US Hedge Funds: Building on historical strengths
By Marianne Scordel – For the third year running, Bougeville Consulting has been asked by Hedgeweek to look at the US hedge fund landscape, particularly as it relates to its European counterpart.
At a time when the global financial markets are integrated in many ways, we had previously highlighted some differences between, and idiosyncrasies relevant to, hedge funds in the US and in Europe. We had explained why the gap was not surprising given the sector's histories, investor's landscape and regulations on either side of the Atlantic.
This report follows on from what we wrote for Hedgeweek in 2014 and 20131, where we compared and contrasted US and European developments. This year again, the overarching features can be articulated around the following themes:
• US hedge fund managers are overall more successful than European ones. This fact has not changed over the past 12 months, whether it is measured in terms of investment performance, capital inflow, or attrition rate as compared to Europe.
• The equity long/short strategy is still what the US does best. Again, this was confirmed this year, and the number of new funds managed from the US and specialising in this strategy testifies to this fact. The only nuance here consists in making this relative to the success of other strategies, as well as to highlight investors' preference evolving towards the long side.
• The investors' landscape remains different in the US compared to elsewhere, with the persistence of Funds of Funds, the preeminence of large long-term investors, and the relative lack of demand for liquidity. This is having consequences in terms of the future of the hedge fund industry on both continents.
• Regulatory frameworks have contributed to market fragmentation. While this was widely anticipated, we have now seen evidence of the extent to which cross-border marketing has been evolving.
We will look at each point in turn.
US Hedge Funds perform better than their European counterparts
In their last report on the topic, EurekaHedge2 explained that US managers did better than their European counterparts, however the report, as well as comments we heard from various other sources, also introduced an interesting level of granularity which puts this fact into perspective.
Performance has been better than elsewhere on many fronts:
• Absolute performance – "North American funds performed the best, almost half of the top 150 funds returning more than 20% in 2014, and 10% of the best performing funds gaining in excess of 10% for the first month of 2015" says the EurekaHedge report. It adds that "The top 150 North America-focused hedge funds also managed to outdo their counterparts in other regions for both 2014 and January 2015, which was likely a combination of the larger population of hedge funds to choose from in North America and tailwinds from strongly performing equity markets in the region." This completely echoes what we had reported in the previous years.
• Risk-adjusted performance – EurekaHedge explains that "fund managers investing with a North American mandate had the best risk-reward profile with a Sharpe ratio of 1.85 and 1.35 over both the [past] three and five year time period respectively. They also posted one of the lowest annualised volatilities over both time periods, rivalling globally focused funds which utilise a more diversified mandate." While the Sharpe ratio is not necessarily a good way of measuring risk adjusted returns for hedge funds, it is still widely used, and does provide some broad perspective on how the returns mentioned in the previous point are being generated, both relative to some measure of risk and to other regions.
• Attrition rate – In a recent article published in Hedgeweek3, we reported that, for the first time since 2010, Europe had seen more fund closures than new launches in 2014. It is pertinent to compare this to the situation in the US, where the reverse was observed during that same year, and in spite of the number of closures trending upwards there as well.
• Inflow – US hedge funds currently have USD1.45 trillion under management, or two-thirds of total hedge fund AUM. Quoting Preqin, Keith Black, PhD, CFA, CAIA, Managing Director of Curriculum for the CAIA Association, reports that "inflows into hedge funds in 2014 were USD275 billion in North America and USD49 billion into European funds, with 76% of North American managers seeing inflows and 58% of European managers experiencing inflows". This, again, illustrates the success of US hedge funds as compared with Europe.
However, at least three areas remain uncertain:
• Geography – As Eurekahedge puts it: "Only half of all investment mandates ended the year in positive territory. Fund managers with a North America and global focus delivered the best returns, up 5.56% and 4.42% respectively as underlying equity markets rebounded on the back of improving macroeconomic fundamentals and accommodative central bank policies. Managers focused on Europe however, lost 12.31% in 2014 as they were dragged down by losses from exposure to Eastern Europe, which suffered steep falls of 12.73% during the year over the Ukrainian crisis and falling oil prices."
It has to be mentioned that US managers' relative underperformance in Europe is not specific to one continent, but, rather, tends to materialise outside these manager's home markets overall, as evidenced by the fact that "funds focused on Latin America performed the worst on a risk-adjusted basis, being the only regional mandate to report a negative Sharpe ratio over the three year time period"4.
