By Marianne Scordel – When we wrote about the European hedge fund industry a year ago, we described several long-term trends that had emerged recently and were contributing to the re
By Marianne Scordel – When we wrote about the European hedge fund industry a year ago, we described several long-term trends that had emerged recently and were contributing to the reshaping of our industry1. The three major points on which we decided to elaborate – namely, the existentialist crisis impacting various strategies, AIFMD-related changes, and the decline of the FoHF model – have since persisted and, in some cases, become more specific.
However, what we have noticed more recently is a somewhat more optimistic outlook, against which those same trends must be interpreted and reassessed: if a higher number of HF closures than new launches have characterised the past twelve months, overall AUMs grew substantially in Europe, helped by the popularity of UCITS hedge funds. Are the green shoots we identified last year growing into some unexpected shape, due to the recent mildness of a previously erratic clime?
AuM growth, UCITS and market sensitivities
The past twelve months saw more hedge fund closures than new launches in Europe, a fact which comes in sharp contrast with what had been observed during the previous years. A recent study from Eurekahedge2 confirms that “the rate of fund closures […] has been trending steadily upwards every year since ”, and various sources concur to estimating the number of hedge fund closure in Europe to be about 400 funds throughout 2014. While this number went up steadily during the past four years, it is only last year that closures came to exceed new launches.
Behind this apparently negative observation3 characterising the European hedge fund industry over the past twelve months hide a number of facts, some of which point to a rather optimistic picture and to a clearer outlook of the long-term changes within the industry:
• The AUMs of hedge funds managed by Europe-based managers grew by approximately USD33bn in 2014, which brings the total AUMs of our regional industry to just under USD500bn. This confirms two trends which we had previously identified or predicted:
– The combination of net closures and AUM growth does point to some consolidating activity: it is indeed the case that large funds tend to be getting larger. We had observed this previously and this is broadly acknowledged, not least by managers of emerging funds, who are having difficulty convincing investors of their attractiveness in spite of their smaller sizes.
– Net inflows, rather than performance, are responsible for a substantial proportion of this AUM growth: in a recent investor survey4, we found that investors were willing to start again looking at European managers, an activity they had slowed down due to the areas of uncertainties surrounding AIFMD and also as a result of challenging markets. The recent numbers confirm that this has indeed started to happen in practice.
• The total number of hedge funds present in Europe may have decreased, however changes both in hedge fund numbers and in AUMs repartition are unevenly split, particularly between UCITS and non-UCITS. Again, we had previously highlighted this trend, which started at the beginning of the global financial crisis but really accelerated in the past two years:
– Last year, Keith Black, PhD, CFA, CAIA, managing director of curriculum and exams for the CAIA Association had said: “Alternative assets in UCITS format were EUR40.9bn in 2008, EUR84.9bn in 2009, EUR125.3bn in 2010 and EUR156.7bn at the end of Q3 2013, which addresses a demand for liquidity, particularly in Europe5”. This year, Dr Black6 is reconfirming this by explaining that 2014 saw a USD70bn inflow into alternative UCITS – which brings the AUMs of UCITS funds to about the same level as assets invested in European non-UCITS hedge funds, for the first time ever.
– Worldwide, Dr Black indicates that liquid alternatives currently hold assets worth a total of USD600bn, split between Europe and the US, versus USD2.9trn for the conventional hedge fund model. This confirms the view that European investors are relatively more biased in favour of the continent’s home-grown version of the liquid alternative than their American cousins; while the traditional offshore and less liquid model remains strong on the US continent, the question of this model’s future in Europe is worth asking.
• Finally, the inflow of new investment varied not only in terms of vehicle, but also when looked at as a time series, thus highlighting the importance of the economic cycle and investor’s reactions to the state of the market.
– The fluctuation materialised as follows: “Investor interest in the Euro zone was revived in 2013 amid improving macroeconomic fundamentals and rallying markets as the region began to emerge from the depths of the crisis. Q1 2013 to Q2 2014 saw a sharp rise in the region’s AUM, with six straight quarters of investor allocations during this time totaling USD98.7bn, accompanied by strong performance-based gains of USD28.2bn for the same period. Growth stalled again in the second half of 2014, with net flows reversing into negative territory while performance has been muted.7”
– This pattern is a healthy reminder of investors’ sensitivity and speed of reaction to market movements when it comes to their investing in hedge funds. While we previously looked at this phenomenon from a qualitative perspective8, the point here is also to nuance, and to shed a new light, on the optimism we have observed and read about concerning the renewed appetite for European funds as mentioned above: the extent to which this can be expected to last or to fluctuate depends on the strength of the relationship between market movements and hedge fund investors’ decisions, and on the predicted degree of fluctuation according to that relationship.
