, the passage of the Dodd-Frank Act in 2010 now requires all managers with assets over USD150 million to register with the SEC. In Europe, hedge fund regulation focuses on the manager. The AIFMD only allows funds (including private equity and hedge funds) to be marketed to EU investors if the fund’s manager has been authorised by a specified EU regulator. Once managers have complied with EU regulations, the funds are available to a broader group of investors than is the case in the US”. Meeting the EU requirements is anticipated to be more expensive, as the upcoming European framework seeks to protect a broader range of investors
• Some respondents, investors and suppliers (brokers) alike, say that the cost of regulation will not only impact the fund directly, but will also have a negative effect via others having to comply, and the resulting changes in the market structure. For example, requirements imposed on brokers will change the cost of trading. The extent to which these costs are passed on down the supply chain will ultimately impact the viability of the business by making it more expensive to be in, either directly, or via the redefinition of the brokerage industry and the number of players in it able to supply services to hedge fund managers
• Finally, a less expensive framework in the US than in Europe means that the AUM required to start up a fund will be lower in the US, thus favouring smaller funds thanks to a more manageable level of barriers to entry. This point seems to nuance the one made previously relating to the size of US hedge funds. However, it concurs with Professor Ramadorai’s thesis; it also echoes the fact that many, among the top three hedge funds in each category, are relatively smaller funds.
From the above it appears that US hedge funds are, from many respects, different from their counterparts from elsewhere in the world. While the mobility of capital would tend to argue in favour of a single market for hedge funds worldwide, the increasingly regional regulatory framework, as well as investors’ preferences, shows an enhanced degree of fragmentation for now and for a few years to come. Understanding those differences and incorporating them in strategic planning is a worthwhile exercise for emerging and established managers alike.
Marianne Scordel founded Bougeville Consulting in 2009 to assist alternative fund managers with their business strategy. 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 an Alumna of St. Antony’s College, Oxford.
1. 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.
2. The author is a co chair of LISIG, the Legal Issues Special Interest Group at CFA Society of the UK
3. See previous article in hedgeweek
4. “The Five Competitive Forces That Shape Strategy”, by Michael E. Porter, Harvard Business Review, January 2008.