This may be one of the reasons why many US managers prefer to stick to what they know best. As a US managers told us recently: "There is no need for us to go and invest in Europe, we have plenty to do here in the US". Whether this is a matter of regional expertise (or lack thereof) or is the result of adverse market movements is up for debate. What remains though, is a case for a US market where opportunities still exist and are taken advantage of by US managers, versus a European one where opportunities also exist but are currently under-exploited by both US and, to some extent, European managers too, since the latter overall underperformed in their home market. Whether this might contribute to supporting the theory according to which markets are inefficient in is also an open question.
• Inflows – While we mentioned these compared positively with Europe, it must be noted that Q3 2014 was marked by an important slowdown in investment into US hedge funds. The size of CalPERS' withdrawal may have been largely symbolic5, it remains that it was perceived as the possibility of a broader disenchantment with the asset class, in spite of the strong performance. As a result, inflows in US hedge funds in 2014 were lower than in 2013. This, coupled with our findings from our recent investors' survey6 according to which investors intend to allocate more capital to European hedge funds throughout 2015, raises a question mark over how US sectors will fare in the near future. (Incidentally, observing how this development will unfold can also provide information about how investors may want to approach the market inefficiency we referred to above.)
• Currency risk – The strength of the US Dollar against the Euro is also raising a question mark as to whether the glowing picture that has just been portrayed is likely to be sustained over the next months. Dr. Black has hinted at a rebalancing towards Europe7, while underlying the fact that some investors may want to stay with the trend and keep their US investments for further appreciation. Additionally, the risk of currency appreciation being detrimental to the asset class is mitigated by the fact that a heavy proportion of investors in funds investing in the US have the US Dollar as their reference currency.
The equity long/short strategy is still what the US does best
Over the past two years, we reported the fact that US long/short managers did much better than their counterparts elsewhere. Again in the past 12 months this strategy performed better in the US than elsewhere; however we have observed a resurgence of net long, or long only, strategies.
In 2014 and Q1 2015, the strategy of choice of US managers remained so:
• EurekaHedge reports that in the 12 months to January 2015, there were 238 new launches of equity long/short funds managed by US managers (versus 125 closures), which was by far the highest number as compared with other strategies. CTAs came just after, however the attrition rate was higher among CTAs, which suggests not only quantitative, but also qualitative, success.
• The strength of the strategy is indeed reflected in performance. In "almost all strategic mandates except relative value in positive territory", "CTA/managed futures funds led the table with returns of 9.13% owing to strong performance in the latter half of the year as market volatility increased sharply. A number of other strategies also fared positively, with exposure to equities being a key winning theme as the US S&P500 index rose 11.39% during 2014"8.
• Lastly, it must be noted that this comes in sharp contrast with Europe: in a previous article9, we reported that fixed income strategies managed by European managers had witnessed a strong asset inflow last year, and was now standing at 19.4% of total European hedge fund AUM, with investors being drawn by the steady, modest returns afforded by fixed income hedge funds. We had also commented on US's better ability to manage activist strategies, and to make profit on short positions – mostly US short biased strategies were profitable in the past three years – which is due to cultural reasons as well as to the firepower at the disposal of US hedge funds – not least in terms of AUMs.
Having made the case for US equity long/short strategies, we have, over the course of our work in the past year, noticed a slight change with respect to the relative preference for the long versus the short side. In last year's report we had said that short biased hedge funds had underperformed overall, due to market movements, however US managers had performed markedly better than European ones for these strategies. In spite of this relative success, the ongoing trend of US investors to choose long biased and long only strategies has accelerated over the past 12 months. This appears to be for the following reasons:
• An investor points out the fact that "the short side has been difficult in both absolute and relative terms. Not only markets have rallied, but shorting some expensive stocks has been painful. This also couples with increased corporate activity making takeover risk higher. Therefore, the alpha comparison of long and short book of the managers – not only the direct long and short performance attribution – shows figures disproportionately tilted to the long side, hence the appetite for these strategies".
• Additionally, some managers manage large net long biases and still collect fees from flat performance. Investors are disappointed with this, and prefer to have a management fee only (or relative performance fee) structure and pay for what they actually get. This makes them more likely to direct their investments towards long-only products, as they do not typically charge on performance.
• Another reason is that "the US investor landscape is disproportionately composed by a segment – pension funds – who have ultra long-term investment horizons. For these, the volatility-reducing argument for going long-short is of less value if it is at the expense of long-term performance", adds a European investor familiar with US strategies. This, again, contributed to the trend towards long only products in the US.
• Finally, long-only products tend to be perceived as less capacity constrained than long short. This is clearly the case on the short side (availability of borrow), however it is also true that if the manager wants to exit a long position quickly, the long-only product will still be a burden.
