The second part of a report released by Deutsche Bank in September 2014 reveals that investor allocations to US alternative mutual funds currently stand at 24 per cent; up from last year’s figure of 13 per cent.
The report, entitled From Alternatives to Mainstream Part Two, surveyed 86 hedge fund managers representing USD6trn in combined assets and 212 investors that collectively manage and/or advise on USD804bn in hedge fund assets. Since 2008, assets have grown 38 per cent on an annualised basis and since end-2013 they have grown 18 per cent (through May 2014).
“Since 2008 I really can’t think of any other part of the asset management industry that has grown so much. However, you have to remember we are coming from a low asset base. Total AuM for ’40 Act liquid alternatives is USD300bn, which is not much compared to the USD2.8trn offshore market. It’s approximately the same for alternative UCITS in Europe, which have grown from EUR36bn to EUR236bn between 2008 and 2014,” says Anita Nemes, Global Head, Hedge Fund Capital Group at Deutsche Bank.
Significantly, the report found that nearly two thirds of investors allocating to ’40 Act liquid alternatives plan to increase their allocations over the next 12 months. Approximately 51 per cent said they currently invested in one of these products. It’s this level of demand that forms part of the survey’s key narrative.
“When we asked managers why they were launching liquid alternative funds a significant percentage (41 per cent) said they were doing so because of demand from existing investors. As the industry matures hedge funds are increasingly finding solutions for clients rather than offer a one-size-fits-all product,” says Nemes.
Indeed, on the supply side the survey found that 42 per cent of managers currently offer a liquid alternative product, up from 27 per cent last year. As Nemes confirms: “We have seen that larger clients seem to be at the forefront of liquid alternative fund launches – two thirds of those surveyed with USD5bn-plus in AuM manage liquid alternative funds, and one third of those managers said they planned to launch at least one new product over the next 12 months.”
David Kabiller is the co-founder of hedge fund firm AQR Capital Management. They launched their first mutual fund back in January 2009. Kabiller was quoted in the Financial Times saying “we see an opportunity because there is a need”. The mutual fund division headed up by Kabiller now accounts for USD13bn of the estimated USD90bn in total assets at AQR.
However, it’s important to keep perspective. If one looks at the types of managers who have launched these products, along with AQR, Arden, Blackstone, Carlyle Group and KKR they largely consist of big traditional mutual fund players: Wells Fargo, Neuberger Berman, Fidelity.
This remains largely the preserve of the big boys; those with a recognised brand name, reputation and who can tap in to substantial distribution networks.
“The liquid alternatives market is growing but we are not personally seeing interest among our hedge fund clients,” says Ted Jasinski, General Manager of Admiral Administration (US) LLC, the alternatives administration arm of Maitland Group. “One manager said to me, ‘Why would I choose not to earn 1.5/20 just to get the assets and face even more reporting?’”
Jasinski is well aware of convergence taking place but says that people need to look at the wider picture.
“Your average hedge fund manager doesn’t want to offer two products because their hedge fund investors have certain performance expectations which they are paying fees for. They don’t want to antagonise them by going off to launch a retail product. That said, some of our hedge fund managers are acting as sub-advisors to multi-manager liquid alternatives. What they aren’t doing, at least currently, is going off and launching liquid alternatives separately to their hedge funds.”
Nemes points out that the number one concern (32 per cent) among managers over launching liquid alternative funds is asset raising, while 30 per cent cite concerns over cannibalising their existing fund(s) because of the low costs.
“Asset raising is the biggest challenge because the audience is one that hedge fund managers are not familiar with; that’s why they many of them are teaming up with mutual funds who have extensive experience,” says Nemes.
Jasinski believes that, aside from the cannibalisation issue and lower fees, another reason why managers might be reluctant to launch ’40 Act funds is that they won’t be able to replicate the same level of performance as their offshore fund.
“We have one USD200m long/short equity manager who said that they were approached by eight to 10 liquid alternative providers over the past couple of years. They turned down every one, even with the opportunity of receiving a USD500m allocation.
“The manager in question made a couple of points; firstly, they’d earn half the amount in fees, they’d have to provide additional transparency and reporting, and they would potentially antagonise their existing clients. They didn’t want to jeopardise the growth of the offshore fund by adding a product that would limit the effectiveness of their trading strategy.
“That’s a good sign. It shows that managers aren’t necessarily chasing assets. They understand what it is that makes them effective; they don’t want to sell out and offer a retail product just for the sake of it,” comments Jasinski.
Martin Sreba is Senior Director, Global Solutions Management & Sales at Advent Software. He makes the point that investor protection is a key aspect in the US. In other words, managers need to think very carefully before launching a regulated fund. Indeed, the SEC has begun its sweep of between 25 and 30 alternative mutual funds launched by high-profile names to ensure that these funds are being run properly.
“In the US, even though the underlying design of Form PF is to monitor systemic risk behind the scenes these reports are forcing managers to be much more aware and sensitive to investors’ awareness and understanding of their funds. It’s no longer a black box investment philosophy. Everything has to be reported.
“Launching a ’40 Act fund will simply push this regulatory obligation to the next level. If these funds want access to the USD15trn mutual fund industry they will have to be more compliant and I would almost go so far as to say that Dodd-Frank regulation and Form PF has prepared hedge fund managers for this next level of compliance where ’40 Act is an even stricter regime,” opines Sreba.