From the above, it appears that our consolidating industry is still undergoing the changes that will result in a transformed landscape compared to the one that prevailed until a few years ago. Those long-term trends are not new, and are essentially the result of demand and supply, themselves the product of historical as well as more contingent factors. In spite of the fact that these trends are not new, they now come across differently to what they did only a year ago, in the light of the investors’ renewed (albeit cautious) optimism and of the resilience of the UCITS framework. A product differentiation from the point of view of investment strategies has also been one of forces shaping our industry, with ongoing developments and consequences.
European strategic specialities
In the above, we noted the trend we had highlighted previously, and according to which Europe was characterised by a greater desire for liquid products: in Europe more than elsewhere, the degree of convergence between the conventional hedge fund model and the liquid alternative framework has accelerated, to form a greater pool of products available to the same investors. We also highlighted that there had been a net investment inflow into funds managed by European managers. Three points are worth making in that respect, each of which relates to some specific investment strategies or mandates.
• The correlation between strategy performance and investment inflow is not always high – in the above we referred to a point previously made according to which investors have reacted to market movements in a way that may have been backward looking in certain cases, allocating to long only strategies after equity markets had gained momentum, for instance. Here we discuss and nuance this point in the light of allocations versus performance over the past twelve months in Europe:
– In our recent investor survey9, we found that investors were still being cautious following the CTAs’ existentialist crisis which started in 2013. While an industry participant observed that the performance of CTAs were strong in 2014, we maintained our view, which was supported by the fact that CTAs were a little bit in the situation of a student who, after being best in class forever, suddenly showed signed that they, too, could suffer from relative weakness. The recent Eurekahedge study10 confirms our view when they say: “CTA/managed futures funds saw a rise in popularity in the wake of the 2008 financial crisis due to their low correlation with traditional market indices, as their market share rose significantly to 15.7% in 2011 from 13.6% in 2009. However, this trend has reversed in the years since 2011 as investors have begun looking for alternatives after a lengthy period of lackluster performance from CTA/managed futures funds, resulting in their share decreasing to 10.4% as at October 2014”.
– Other strategies have, on the contrary, confirmed the strength of the relationship. Thus, the Eurekahedge study includes the following point: “Fixed income strategies have witnessed strong asset inflows, gaining a remarkable 12.4% since 2009 to stand at 19.4% of total European hedge fund AUM in 2014, with investors being drawn by the steady, modest returns afforded by fixed income hedge funds. The Eurekahedge Europe Fixed Income Hedge Fund Index was the top performer on a risk-adjusted basis, with a three and five year Sharpe ratio of 2.01 and 1.60 respectively”. While the study factors in appetite for risk, it also says elsewhere that fixed income is the second top performing category among the funds managed by European managers, with a return of 4.32% in 2014.
• A European version of activism? – In Europe, we are continuing to observe local managers’ difficulty to compete with the US equity long / short product offering, particularly as far as the subcategory of activism is concerned: similarly to last year, the European ranking contains no managers in that category, due to overall poor performance and relative lack of savoir faire. Conversely, we continue to see a concentration of high performers among merger arb fund managers in Europe, a category which, perhaps coincidentally, fits rather well with the UCITS model. Qualitative as well as quantitative data supports the idea of European managers having some sort of specialists’ skills:
– In October 2014, Eurekahedge stated: “The top performers [among European hedge fund managers in 2014] were event-driven funds (up 4.39% YTD), followed by fixed income (rising 4.32%) and CTA/managed futures (gaining 2.93%). Multi-strategy and long/short equity funds were the only mandates with October year-to-date returns in negative territory”.11
– This echoes a debate that went on throughout last year, questioning the lack of strong activists in Europe – a debate which was fed not only by the lack of strong performers among European managers in that category but also by the (related) interest of well-known American activists in our markets. A land of relatively-smaller funds, a culture that does not favour such a style, indeed a need for lock-ups that contradicts European demand for liquidity, may all be arguments contributing to explaining why Europe has not produced great results in that area12. On the contrary, as the above point states, event-driven funds are doing well, and, according to some managers, it is they who sometimes try and use the “activist brand” in an attempt to woo investors and to blur a picture which, in Europe and for this type of question, in rather black and white.