All in all, the resurgence in popularity for long-only products is the result of a combination of factors, which are both contingent – market movements – and structural – specificities of the US investors' landscape.
In fact, the latter constitute one of the driving forces behind the structure of this industry, and, as such, it explains some of the more persistent differences between the US and the European markets.
The investors’ landscape is different in US and Europe
We previously spoke about differences in liquidity preferences between US and European investors, and about the approaches to the question of investing in funds managed by emerging managers. This time again, we look at these two questions, in turn:
• Liquidity – It is a well-known fact that US investors demand less liquidity that their European counterparts, and this is reflected in the offering coming from either continent:
– Dr Black has explained that "liquid alternatives currently hold assets worth a total of USD600 billion, split between Europe and the US, versus USD2.9 trillion for the conventional hedge fund model". According to him, "liquid alts are continuing to grow assets, both in `40 Act and UCITS form", and "depending on how you count, this market is as large as USD600 billion worldwide". While this is factually correct, it is interesting to highlight the difference between the types of investors who buys those products in the US and in Europe, respectively: it appears that the `40 Act funds are a way of making hedge fund-like products available to retail investors, whereas the boom in UCITS products is more the result of European institutional investors wanting to manage risk differently. So, in spite of the "raise of the liquid alt" on both continents, these are for different purposes and the trend does not contradict the fact that differences in liquidity requirements are persisting.
– The Funds of Funds model is also more in demand in the US than in Europe, which, again is a sign of a different industry structure as far as investors are concerned: as European pension funds are getting more sophisticated in their approach to alternative investment and to build in-house expertise, FoFs become less in demand. On the contrary, US investors are still using this model, albeit in a different way. This is not new; we explained it in greater details in a previous article10 but we wanted to mention it again here for the sake of completeness.
• Approach to emerging managers – We previously highlighted a trend towards consolidation among hedge funds, as the industry matures. This has applied both in Europe and in the US, where "The average size of the North American hedge fund closed since 2008 stands at USUSD72.6 million with over 80% of these dead funds having an AUM of less than USUSD100 million". Assets that left smaller funds appear to have been redeployed, hence making larger funds even larger.
Having said that, we previously explained how the appetite for emerging funds tended to concentrate around investors who have a long term horizon and a relatively high ability and willingness to take risk. It must be said that these investors are often to be found more in the US than in Europe, with large university endowments leading the pack.
The sizes of hedge funds across both continents – break even levels, barriers to entry – not only have to do with demand; these days, it is much influenced by regulations, which have happened concurrently but have adopted different approaches across both sides of the Atlantic.
Regulatory frameworks and market fragmentation
This year, investors who usually talk to us have had less exposure to US hedge funds than in the previous years. While this lack of information is somewhat problematic when one is doing some research about the topic, it is actually telling in itself: the usual respondents have made it amply clear that the primary reason for the lack of cross border communication was Europe's AIFMD.
Regulatory obstacles have had several consequences, in ways that are not always symmetrical:
• Dr Black says: "Regulation is a global trend. One of the consequences of it is that large funds are getting larger, because they stand better to comply with the rules, and they can prove that they can afford to spend resources on compliance. Pension fund and endowments are process oriented, and, as part of their due diligence, they need to show unambiguously that resources for compliance are there. This applies as a result of AIFMD and Dodd Frank alike." This argument contributes to explaining the tendency to consolidate within the hedge fund industry, which we mentioned above. This is impacting hedge funds globally.
• In the aftermath of the AIFMD's entry into force, several trends are emerging. We had previously reported that some investors had decided to stay away from hedge funds temporarily as a result of the marketing rules remaining unclear under the new framework11, and then, a year later, that some investors had decided to come back to the space in spite of the persisting lack of clarification12. Facts confirmed our predictions, particularly in so far as cross-border transactions were concerned: US fund managers and European investors alike "avoided" each other in the recent period, with a high proportion of US hedge funds not registering with EU regulators and deciding to rely on reverse solicitation or wait on the sidelines, concentrating instead on their home markets13. As the full impact of the regulatory changes unfolds, we expect this situation will evolve towards more established solutions.
In the US as in Europe, the hedge fund industry is at an interesting time of its history: as it keeps evolving, new business opportunities will arise and materialise. Given the strength of their model and ongoing dynamism, US hedge funds are well placed to turn the current challenges to their advantage. n
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 an Alumna of St Antony's College, Oxford.
5. USD4 billion
7. So did we in our last investor survey: www.hedgeweek.com/2015/02/25/218769/annual-hedge-fund-investor-survey-w…;