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Volatility and desire for bond-like returns pushes demand

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The liquid alternatives space, which by definition includes alternative UCITS funds in Europe and '40 Act registered alternative mutual funds in the US, is not only attracting strong inflows. According to latest research from Preqin, the average alternative mutual fund returned 4.36 per cent in 2014. This compares to returns of 3.78 per cent for the average hedge fund.

The average alternative UCITS returned 1.45 per cent but if one considers performance at the strategy level, CTAs and equity market neutral funds held up well; according to Alix Capital, who run a series of alternative UCITS indices, their UAIX CTA returned 19.74 per cent, whilst the UAIX Equity Market Neutral returned 4.65 per cent.

From an AUM perspective, a report by Deutsche Bank (From alternatives to mainstream: Part Two) noted that liquid alternatives had enjoyed a CAGR of approximately 40 per cent since 2008. Specifically, '40 Act alternative mutual funds grew by 18 per cent in 2014 to over USD300 billion having grown 60 per cent in 2013. The bank's report forecast that alternative UCITS had the potential to represent 30 per cent of hedge fund assets by 2019; it was approximately 11 per cent in 2014. 

By end-2014, Alix Capital reported that alternative UCITS had enjoyed their strongest year in terms of asset growth, noting that inflows totalled EUR70 billion – a year-on-year increase of 37 per cent – to reach total AUM of EUR260 billion.

Looking ahead, a report by PwC (Alternative Asset Management 2020: Fast Forward to Centre Stage) estimates that liquid alternative UCITS funds could see their AUM double to USD664 billion by 2020. 

Discussing these growth trends, Bob Kern, Executive Vice President at US Bancorp Fund Services, confirms that they have enjoyed both a 40 per cent growth in liquid alternative assets under administration and a 40 per cent growth in the number of funds being serviced. 

"Long/short equity and long/short credit are the main trends in the open-ended fund space," says Kern, who suggests that the growth of '40 Act alternative mutual funds in the US has been driven by a defensive posturing by managers as well RIAs and investment consultants.

"Learning from 2008, no one wants to get caught again by being over-invested in traditional assets. The RIAs and investment consultants are supporting allocation into non-traditional assets, as a hedge, on the premise that there could be future volatility in the market. In my view, the main drivers of growth are: diversification, allocation and defensive hedging," says Kern.

The demand among European institutions for UCITS vehicles is something that US managers increasingly find when they come over to do road trips. Anecdotally, Hedgeweek has heard that large European pension plans are also approaching US managers and asking them to establish an AIFMD-compliant fund-of-one, but for many managers, AIFMD is still too new. As such, the UCITS format is an attractive counterpoint to their offshore master feeder. 

"Time and again, we hear many European investors are saying to US managers that unless they have a UCITS fund they simply can't invest in their strategy," says Andrew Dollery, Director, Origination & Structuring, Societe Generale Prime Services. He adds:

"I think there is also a slight push factor with respect to AIFMD. There is still a perception among many US managers that registration is complex, and that it can be quite onerous to raise capital in Europe through AIFMD passporting. Managers are still a little unsure of the marketing rules. The last point I'd add is that over the last four years the level of awareness and knowledge among managers with respect to the structuring and branding of UCITS has grown."

One interesting driver of appetite that might explain the growth in liquid alternatives is a desire among investors to look for bond-like returns in alternative asset classes. There are growing concerns over how traditional equity and bond portfolios will perform in the coming years as QE programs are phased out and market volatility starts to rise; indeed, last month alone saw German Bund yields rise from 0.53 per cent to 0.815 per cent, reaching a YTD high of 0.99 per cent on 10th June. 

Spencer Rhodes is Alternative Investments Global Business Manager at Allianz Global Investors. The firm has approximately USD7 billion in alternative strategies, the majority of which are in alternative UCITS; it currently has two '40 Act alternative mutual funds in addition to 10 alternative UCITS funds.

"One characteristic that most of our strategies share is that they tend to be on the low risk side of the spectrum," says Rhodes. "For example, all three of our equity long/short funds are equity market neutral with net exposures of +/-15 per cent. They are targeting 5 to 8 per cent annualised return with low volatility. We also have some options trading strategies targeting a similar risk/return profile and we have a merger arbitrage strategy that targets 2 to 5 per cent annual returns. Our global macro strategy targets Libor plus 4 per cent.

"So, for us, our liquid alternative strategies tend to be used by clients as bond substitutes."

Rhodes confirms that between Q4 2013 and Q4 2014 the group's AUM in alternative UCITS more than doubled. This year alone has seen net inflows of approximately EUR600 million, says Rhodes.

What makes the growth of these liquid alternatives even more impressive is that it has happened during a period of unprecedented performance in bonds and equities. Investors have locked in incredible gains as bond yields have raced to zero, whilst equity markets have reached historic highs (notably the S&P 500 on 21st May). 

