Hedge funds for the rank and file

The trend for European jurisdictions to bring hedge funds onshore could herald dramatic changes in the industry’s client base. “The net result of the regulatory trend is to increase access for all classes of investor,” says Stephen Smith, head of funds and alternative solutions within the asset management division of Credit Suisse. “Hedge funds are increasingly the preserve of, on the one hand, institutional investors, and on the other, the mass affluent.” This is not to say that hedge fund managers are being swamped by retail assets.“It really depends what we call ‘retail’,” says Sophie van Straelen, managing director of Asterias, a research firm that advises European hedge fund managers on their distribution capabilities. “In Italy the minimum investment is e500,000. In France for funds of hedge funds it is e10,000, so even that is not exactly retail.” “A high minimum investment is a very blunt instrument,” observes Andrew Lodge, managing director at Nedgroup Investments, which has retail hedge fund reach in South Africa. “It assumes that just because someone has a lot of money they must be financially-sophisticated.” And this is evidently not the case. According to the Spectrem Group, only 18 per cent of affluent investors wielding $500,000 (e370,000) in investable assets claim to understand hedge funds. UK takes the lead The latest moves have come from the UK’s Financial Services Authority (FSA), which is consulting with the industry until 27 June on its proposals to lift the 20 per cent investment restriction into unregulated collective investment vehicles in its non-Ucits retail schemes (Nurs). Because the FSA shares Mr Lodge’s view on minimum subscriptions, this could eventually give the UK true retail funds of alternative investment funds (Faifs). “We believe it is important that consumers get access to the latest techniques to manage their own savings and investments,” says Dan Waters, the FSA’s director for retail policy and asset management, and the consultation paper talks up the benefits of alternatives for diversifying risk. It is therefore surprising that the FSA does not anticipate “an immediate influx of FAIFs” and does not expect them to form “a large part of the retail market”, particularly as it admits that it is catching up with other jurisdictions partly to dissuade retail investors from seeking out foreign products. Indeed, the decision to only offer funds of funds access fits with the regulation and demand seen elsewhere. Spain at e50,000 and France and Ireland at e125,000 have a restrictive minimum investment threshold for single-manager funds; Austria and Germany prevent the launch and the retail marketing of single-manager funds, respectively. According to Asterias, 87 per cent of assets have gone to funds of funds in France and 90.9 per cent in Italy. “There is absolutely a market for something that is superior to cash with very low volatility, mainly from people who’ve seen a few market cycles,” says Mr Lodge. “We launched a fund of hedge funds in 2000 as a cash alternative for clients, and it has outperformed cash by 30 per cent since inception, with volatility of only 3.25 per cent.” That sort of thing would be perfect for France where, according to Asterias, 40 per cent of investments wind up in monetary funds. The domestic hedge fund market there looks pretty healthy: since the new regulations appeared in 2003, 201 funds of funds have picked up e22bn and 20 single-manager funds have attracted e2.9bn. “However, inflows into registered products includes institutional money,” says Ms van Straelen. “For the moment these products are not really accessible to retail investors. Large groups with retail distribution networks are working to develop true retail products. One of them, SGAM AI, just did quite a big campaign on one of its registered funds of hedge funds. But it is only starting to work with the retail banks now – and there is a big education issue.” Germany has only seen 25 single-manager funds and 15 funds of hedge funds emerge, and inflows have disappointed. The new Spanish regime is faring better: in just a few months, 17 firms have signed up to offer 13 funds of funds and seven single-manager funds. “Some fund of hedge fund managers have indeed developed strategic relationships with commercial banks in Spain,” says Eleonore Dachicourt, head of the hedge fund advisory board at Credit Suisse Private Banking. Ms van Straelen agrees: “In the last two weeks a big wave of new products have been fed into Spanish retail banks, which are pretty good at retail distribution.” Distribution channels These products really depend on effective, competent distribution networks. According to the Spectrem Group, only 9 per cent of affluent investors are interested in hedge funds. “Given their lack of interest, it seems unlikely these investors will step forward themselves seeking more information,” says managing director Catherine McBreen. Where Spain has effective retail banks, the UK may be able to draw on its network of independent financial advisers (IFAs) to educate and stimulate demand. This is probably why the FSA expects Faifs to be most relevant to larger firms with existing retail client bases. Sure enough, alongside the Alternative Investment