One of the most successful managers to run a registered fund-of-hedge-funds in the US is SkyBridge Capital. SkyBridge Multi-Advisor Hedge Fund Portfolios LLC – Series G launched back in 2003 under the ’40 Act but unlike an alternative mutual fund it is only available to US accredited investors. The fund also provides quarterly liquidity.
The fund currently comprises 37 managers, with the Paulson Recovery Fund at 12.69 per cent currently representing the largest position in the portfolio.
Through 2014 the fund has continued to attract significant investors from high net worth investors. Series G sits on 16 different platforms including the likes of Morgan Stanley and Bank of America Merrill Lynch. Through August the fund has returned 5.38 per cent (net of fees).
With respect to how Series G has performed over the last two years, Max von Bismarck, partner and CEO, Europe at SkyBridge Capital says that in 2012 the portfolio was 80 per cent skewed towards cash flow generative strategies and only had 20 per cent exposure to catalytic strategies.
“In 2013, approximately 43 per cent of the portfolio was turned over as we became more constructive on US equities. Subsequently, there was a rotation out of debt into more idiosyncratic equity strategies.
“Event driven strategies increased from 15 per cent to 40 per cent in the portfolio. If we hadn’t have done this, and retained our exposure to credit-based strategies, we would have generated roughly 500 basis points less in the fund in 2013,” confirms von Bismarck.
“With equity markets expected to experience a 10 per cent correction at some point in the near term, the SkyBridge investment team reduced the level of directionality in the fund at the start of 2014.
“The M&A market is still good for event-driven managers but we’ve moved to reduce market beta in the portfolio and have rotated out of long-biased managers. The portfolio exposure to event-driven managers remains at 40 per cent, it’s just more market neutral than it was last year,” confirms von Bismarck.
One of the first firms to enter into a partnership with a traditional mutual fund manager to launch a multi-manager alternative mutual fund was Arden Asset Management LLC. Back in 2012, Arden teamed up with Fidelity’s Portfolio Advisory Service to launch the daily liquidity Arden Alternative Strategies Fund, an open-end mutual fund that gives investors access to a portfolio of hedge fund managers.
Speaking at the time, Averell Mortimer, President and Chief Executive Officer of Arden said: “Delivering greater access and choice is clearly the wave of the future and we believe our programme is an excellent way to add portfolio diversification and represents a landmark in expanding the investable universe for retirement assets. We think this fund is a real game changer.”
It seems to be working. Not only has the fund exceeded USD1bn in assets, Arden have since gone on to launch a second product: Arden Alternative Strategies II Fund. The multi-manager fund is available for a minimum investment of USD1,000. Through June 2014 the fund was up 2.90 per cent. Arden declined to comment on the fund.
Service providers have been quick to develop solutions to support those managers wishing to get active in the ’40 Act fund space. US administrator UMB Fund Services has developed two products suited for managers interested in the growing liquid alternatives space says Jill Calton, managing director at UMB Fund Services. Both are turnkey solutions designed to help managers launch new products.
“We offer the Investment Managers Series Trust – a turnkey solution for establishing a mutual fund. We help with everything from product education through to launch and distribution, which takes around 120 days. In addition, we’ve developed Registered Fund Solutions, a platform for managers who wish to launch registered hedge funds,” says Calton.
Note that a registered hedge fund here would be akin to the Series G onshore fund-of-hedge-funds run by SkyBridge; not a mutual fund but still regulated.
“We are seeing demand for both products,” confirms Calton. “Our Series Trust, for example, has experienced significant success and we’ve recently launched a second trust for new advisors. In fact, many of the most recent funds to launch within our trust would be considered liquid alternatives.”
Advent Software’s Martin Sreba says that the number one operational challenge to running a ’40 Act fund is the ability to handle complex asset classes.
“That has not been a strong suit of a lot of legacy systems. The ability to natively handle these asset classes is critical for producing accurate valuations and exposures – not just market risk exposures but also to different counterparties, which is what the regulators want to see.
“Also, running a ’40 Act fund requires constant compliance. These products have specific rules regarding portfolio construction. You have to develop a cookie-cutter regime to constantly monitor the fund and that requires a lot of real-time information to capture to understand the real-time risks you and your investors are exposed to,” says Sreba.
Given the tight pre- and post-trade controls that will need to be in place to remain within strict investment parameters Sreba suspects that the barriers to entry will likely be quite high.
“The cost of systems to effectively monitor everything throughout the trade lifecycle will be high. Managers will need to become much more institutional by nature,” suggests Sreba.
Interestingly, one area of activity that Jasinski is seeing at Admiral Administration is an increasing number of fund-of-one launches by institutional investors. In many ways, these are a cross between a ’40 Act fund and a hedge fund: they provide superior transparency, more investor control and better liquidity provisions.
“We are seeing a range of these products launching, spanning vanilla fund-of-fund assets all the way through to more esoteric assets. For example, structured finance, asset-backed loans – airplane leases, farm leases, container leases, entertainment royalties. We’ve seen some interesting launches and it’s been a good area of growth for us. We’ve just broken through USD30bn in AuA and we anticipate being able to double that in the next three to five years,” says Jasinski.
If the supply/demand curve for liquid alternatives in the US continues its exponential rise there will certainly be plenty of opportunities for managers and service providers alike to enjoy a bigger slice of the pie.
In conclusion, Nemes reflects on the situation by saying: “A lot of hedge funds have become true asset managers today. They’ve got the infrastructure in place and sizeable investment teams. If they feel that their investors are interested in liquid alternatives, and it’s a product they can develop and deliver the right level of expertise then it’s a way for them to first grow their business and diversify the revenue stream.”