London’s hedge fund industry is confident about its long-term future, but participants acknowledge that the year ahead is likely to be a difficult one, as managers adjust to the impact of 2008’s turbu
London’s hedge fund industry is confident about its long-term future, but participants acknowledge that the year ahead is likely to be a difficult one, as managers adjust to the impact of 2008’s turbulent markets and negative performance, as well as the ongoing surge in investor redemptions. But many are already looking ahead to a future rebound in institutional investment and are exploring new ideas that may provide them with an early opportunity to resume growth.
While providers of services and technology to the industry also acknowledge that the difficult market environment and economic climate are an issue, overall any enhancement of hedge fund operations, reporting and transparency that emerges from the current global regulatory rethink, as well as investor insistence, are likely to increase rather than diminish the role played by third-party providers and by technological aids to asset management and operations.
Right now managers are more focused on trying to build on December’s upbeat performance figures, which brought to an end a six-month losing streak for the industry, but there are no illusions about the difficulty of the current environment. “It’s going to be rocky for at least another six months,” says Andrew Baker, chief executive of the Alternative Investment Management Association. “There will be an evolution of strategies. Anything that relies on access to leverage will struggle.
“However, we believe the business model remains intact. A number of players in the industry could well go back to the strategies that were successful in the 1980s and 1990s before a lot of leverage was available. The hedge fund industry still has a very great deal to teach the traditional investment management industry in terms of efficient risk management and use of alternative instruments, and we see the convergence between the traditional industry and hedge fund techniques continuing.”
At least for now, it seems that one victim of the crisis is the long-running initiative by the Financial Services Authority to open up investment in funds of alternative funds to a more retail market. Launched more than three and a half years ago, the plan has been through repeated stages of industry consultation but at present it’s still not clear when the proposed regime will come into force. In the current environment, it’s certainly not a priority for the industry.
“I suspect it will remain on the back burner for the time being,” says Baker. “Retail investors are still redeeming their investments. Risk aversion is immense, and until people see the [authorities response to the problems made apparent by] the Madoff affair, I suspect it will be very difficult for a provider even with the perfect product to drum up a lot of demand.”
To some extent, providers have sidestepped the problem of authorisation of alternative products for a broad market by using the provisions of the European Union’s 2002 Ucits III directive to launch funds that use hedge fund techniques but benefit from the Ucits ‘single passport’ that allows unfettered distribution throughout the EU.
One such investment house is GAM, the London-based alternative asst manager owned by Swiss private bank Julius Baer, which has been examining opportunities to bring its range of single-manager funds to a wider investor base. “As long as the managers felt comfortable with the daily dealing aspect, which was something many retail investors wanted, we could convert some of our existing managers into the new Ucits III world,” says Matthew Lamb, head of Middle East wholesale and institutional clients. Most recently, in September the firm converted Ross Hollyman’s GAM European Systematic Value Hedge fund into a tax-efficient, daily dealing Dublin Ucits III fund.
According to Lamb, the key to the success of these products is that they are run by hedge fund managers with an absolute return mindset, rather than long-only managers that are being invited for the first time to add short positions to their portfolios. “Hedge fund managers can add value on the short side, even though they might not always deliver absolute returns,” he says. But more importantly, when they look at a stock or a sector, they are not thinking about its weighting in the benchmark.
“The Ucits structure will hopefully make that ability to generate alpha more accessible to the retail investor and multi-manager investors rather than just funds of hedge funds, family offices and high net worth individuals. What one has to avoid is long-only index-tracking managers jumping on the hedge fund bandwagon by launching Ucits III structures, as a lot of people are doing with 130/30 funds. At GAM we’re evolving our business rather than jumping on some new bandwagon, which is something we try to avoid.”
Service providers see as many opportunities as problems in the wave of change sweeping through the industry in the wake of the credit crunch, according to Guy Martell, head of business development and client relationships for alternative fund services in Europe at UBS Global Asset Management, whose London-based team deals with clients in Europe, the Middle East and Africa that use UBS’s service centre for alternatives in Ireland.
