Hedge funds have finally enjoyed a sustained period of good performance over the past 12 months, going some way to assuage investor concerns. The HFRI North America Index is up 5.54 per cent YTD, and up 8.68 per cent over a one-year period; slightly higher than the HFRI Fund Weighted Composite Index (7.16 per cent).
With equity markets continuing their bull run, it is proving to be a blessing for equity-focused hedge fund managers. On 12 October, the FTSE 100 index reached a record-high, closing at 7,556.24, largely in response to Brexit negotiations pushing the price of sterling lower. Since July 2016, the FTSE has recorded gains of 23 per cent.
Equally, the S&P 500 has gone from strength to strength. The market closed 19th October at a record high of 2,562.1, thanks in part to strong earnings growth. Apart from a slight dip in 2015, the forward P/E ratio for S&P 500 stocks has steadily risen since 2011 from approximately 10 to 181 (as of 19th October).
It is, therefore, perhaps no surprise that equity strategies have dominated new launch activity in the US this year.
“We are seeing four times as many equity fund launches as compared to anything else,” confirms Frank Napolitani, Director, Financial Services at EisnerAmper LLP. “Typically, with concentrated portfolios – 20 names or fewer – covering global equities, US equities and specific sectors; for example, Financials and TMT.”
Napolitani thinks the continued bull market is undoubtedly giving new managers the confidence to launch. “Investors have given these prospective managers an indication that they would invest with them. However, I am not a market prognosticator and I don’t know when this market is going to turn, but eventually it will turn, and I believe we’ll see a rotation away from Equity Strategies and into Macro and Distressed Funds.
“That said, a lot of assets are going into ETFs, which could explain why the market upswing has been exacerbated in recent times. However, ETFs could also exacerbate the downturn. I don’t feel there is an impending cataclysm on the scale of ’08 but I do think the market is due a correction,” suggests Napolitani.
With equity markets getting `toppy’, there is a genuine risk that those who fail to develop short position programs in their portfolios – not simply going long and using an index overlay to hedge the market – could get caught with their tails between their legs. Many get seduced by benign markets, forgetting that investors want to see the manager’s skill at generating alpha on the short side. Investors aren’t paying fees for managers to just go long.
Those that can present case studies on how their made money on the short side – in equity or credit markets – against the headwinds of a rising market will undoubtedly catch the attention of allocators; and really prove their worth when shorting in a market tailwind following an inevitable correction.
“Someone who can actually make money on both sides of the market – not just go long 20 or 30 names and short an index because to me that’s not a hedge fund – will stand out to investors,” adds Napolitani.
One prominent Boston-based hedge fund manager, who asked to remain anonymous, tells Hedgeweek that in this environment, the team spends time looking in out-of-favour sectors of the market which are often down by 50% or more over the prior year, by the time it looks at them, citing generic pharmaceuticals is one good example.
“As such we are less concerned whether the P/E for the market overall is above a certain threshold. Provided something is going wrong somewhere in the world – and usually there are several such disruptions – we have opportunity sets to look at,” he says.
The manager in question has a strong security-specific short credit book, coupled with its long book, pursuing a global mandate to buy debt and equity in companies facing reorganisations, restructurings or difficult-to-analyse situations. Aside from generic pharmaceuticals, coal and Greece have also proven to be effective alpha generators in 2017 for the manager.
He says that the firm’s approach to shorting ensures any losses from the short book are capped, even in a “raging bull market”. “We short primarily via CDS – all single name, alpha shorts, but using what effectively amounts to five-year puts. So we know we can never lose more than the premium we’ve agreed to pay. Usually that is in the order of 0.5-1.0 per cent per year if nothing goes our way.”
Interestingly, in terms of where the smart money has been going this year, global macro has been a clear benefactor. According to Preqin’s figures, hedge funds attracted approximately USD25 billion of net inflows for 1H17, of which Macro strategies attracted USD13.5 billion.
Global macro attracts most inflows
The latest figures from Preqin also show that 71 per cent of new fund launches in Q2 2017 originated out of New York. And there have been some substantial launches: Brandon Haley’s Holocene Advisors LP, for example, went live this April with USD1.5 billion in AUM, while Ben Melkman’s Light Sky Macro launched with more than USD1.5 billion also.
Discussing the global macro inflow figures, Jorge Hendrickson, Head of Sales and Business Development at Opus Fund Services in New York says that whenever there’s money flowing into a certain strategy “you probably assume that there’s going to be an uptick in new launches. Managers see it as the right time to strike out if they can see that investors are actively allocating. Following this logic, I have to say that we haven’t seen that many new launches in the global macro space, as we have in other areas and sectors, so these capital inflows must be going to more established managers. The markets are certainly very macro-themed, but we have also seen money flow to well performing equity strategies, private equity, venture capital, real estate and lending strategies,” says Hendrickson.
According to Hedge Fund Research’s latest newsletter, Macro strategies led inflows for Q3 2017. They point out that “macro funds collectively received net inflows of USD4.2 billion for 3Q17, bringing YTD inflows to USD10.2 billion and total Macro capital to USD587 billion. The HFRI Macro (Total) Index posted a narrow gain of +0.4 per cent for the third quarter, though the Index has declined -0.4 per cent YTD for 2017.”