On a relative basis within their asset class categories, liquid alternatives have done reasonably well but on an absolute basis, when compared to the broader market indices, they've come nowhere close. Nor should one expect them to. The point here is that if these vehicles are enjoying year-on-year AUM growth in bull markets, imagine what could happen when markets start to correct. 

"Currently, RIAs who utilise liquid alternate strategies for their clients might only be allocating a 5 per cent position to these funds. When the market corrects itself I believe that allocations will climb closer to 10 per cent. It's a great story that they've managed to do as well as they have over a difficult absolute return performance timeframe," comments Joe Redwine, CEO, US Bancorp Fund Services.

One of the leading alternative UCITS fund platforms is the Dublin-domiciled FundLogic Alternatives platform run by Morgan Stanley and headed up by Stephane Berthet. He says that whilst they have seen a bit more volatility in returns and performance dispersion among funds running similar strategies, performance this year has been broadly in line with investors' expectations. 

"You can't compare these funds to the long-only space where investors have been enjoying a bull market and outsized returns. To be frank, this type of comparison always gets made from time to time," observes Berthet. "This year will be interesting in that equity markets are becoming more volatile and challenged, which will create a tougher environment for long-only strategies. It's this type of market where hedge fund managers can add value. Looking at the performance of the platform today, the vast majority of funds are in positive territory. The best performing fund – MS Dalton Asia Pacific UCITS Fund – is up nearly 20 per cent."

Over at Allianz Global Investors, Rhodes confirms that their two best performing funds this year are, coincidentally, their flagship funds. The first is Discovery Europe, a European equity long/short market neutral fund which has already returned +6.73 per cent (through 30th June). 

"The second flagship strategy is called Structured Alpha which launched in 2005. It's a volatility arbitrage strategy trading listed US index options. It's had a strong first half of the year and is up +3.45 per cent through 30th June and has a 3-year volatility of only 1.09 per cent," confirms Rhodes.

According to research by Preqin, 53 alternative mutual funds launched in the US in 2014. By far the biggest demand for these products is coming from FoHF managers, accounting for 62 per cent of investors surveyed by the research firm. 

Asked whether Morgan Stanley had grand designs on tapping in to this growth dynamic, Berthet is quick to point out that it is a different market catering for a different audience and that there are no plans to develop FundLogic Alternatives in the US.

"The '40 Act alternative mutual fund industry is mainly driven by multi-manager products whereas in Europe alternative UCITS funds are predominantly single manager products. Also, the '40 Act fund market is much more retail than it is in Europe. To run multi-manager products you need to assume fiduciary responsibility for selecting funds, which I don't think we as an organisation are contemplating at this time. We help some multi-managers with their offering, so we are participating, just indirectly," says Berthet. 

The multi-manager arrangement is interesting in that it allows US managers to indirectly participate in the '40 Act space without cannibalising their existing offshore investors. They are appointed as sub-advisors, and whilst they have to adhere to stringent liquidity and risk management guidelines they aren't steering the ship on their own, as is the case for single managers running UCITS. 

US managers are less likely to launch '40 Act products on their own, therefore, at least for the foreseeable future. It also doesn't help that the regulators are paying far greater attention. The SEC is checking that managers are doing exactly what they say on the tin and are sticking to the rulebook. 

Back in February this year the US regulator hit Water Island Capital LLC with a USD50,000 penalty for improper handling of alternative mutual fund assets. The firm was holding millions of dollars of cash collateral with broker-dealer counterparties instead of the funds' designated custodial bank. 

"The whole industry needs to be cognisant of any changes that regulators could introduce in the future," warns Dollery. He says that managers need to be aware that for alternative UCITS, most unencumbered assets and cash tend to sit with the custodian rather than with the prime broker directly. For strategies that trade on margin, this could lead to concentration issues on the balance sheet of the custodian. A manager cannot hold more than 20 per cent of their fund in cash on the balance sheet of a single credit institution. 

"You tend to find that in the UCITS space, in particular for CTAs and global macro funds that trade mainly through derivatives, they have to diversify their exposure by opening deposit accounts at a number of banks. Or they buy short-term bonds or money market funds; some sort of treasury management solution.

"Another challenge for managers entering this space is structuring their fund and portfolio to remain compliant: commodities exposure; OTC counterparty limits; establishing custodial relationships and possibly pledge accounts; managers might need help wrapping those considerations together," comments Dollery. 

From a liquidity management perspective, a manager needs to keep 5 per cent cash to cover redemptions in a liquid alternatives fund whereas in a hedge fund they might be fully invested. It is a cashflow management issue. 

So this is no cakewalk. Whilst investor demand is clear, managers have to make sure they are launching one of these funds for the right reasons. 

In conclusion, Redwine thinks that the same sort of stress testing common to fixed income funds could eventually apply to those running liquid alternatives: "Those strategies that are a little less liquid and incur a run on the fund could have a significant impact on performance, so don't be surprised to see stress testing become best practice."

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