Martell believes that the industry turbulence is already encouraging managers and their investors in a flight to quality with regard to service providers, although he says this may benefit not only big players with a global reputation but niche administrators that “have a strong value statement and specialise in certain strategies and specific parts of the value chain, in terms of both services and products”. However, he adds: “More enhanced due diligence could potentially provide a challenge to some smaller administrators.”
He is doubtful about whether investors and managers are necessarily looking for the one-stop shop for prime brokerage, administration and custody promoted by some global providers. “The more you can demonstrate the independence of each service provider, the greater the operational integrity of that infrastructure,” Martell says. “Where prime brokers operate under the same roof as the fund’s administrator, that does not necessarily impair in any way the independence between the functions provided by that organisation, but they are likely to be asked those questions more in the future.”
However, Nick Roe, head of prime finance at Citigroup, says that being able to offer a comprehensive range of services is opening up new types of opportunity in the alternative investment market. He points to the agreement announced late last year with Danish pension scheme ATP to implement an alpha-based investment strategy that Citi had already helped to devise in a consultancy role.
Says Roe: “We have now helped ATP launch its first fund, a Luxembourg Sicav for which we are the prime broker, fund administrator and custodian, and they will continue to launch a series of funds over the next few quarters. Now other pension schemes have seen what ATP has done and want to do the same.
“This is where prime brokerage will evolve. What we can achieve with the holistic packaging of all the products within Citi for alternative asset managers is very compelling. For pension funds, there’s only one place to go for this suite of services, a bank that has the technology to put on your desktop, the prime brokerage and hedge fund administration ability, custody and structured products. We’re now able to offer packaged services in which we work very closely with our partners in other areas of the group.”
One important result of the events of the past year, according to Roe, is that hedge fund managers have paused in their rush to develop multiple prime brokerage relationships. Previously, he says, managers saw the value of having as many as four or five prime brokers in order to increase the efficiency of their funding, and to exploit the strength of different institutions in particular geographical regions, economic sectors or asset classes.
But now things have changed, and not only because hedge fund managers have been forced to confront for the first time the possibility that a prime broker might go bankrupt. “Now they can’t be with five prime brokers because two of them want to get out of the business or haven’t made their mind up whether they should be in it,” he says. “Plus assets are reduced by 50 or 60 per cent and [the funds] are no longer meaningful enough to those five prime brokers to exert the power of the commission dollar.
“So they need to rationalise those prime brokers down to one or two really meaningful partners whom they can trust in credit terms and which can provide as much as they can possibly get in terms of finance, global reach and product mix. They need solid partners in a time of volatility, so managers are consolidating rather than diversifying.”
Meanwhile, the renewed focus on due diligence and also the closer examination of fund managers’ operational capabilities is opening up new opportunities for providers of technological solutions geared to the industry, according to Mark Rice, a senior vice-president in the Tamale business unit acquired last autumn by Advent Software. Tamale, which enables firms to centralise and organise research materials of all kinds in a central resource, was launched in the US in 2004 and is increasingly gaining traction among European managers, he says.
“This concept of total knowledge management has been bolstered by the recent market turmoil,” Rice argues. “In the past hedge funds were often dependent upon a single prime broker, but now they have diversified that are being forced to do themselves things that they hadn’t done before. They’re buying Advent accounting systems because they need to track all their own investment positions and carry out reconciliation. They also have to be more diligent in the way they choose and monitor their prime brokers, and in the investments they are choosing.”
He says the effects of these trends are visible throughout Advent’s business. “Sales of Geneva have really accelerated, again because of the need to be more self-reliant. UK hedge funds have always been a bit less reliant on their prime brokers than those in the US. They were always required to have an internal system, but we’re seeing more demand for the ability to calculate the full net asset valuation of the fund to check up on the providers.”