Christopher Riccardi is Partner at Seward & Kissel LLP in downtown New York. He says that the firm has seen a steady flow of new managers this year, though slightly down on previous years.
Most of the managers who have successfully launched this year, says Riccardi, are mostly spinning out of existing successful hedge fund firms and have a high pedigree.
“I think investors are being a little more choosy over who they allocate money to but the start-up market is still good,” says Riccardi.
Asked to comment on whether today’s record-breaking market levels make it more difficult for managers to launch and still expect to lock in good levels of outperformance for their investors, Riccardi says: “I think the market’s bull run has made it difficult for new launches and the lack of volatility has contributed to lack lustre returns. Allocators are a little cautious. It’s hard for them to evaluate and judge a manager’s performance when the market has only been moving one way for such a long time.
“Managers do therefore face a difficult time launching today, because all the signs are that the market has to correct itself at some point. I think that’s why we are seeing interest growing in cyptocurrencies, as these have not yet shown correlation to broader markets.”
Rise of cryptocurrency strategies
Cryptocurrency funds have certainly become a new trend this year, helped by the higher profile of bitcoin, and the numerous cryptocurrency proofs of concept being developed by investment banks; Goldman Sachs, for example, has developed SETLcoin, a cryptocurrency settlement system.
Still very much in their infancy, cryptocurrencies are beginning to be used by hedge fund managers in parts of their portfolios to try and juice returns before the end of the year.
“Managers are skirting around the edges right now. People are still trying to figure out how this works. There are competing arguments. Some Wall Street CEOs, for example, think it is a complete fad. I think the jury is still out on the long-term viability of this asset class,” says Riccardi.
Service providers are busy getting up the curve on this new market development, with a view to coming up with industry best practices.
“Fund formation attorneys, administrators, audit and tax firms – those are the core providers who are going to have to figure out what is going to be required from these funds, in order to figure out how to service them,” says Hendrickson.
“We’ve probably spoken to 30+ cryptocurrency funds in the last couple of months. We are selectively onboarding a few, but the service community is certainly going to have to come together to work out how best practices can support these funds to ensure that nothing is being overlooked. There needs to be regulatory and procedural guidance around the trade life cycle, verification of assets and custody, pricing and valuation of the assets, investor AML/KYC, and confirmation of beneficial ownership of assets.”
Napolitani says that until there is regulatory oversight for these funds, “we have taken the position that we will not audit them”.
Nick Rogers heads the Cayman Digital, Blockchain and Fintech Group at Ogier, a leading off-shore law firm. He says that within the group, they have developed specialist understanding of the particular issues that arise including around custody, intra-day dealing, valuation and regulatory and compliance issues.
“At this stage in the evolution of cryptocurrencies, there are still quite a few barriers to entry – e.g. regulatory treatment, limitations on short selling, volatility, technical complexity – but even if the Initial Coin Offering (ICO) market cools it seems clear that blockchain applications and digital currencies offer the key to future financial innovation.
“Institutional investors will get themselves comfortable investing in these technologies and that will unlock a huge amount of investment that will fuel their growth,” says Rogers.
Unlisted closed-end funds
On the structuring side of things, one trend that is emerging, more so among large institutional hedge fund and private equity managers running complex strategies, is to establish unlisted closed-end funds as an alternative to daily liquidity alternative mutual funds.
Managers would like the opportunity to go downstream and attract more retail investors but in a way that avoids cannibalising their existing investors. This is possible with a tender-offer fund, which can charge performance fees yet still offer a lot of the benefits of a registered ’40 Act mutual fund; unlimited numbers of investors, transparency, board governance and so on.
“A lot of the firms we see that are moving into this space are already fairly diversified in terms of what they offer,” says Tony Fischer, President, UMB Fund Services. “For these big blue-chip managers, their flagship products are typically limited partnerships but they understand the need for a hybrid solution. An interval fund or tender-offer fund is just another lever for them to pull to attract a certain type of investor.”
Fischer believes that investors are looking for diversification and the illiquidity premium that a private fund would give them, and are, as a result, moving away from traditional liquid alternative funds that are still quite highly correlated to the market.
“These managers face a number of constraints: daily liquidity, daily redemptions, they have to manage their portfolio in adherence with the investment strategy yet all of this operational activity disrupts their ability to generate alpha,” says Fischer.
“A lot of managers are looking for a solution that is close to a liquid alternative product but doesn’t hamstring their ability to hold true to the underlying strategy by having to make daily redemptions. This is why the interval fund structure is becoming increasingly appealing.”
In an interval fund, the manager can take daily subscriptions, but they can limit redemptions to a quarterly timeframe, and also limit the amount: up to a maximum of 25 per cent of the fund’s AUM.