Management Association (AIMA), firms such as JPMorgan, Schroders, F&C and Threadneedle were quickest to welcome the new consultation paper. The big diversified fund of funds players have become dominated by institutions and could do with some client-side diversification. Indeed, Ms Dachicourt at Credit Suisse, thinks the need is even starker than that. “Many high-net-worth clients who started with funds of hedge funds five to 10 years ago are now moving to invest directly into single-manager funds,” she observes. “Some institutional clients also want direct exposure and have been building core [funds of hedge funds] and satellite [single-managers] types of portfolios. Therefore, a retail client base could provide a means for funds of hedge funds to maintain their assets under management levels.” But is all diversification good diversification? The FSA acknowledges that hedge funds trading illiquid positions prefer the “sticky money” of a few high- net-worth individuals. Is it wise to move towards investors more used to daily-trading unit trusts who, as the FSA warns, may “need to redeem their investments quickly to meet their own particular needs”? Last year the FSA suggested that liquidity issues might leave some underlying hedge funds out-of-bounds, and that raises concerns for Ms Dachicourt. She says: “This may mean that retail Faif investors would then only be exposed to the more liquid and therefore more plain-vanilla strategies, such as equity long-short funds, which may not offer the most diversification as they tend to be more correlated to traditional investments.” Robert Kelly, managing director of hedge fund insurance specialist Baronsmead, says that from his perspective the broad investment remit for hedge funds is great because it gives much less room for investor complaint. “If things become more prescriptive regarding the way operational risk or liquidity requirements are handled, it’ll be easier to breach the rules,” he observes. “If you look at sales documents on products where there have been problems in the past, the risk warnings have been OK. But quite often the regulators seem to take a much broader approach when industry-wide problems occur – everyone who sells those products gets caught up in the same investigation.” For Mr Kelly, the liquidity issue raises the spectre of what happened in German retail property funds in the winter of 2005-06 – when a lack of liquidity was particularly acute – but the FSA already has experience with the direct-property Nurs, which is allowed to limit redemption periods to once every six months. The new Faifs (which could be funds of property or private equity funds) look set to follow these rules, and the FSA deems standard hedge fund due-diligence processes appropriate in matters of both manager selection and liquidity management – but hedge fund-style notice periods will not be allowed. “The FSA is keen to focus on how the product is sold rather than what happens at the investment level,” says Neil Simmonds, partner in the funds practice at law firm Simmons & Simmons. “Managers will have to take responsibility for liquidity, and six-monthly redemptions will obviously be a great help.” There is still a bigger obstacle to overcome, in any case. “The main issue is tax,” says Mr Simmonds. “The whole project will fail if the Inland Revenue does not produce an offshore funds regime that works for UK investors.” Offshore unauthorised funds are not capital-gains tax efficient – and the FSA concedes that taxation issues may be the reason why no qualified investor scheme (QIS) funds of hedge funds have been created. Its announcement that it is “working closely” with the Treasury’s review of the offshore tax regime was welcomed by all commentators – but developments are not expected until next year’s Finance Bill at the earliest. Lack of consistency Across Europe, no jurisdiction has a specific tax regime to cater for domestic hedge funds. Treatment at investor level varies widely. For example, some onshore-offshore jurisdictions offer simple regimes such as the Channel Islands’ 20 per cent on income with capital gains exempt. Ireland levies 20 per cent income tax and 23 per cent capital gains. Portuguese investors pay 10 per cent on capital gains and a 25 per cent withholding tax. In the Netherlands, investors’ real income and gains are not taxable, and instead 20 per cent is levied on a notional 4 per cent yield. Germans pay 15-42 per cent income tax, with dividends 50 per cent tax-free; capital gains are generally exempt. France looks set to introduce a hedge fund-specific regime soon. Spanish tax reform looks likely to improve the lot of investors; but Italy’s 12.5 per cent withholding tax increased to 20 per cent in January. With less punitive taxation and a good fit with distribution networks – and if hedge funds become one of those fads that periodically grip the retail market – this could be a big source of new assets. “But I don’t think it’s an attractive client base for hedge fund managers at the moment,” says Ms van Straelen. “They will have to address it, because it’s going to be a big, big market – but it’s more a two-to-five-year view on your business.”

‘Some fund of hedge fund managers have developed strategic relationships with commercial banks in Spain’