Clear benefits tempt private investors back to hedge funds

There was a time, pre 2008, when the hedge fund was the ultimate must-have accessory for the fashionable high net worth individual about town. But today, despite record institutional assets invested in hedge funds, private clients are not surprisingly shy about commitments, having suffered the most in frauds, including Madoff-related losses, and through poor performance.

It is a tough conversation for private banks to have with their clients to convince them to re-allocate to hedge funds, but a very necessary one, say leading private bankers.

“In a more conservative holster, we are adding some hedge funds as a replacement for bonds,” says Fan Jiang, chief investment strategist at JP Morgan Private Bank Asia

“If you owned too much in bonds last year, it hurt. As a risk manager for ultra high net worth individuals, our job is to preserve and grow capital. We are not paid to be a hero. Hedge funds play a vital role in capital preservation and growth.”

The banks are particular fans of relative value strategies, which allow managers to go both long and short convertibles, loans, distressed debt and “alternative opportunities in the fixed income space”.

The alternative approach can also be a more efficient avenue into the emerging market space, particularly when it comes to buying into the African story, says Mr Jiang, referring to the continent’s 1.2bn population.

“Africa is the new China for the world,” he says, overtaking short-term market love-ins with the likes of Vietnam and Bangladesh. But due to the lack of invisible public equity markets in Africa, the alternative approach can bear dividends.

“You need to team up with the best hedge fund managers and private equity investors for local knowledge and connectivity,” says Mr Jiang.

Particularly attractive are those private equity funds which are staffed by industrial experts, former CEOs of companies, rather than financiers. “We have used managers in the past who specialised in very niche high growth potential markets, such as Africa,” he says.

Room to manouvere

This more flexible interpretation and understanding of hedge funds is vital to their effective use in private portfolios, believes Mattia Nocera, CEO of Belgrave Capital Management, part of Italy’s Banca del Ceresio group, which manages assets worth $9bn (€6.6bn).

“If you are interpreting hedge funds as talented managers, and not pigeonholing them into specific strategies, then there is plenty of talent in that space,” believes Mr Nocera. “In the equity space, there is a lot of distinction between good and bad companies. Now that the market has rationalised and stabilised and the stresses of 2008 have gone away, there is a lot of room for managers who can pick stocks both on the long and short side.”

While there are big flows into hedge strategies in the US and some in the UK, most private clients in continental Europe fled this product offering soon after 2008 and are reluctant to return, he says.

Many were sold hedge funds by their advisers as if they were an asset class separate to equities, bonds and commodities, when in reality, the devices these products have to offer can simply amplify or dampen down the characteristics of these three key investment sectors. Typically, Belgrave will use hedge funds to emphasise equity allocations.

“Many clients bought hedge funds as a bond-replacement alternative, believing this was an investment to make money in every type of investment environment,” says Mr Nocera.

“But in reality, a hedge funds manager good at managing an asset class can soften or diminish a loss when markets are collapsing,” he says. “In 2008, good hedge managers in the equity space made money in Europe. Most lost money, but they lost a lot less than the underlying index.”

This means that unlike traditional equity markets, which are difficult to time, investors do not need to withdraw money. Because their losses are contained, they can stay in and await the uptick.

“The advantage of hedge funds is that they smooth asset class performance and allow you to remain invested,” says Mr Nocera.

But whereas institutional investors, together with family offices and endowments,  have come back into the fray, private banks are reluctant players. “They have always lagged institutions,” he says.

Part of the reason for this, believes Mr Nocera, is that the retail-friendly, mass market products which they have created for clients are totally inappropriate and ineffective. “They are offering watered down, liquid Ucits versions of hedge funds, which have failed to perform,” he says, adding that some of the banks responsible for pushing these funds are likely to give up and turn back to more old-school hedge funds.

While clients and their advisers need to look at US interest rate policy and quantitative easing as determinants of asset
allocation, other developments including positive news from Spain and Japan and the uncertain Chinese situation, plus a more downbeat outlook in emerging markets, should also be considered by investors.

“I still feel people are over-exposed to fixed income local currency in emerging markets,” says Mr Nocera, expecting more outflows from this product grouping.

While Europe remains more attractive on the equity side, private clients need to look at new ways of accessing this growth, he says. “If an alternative manager is a good stockpicker, they can sell bad companies and go long on good ones. We may be coming to a point where the whole EPS (earnings per share) way of investing is going out of fashion. Smarter investors are beginning to understand that it’s no longer the only game in town.”

Funds of hedge funds provide an effective way of entering the alternative space because they provide access to otherwise closed or restricted funds. But he warns that their promoters should not exploit their purchasing power by charging “rip-off” fees.

On the rise

Hedge funds are increasingly entering the mainstream, believes Amin Rajan, CEO of the Create research consultancy. “Hedge funds may have been a disruptive innovation in the last decade when they totally revolutionised existing business models,” he says. “But now 16 out of the top 20 hedge fund managers are predominantly long-only managers.”

Money starts returning from many private clients as soon as they see hedge fund returns improving, he believes, with a feeling that the bad karma associated with some alternative strategies when it comes to private client sentiment is somewhat overcooked.

“The share of hedge fund assets held by private banks has definitely risen in the last two years after the fall of 2008,” says Mr Rajan. “We are seeing risk returning to the table and private clients no longer see hedge funds in the same way as they did in 2009. A lot of these assets are now hedged in the way they are supposed to be hedged.”  

All eyes on AIFMD

While some banks and commentators are preparing for increased allocation to hedge funds for private clients, Tara Doyle, partner in the Asset Management and Investment Funds Group at Matheson solicitors in Dublin, is expecting an explosion of alternative products registered for international distribution under the AIFMD directive.

“I expect AIFMD to be the big story of 2014 in terms of cross-border distribution,” says Ms Doyle. Only a small number of managers initially chose to avail themselves of the European passport for alternative funds when it first became available in July 2013. However, the transitional period for European alternative managers is open until July 2014.

“Now that the picture as regards AIFMD is clearer, I expect many more managers to apply for AIFM licences in 2014. The rewards for obtaining an AIFM licence are the ability to passport management services into other European countries and to sell funds to professional and institutional investors across Europe,” she says.

“This will significantly improve the distribution capabilities for European alternative products – particularly Irish-domiciled alternative funds, which have a long history of distribution in Europe on a private placement basis.”

AIFMD and Ucits V both contain proposals regarding remuneration of portfolio managers, but in practice, says Ms Doyle, most institutional asset managers already had internal remuneration policies, which encouraged employees to manage risk and to think longer term about their funds’ performance. The challenge with overly-prescriptive rules is that they are difficult to adapt to different business and taxation models. If the European regulation is not practical enough, she fears a brain drain to rival jurisdictions not subject to such restrictive rules.

Not surprisingly, Ms Doyle expects her native Ireland to particularly benefit from the new regulations. “Traditional offshore jurisdictions such as the Cayman and Channel Islands will have less relevance for European capital.”