All grown up now

For all the excitement about hedge funds, they only represented a very small part of the European fund scene in early 2002. In spite of, or perhaps because of, the volatility of global financial markets, they have become much more important to investors – but only in some countries. Andrew Hutchings of Sector Analysis explains. The rise of hedge funds is one of the few undeniably bright spots in the European funds industry. Thanks to another year of falling stockmarkets in 2002–3, most participants experienced a fall in overall assets under management. Many distributors have turned away from third party funds towards in-house funds. The dismal background Hedge funds are unlike conventional funds in that relatively few distributors – be they universal banks, large portfolio managers, insurance companies or intermediaries – and even fewer end users, such as pension plans – have the capacity to “manufacture” them or to run them. Hedge funds are almost invariably sourced from other suppliers. They are a part of the universe of what we call third party funds. This matters, because 2002–3 was a bad year for third party funds. As Chart 1 shows, the number of organisations (end users or distributors) in Europe using third party funds fell from an estimated 61 per cent to 54 per cent. In many countries (e.g. Spain and Italy), the fall has been even more precipitous. Switzerland is the only country where the number of organisations using third party funds actually rose – and then not by very much. Had we considered other statistics, the story would be the same. Estimated total demand for third party funds in Europe fell from US$1200bn (E1050bn) to US$980bn in 2002–3. In early 2002, third party funds amounted to about 7 per cent of overall assets under management. Now, it figures around 5 per cent. Measuring demand Many industry commentators look at the hedge fund industry from the suppliers’ point of view. Provided their research can identify a large enough number of hedge managers, and obtain from them basic information such as volume of assets managed, the commentators can reach some useful conclusions. There are several challenges with this approach. The first is that hedge fund management is a new, fragmented and very rapidly changing part of the general fund industry. Hedge funds are being set up and closed down all the time. Sometimes, whether as a result of investment performance or net subscriptions, the assets handled by individual managers can grow or shrink at amazing speed. Most importantly, this kind of industry assessment does not identify distributors and end users of hedge funds. Distributors are more important than they are for traditional funds because often the best hedge fund managers have no internal sales or marketing teams. The funds are often distributed across national borders: the investment manager may be geographically distant from clients. Sector Analysis estimates total demand for hedge funds of users/distributors in Europe rose from US$30bn (E26bn) in early 2002 to US$74bn in early 2003. See Chart 2. Eighteen months ago, the key markets for hedge funds were Switzerland and France, between them accounting for two-thirds of the market. Sector Analysis also found users of hedge funds in Spain, Sweden, the UK and Luxembourg. Since then, it appears demand for hedge funds has risen by 150 per cent in France, and almost 100 per cent in Switzerland. Demand has exploded in Spain. The Netherlands has emerged as a significant market for hedge funds through 2002–3. By contrast, demand for hedge funds in Sweden, the UK and Luxembourg remained reasonably constant. In other words, the rise of hedge funds has not been even. The UK may be home to large numbers of outstanding hedge fund managers, but contains few large users or distributors. Demand for hedge funds remains minimal not only in Germany, where legal restrictions prevent their use, but also in Belgium and Italy. Entering the mainstream For all their surrounding publicity, hedge funds were a very minor and esoteric part of the European funds scene in early 2002. As Chart 3 shows, Sector Analysis estimated hedge funds accounted for 2 per cent of third party funds used/distributed in Europe. As we have seen, third party funds represented 7 per cent of overall managed assets. Since then, hedge funds have grown so rapidly relative to conventional funds that they now represent 7 per cent of Europe’s third party funds. Except in Sweden, where an extraordinary 10 per cent of third party funds appeared to be hedge funds in early 2002, the comparative importance of hedge funds has risen everywhere. Sector Analysis estimates hedge funds now account for 17 to 18 per cent of all third party funds used/distributed in Switzerland and the Netherlands, the two countries with the most sophisticated asset management industries in continental Europe. Hedge funds also account for 14 per cent of third party funds in Spain. In any assessment of markets for third party funds in these three countries, it is no longer possible to ignore hedge funds as exciting, if exotic, products that are widely spoken of but rarely used. They have entered the mainstream. By contrast, hedge funds represent a very small portion of third party fund markets in other countries. Absolute returns How third party fund assets are invested is determined ultimately by two factors. The first is whether distributors and clients want to use third party funds to access particular asset classes or whether they prefer to invest directly, or through segregated mandates or in-house funds. The second factor is the perception of investors about the relative merits of asset classes. Chart 4 shows how asset allocation of all third party fund assets in Europe changed from early 2002 to early 2003. Perhaps surprisingly, given the dismal stockmarket performance, allocations to European equities remained constant at 28 per cent. By contrast, allocations to non-European equities dropped from 30 to 23 per cent. Holdings of non-European bonds also fell. Allocations to European bonds and money market assets rose from 29 to 34 per cent. This was largely as a result of a surge in importance of money market funds, which accounted for 17 per cent of overall third party fund assets in Europe earlier this year. Hedge funds also increased in importance. In other words, in their search for absolute returns, investors turned to hedge funds, which most distributors were unable to provide. In addition to hedge funds, private equity and “other” asset classes amounted to an estimated US$51bn (E45bn), or about 5 per cent of third party fund assets in early 2003. Chart 5 shows these assets concentrated in four countries – The Netherlands (mainly private equity), Germany (mainly “other”), France and Italy (a mixture). The bottom line is that private equity and “other” asset classes are much more exotic in Europe than hedge funds. While 2002–3 will be remembered as a most unpleasant year for suppliers and distributors of conventional funds in Europe, it will be seen as the year in which hedge funds truly came of age. Andrew Hutchings, research editor, Sector Analysis