• The attractiveness of European markets as investment targets – We mentioned above that European managers attracted a net inflow of capital; and we note elsewhere that it was European investors’ intention to allocate more capital in the next twelve months than it did last year13. This renewed activity is confirmed by Eurekahedge’s latest study which dedicates one of its sections to geographical mandates: “[European] hedge funds with a global mandate are the largest constituent at 61.4% [of the European hedge fund industry] in October 2014, although they have seen a fall of 8.2% in their share since 2011. Conversely, European focused funds were the biggest gainers, expanding their market share by 7.3% since 2009 to 29.0% currently”14. An interest in European assets, from European investors, as well as from investors located elsewhere, may be the sign of investors seeing the green shoots in our markets after a European winter that lasted so long.
Life after the AIFMD
In 2013, various studies were pointing to certain investors refraining from considering funds managed by European managers for the purpose of allocating assets, and to many European investors having concerns regarding the marketing rules under the AIFMD15.
Towards the end of 2014, our annual investor survey found that many of these investors had decided to invest regardless, even though many of the same rules had not yet become clearer. While this may explain part of the increase in allocation mentioned above, from an observation point of view this also allows one to start and envisage what our transformed industry may look like in the post-AIFMD world. We have identified three main points:
• The new offshore – Many are currently wondering whether the passporting options under the AIFMD – only available when a fund is incorporated onshore, i.e. in the EU – will redefine the European hedge fund landscape in the sense that jurisdictions such as Cayman or BVI may soon be replaced by countries such as Malta or Cyprus.
– Countries such as Ireland or Luxembourg, traditional homes to UCITS funds are now being considered as potential jurisdictions for non-UCITS funds to an extent that had not been the case previously. Whether this trend will persist and grow remains to be seen and lawyers we have spoken with agree this is an open question for now.
– As mentioned above, the popularity of the liquid alternatives in Europe is also driving many funds onshore, which, all taken in combination makes one wonder about the relevance of the offshore (e.g. Cayman) model as far as European managers are concerned: with US laws surrounding tax and transparency becoming more stringent, many European managers choose upfront not to accept US investors, which compounds the possibility of the offshore model falling completely into disrepair in Europe. Whilst this remains to be seen in practice, this also acts as a reminder of Europe and the US being two different markets, a point we have explained elsewhere in more detail.16
• Private investors – Related to the fact that the AIFMD is in the process of changing the European hedge fund landscape is the possibility of the return of private investors to the hedge fund world. While we have said (above) that European hedge funds had seen a net increase in investments, a qualitative analysis of this inflow could reveal to what extent our survey17 findings were accurate: we had predicted a renewed interest in the asset class on the part of private investors, which would be a way of for the industry to come back full circle, after the sector’s institutionalisation since the beginning of the financial crisis. A more regulated, and hence “safer” environment, the existence of a new middle ground with the proliferation of the converging alternative UCITS model, both concur to explaining why private investors may be returning to hedge funds as an asset class.
• Cap Intro – We had previously mentioned how this function, which has traditionally pertained to the prime brokers’ area of added value to clients, was changing. The AIFMD’s uncertainty towards marketing rules is, in this case, only part of the equation: while regulatory grey areas do remain of concern, the commercial dynamics impacting the PB business, the relative scarcity of capital over recent years, and the fact that many clients now fall outside the perimeter within which they would be offered those cap intro services have led to other ways for managers to meet investors: IT-based solutions, specialist publications hosting events for the purpose of such encounters between hedge funds and their potential investors, have been new ways of exploring the potential gap PB cap intro teams will have left behind. It is our belief that these solutions will continue to develop and to evolve, and we will keep watching this space, as the new European season emerges.
Marianne Scordel, a specialist contributor to Hedgeweek, 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 a co-chair of the Legal Issues Special Interest Group at CFA UK and an Alumna of St Antony’s College, Oxford.
3. A recent Reuters article elaborated on it: www.reuters.com/article/2015/02/16/hedgefunds-europe-closures-idUSL3N0U62N620150216.
4. Soon to be published in Hedgeweek.
6. Dr Black is using data from www.ucits-alternative.com.
8. In www.hedgeweek.com/2014/04/01/199431/european-hedge-funds-age-wisdom we discussed the occasionally “backward looking” behaviour of certain types of hedge fund investors.
13. In an article soon to be published in Hedgeweek.
17. Published in Hedgeweek.