“We are finding mutual fund managers running liquid strategies who cannot afford to exit positions to satisfy the requirements of a ’40 Act fund. These structures give managers the flexibility to gather assets and limit the frequency of redemptions,” says Fischer, confirming that UMB Fund Services currently services approximately 20 per cent of the estimated USD41.7 billion in these products.
Fee structures
Across the board it would appear that fee structures are holding fair, at least when it comes to looking at emerging managers. Much has been written about fees collapsing.
However, according to an industry survey2 published this summer by AIMA in partnership with GPP, a London-based boutique prime broker, which looked specifically at some of the challenges and opportunities facing emerging managers, whilst fees are under pressure they are not collapsing.
“Some 14 per cent of respondents said they are charging 2 per cent or more. Half of respondents were at 1.5 per cent or more and 90 per cent are paid at least 1 per cent,” confirms Sean Capstick, Head of Prime Brokerage, GPP. He notes that there was a very visible longevity bias in the survey. Those managers who have been running their businesses for longer are able to command a higher management fee.
Before an allocator even thinks about fees, the primary consideration is talent. Just how good is this manager they are sat opposite? What’s their edge?
Second, they want assurances that the business is sound, which they can determine via detailed operational due diligence. Only then, once they’ve completed their underwriting and they want to make an investment might the allocator open up the discussion on fees.
“At that point I would place investors in two camps,” says Napolitani. “Those that invest directly in the LP and attempt to get a founder’s class share or some discount on fees through a side letter, and those that invest through a separately managed account. Given the often larger ticket sizes, they will tend to get much more aggressive fee structures with an SMA.”
Riccardi confirms that from his vantage point, fees remain at a reasonable level. A good seed investor recognises the value that his seed investment is going to increase in value if the manager is successful. “If the fees he is charging are too low, there’s not going to be enough money for the manager to run the business. They are coming up with fair market terms for start-ups, as a result,” says Riccardi.
At the same time that fees are coming down, managers are able to expense the fund a little more.
Let’s say the management fee is reduced from 1.5 per cent to 1 per cent. If the manager is able to charge more expenses to the fund than he could in the past, that can help make up the difference. “Allocators recognise that managers need a decent amount of cash flow to build and maintain infrastructure, hire people, etc.
“I would therefore say that on the fee issue, things are stabilising a little bit. Investors want to make sure managers are structured properly but properly incentivised i.e. that they aren’t using the management fee as a profit centre but using it to operate and hire talent. They just want to pay for performance in excess of the market returns,” adds Riccardi.
With so much competition to raise capital in the US, one might think that Europe would be viewed favourably by US hedge funds. Anecdotally, having recently engaged with a number of managers at Hedgeweek events in New York, there was actually an overwhelming desire among managers to steer clear of Europe; or, at the very least, engage with European investors on a very limited basis.
Asked to comment on this, Joanne Huckle, Partner, Investment Funds Team, Ogier (Cayman Islands), says: “A lot of the US managers that we work with have little interest in Europe. They don’t view Europe as a huge source of capital to be raised. Some US managers continue to use private placement rules and are generally happy with this approach, they aren’t too concerned as to when they may be able to rely on passporting under the AIFMD. There really isn’t too much interest.”
Complying with private placement regimes is difficult. Each one is different and has its own filing requirements, etc. This is definitely causing a chilling effect with respect to fund raising in Europe.
US tax reform?
One potential positive for US hedge fund managers is whether tax reforms come to fruition. The Republicans are pushing for something to be enacted before the end of the year although many people believe that it may roll over into the first quarter of 2018.
In Huckle’s view, tax reform under the Trump administration could be beneficial and positively impact hedge fund managers, she explains: “We are hoping this will lead to improved performance, which will boost investment and growth in the hedge fund industry. In terms of more specific trends, it is likely that in the short term we will continue to see downward pressure on fees, with hedge fund managers coming up with more imaginative ways to tailor fees. For example, we are seeing more sliding fee structures for institutional investors. Interestingly, fee pressure is not something we are seeing mirrored on the private equity side.”
The biggest issue is going to be whether or not the US Government decides to eliminate the carried interest tax treatment. Earlier this year, the President made statements that this should be removed. “However, in the current proposals there is no mention of it. If this does get eliminated, it may change the way that some US funds are structured. Perhaps there will be some other tax efficient structure that could be used,” suggests Riccardi, stating that it is still early days to speculate further.
Looking ahead, Hendrickson postulates that the big theme for next year ties back to the earlier remarks regarding cryptocurrency funds.
“How will global regulators adapt to this new asset class? Like anything else, whenever there’s a new asset class and good returns to be had, managers will flock to it to launch funds and capture that opportunity while it exists. Over time though, it will need to be fine tuned and regulated appropriately.”
As is always the case in this industry, innovation and new trends/strategies constantly rise to the surface. Whether these cryptocurrencies have the staying power to really take off remains to be seen. For now though, managers will look for ways to utilise them the best way possible to enhance their portfolio returns. n
Sources:
1. https://www.yardeni.com/pub/peacockfeval.pdf
2. http://gpp.group/application/files/1114/9933/5545/14267_GPP_report_v7.pdf
