Hedge fund industry alive & kicking

Another year and, I’m pleased to say, another fantastic Global Hedgeweek Awards event. There was a lot to be cheerful about for this year’s winners, who once again demonstrated that creativity and innovation, not to mention a commitment to excellence, are alive and kicking in the hedge fund industry.

More than that, the sense of optimism emanated from what was, finally, a good year for performance. The industry returned a healthy 11.41 per cent and attracted net new inflows of USD49.5 billion to take total industry AUM to USD3.55 trillion.

Multi-strategy funds proved to be the most popular, according to Preqin’s 2018 Global Hedge Fund Report, attracting net inflows of USD24.2 billion. Although this 14 per cent increase took total AuM in this strategy sector to USD485 billion, Macro strategies remain the most dominant sector, with AuM rising 8 per cent to USD1.054 trillion. They recorded a net increase of USD17.2 billion, ranking them third for the year behind Macro and CTAs, which saw a net increase of USD22.6 billion.

With increased market volatility expected for 2018 and already signs of geopolitical risks such as a US-Sino trade war potentially impacting risky assets, there should be plenty of opportunities for active managers to prove their worth. Indeed, the more central banks scale back their level of interference, which has done nothing other than keep developed market economies on life support, the more markets will normalise and return to fundamentals.

Some investors such as Optima Fund Management, a leading New York-based FoHF, expect, at the country level, to see more differentiated performance as policy leaders cope with a gradually tighter supply of international dollars. From a bottom up perspective, investors like Optima are already seeing continued improvement in individual stock performance with falling cross-correlation and rising dispersion when looking at the constituents of the S&P 500 Index.

Optima says that it sees powerful changes influencing how risk is being perceived and how company benchmarking is evolving. This evolution is a welcomed change from the dynamics of the past nine years where every stock was a winner just for showing up.

In contrast, the benefits that spawn from changing policy mandates and differentiated growth patterns will likely be more unevenly distributed going forward. Optima expects this to more fully reward those managers who make skilled active long/short bets with judicious use of leverage and concentration.

On balance, Optima sees the risks as skewed in favour of a higher visibility, mid-to-late cycle global economy that may incur bouts of higher volatility, but generally favours the active manager.

Prime brokers will understandably welcome any developments that encourage more trading activity. Firms like Cowen, whose prime brokerage business is an integral part of its institutional offering, are singularly focused on ensuring they can help their active manager clients outperform to the best of their abilities and view themselves as an integral part of their alpha generating capabilities.

Among all prime brokers the collective belief is that sophisticated investors are always willing to pay for alpha. That said, the more experienced investors get at investing in hedge funds, the more discerning they become. By partnering with best-in-breed service providers such as Cowen, whose equities research team alone marks it out from much of the competition, hedge fund managers take confidence they can be supported in seeking out new sources of alpha.

Indeed, the role of manager and service provider (or partner) has become more integral than ever before, especially with respect to research capabilities. Under MiFID II, European managers will only be willing to pay for the highest quality research that they believe can justify the costs. In many ways this is game changer. Prime brokers will be under the spotlight more than ever on the issue of research. Quite simply, there will be winners and losers over the coming few years.

But that is not something to fear. As this industry has demonstrated time and again, necessity is the mother of invention. Service providers and managers will find new ways to work and collaborate to achieve the most optimal outcomes.

Firms like Invast Global, a prime-of-prime, have grown their multi-asset Prime Services offering very successfully over the past few years and has plans to expand, opportunistically, into other business lines throughout 2018.

The intention is to incubate a number of businesses as opportunities present themselves. This might include opportunities brought to Invast Global by Investment Bank executives who are looking to move their business to a more accommodative, flexible platform; or opportunities that its existing staff recognise themselves.

Invast has created an environment for intelligent, hardworking people to build businesses they are passionate about. Such businesses might include, custodian services, fund administration capital introduction, regulatory/compliance advisory, etc.

Some of the new product launches in the pipeline for the first half of 2018 include providing DMA connectivity to allow brokerages to offer access to a wide range of global exchanges to their private clients via the ubiquitous Metaquotes MT5 platform, as well as advanced plans to open offices in Hong Kong and London.

One point to mention on MiFID II is that many non-European managers think they are not impacted because they only focus on global equities or US equities and therefore won’t need to concern themselves with transparency reporting requirements.

What is more of an issue is that under this regulation, if you are a US-based manager operating managed accounts for European investors you absolutely will be impacted, no matter what strategy is being pursued. This is catching people out. The fact is, if they are coming to Europe to market their strategy in a managed account format to potential European investors it is regarded as a MiFID activity, in which case they must have some sort of MiFID representation.

This is playing into the hands of firms such as DMS Governance, who not only offers Management Company solutions to those wishing to operate UCITS funds and AIFs, but who also has a MiFID licensed entity. DMS is seeing increased demand among investors for MiFID representation.

A large pension plan might, for example, award a managed account mandate to an investment manager in New York, but in order for them to maintain that relationship they need to appoint a regulated MiFID entity; essentially DMS would enter into a tri-party agreement to oversee that managed account on behalf of both the investor and the US fund manager.

This illustrates how the vagaries of fund regulation can easily lead to unintended misunderstandings and also underscore the importance of selecting quality service providers. Outsourced trading platforms such as JonesTrading are only too aware of these regulatory developments, especially as MiFID regulated entities will need to demonstrate best execution is being achieved during the trade cycle.

The team at JonesTrading handles all allocation, execution and any trade reconciliation. It tracks all of its outsourced trading clients’ execution performance with a third party TCA provider called Markit. Indeed, JonesTrading has been recognised in the industry for many years for its ability to provide best execution to clients, sharing the results of each execution on a T+1 basis.

Aside from ongoing regulation, one issue that hedge funders will need to continue to monitor is the growing sophistication of cybersecurity attacks. COOs have to be on top of this and put proper working groups in place to run war room scenarios, practice drills and test their disaster recovery protocols. Once completed, they should be documented, detailing what the outcomes were and what steps were taken.

Simple fact is, investors expect this. They are asking for evidence of DR and BCP in their due diligence process. It’s not enough for a fund manager to say they have a WISP in place, or a cybersecurity program, they want to know how regularly it gets tested.

At one event I attended recently, I heard someone recall an anecdote about a hedge fund COO who, when asked about cybersecurity, responded, ‘I don’t need to worry about, I outsource to an IT firm’.

That would set the alarm bells off in any institutional investor. The merits of outsourcing are myriad but any COO worth the salt knows that outsourcing any function, including cybersecurity, simply does not mean that one can outsource their fiduciary responsibilities.

As cyber attacks evolve, hedge fund managers will no doubt continue to rely on the expertise of cyber specialists but they must ensure that the right culture and mindset is fermented internally, from top management downward.

The biggest budget line item for the SEC this year is for cybersecurity. It’s not necessarily expensive to engage with third parties on this to have a plan. But you have to have a plan.

2018 promises to be another rollercoaster ride for the hedge fund community. For all the challenges that come their way, plenty of opportunities will arise. Those with an open mind, a can do attitude, and a willingness to test new ideas – be it with new data sets, AI, hiring data scientists, etc – will continue to flourish. And wonder what on earth all the fuss was about.

So good luck and congratulations to all of this year’s award winners and be brave in your pursuit of excellence. 

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