Institutions step in as high net worth individuals shun black-box strategies

Hitting assets of $2.13tn (E1.68tn) in the first quarter of the year, the hedge funds industry boasts record levels of client funds, driven by net inflows and positive performance.

But the nature of the hedge fund industry’s clients appears to be changing, with greater inflows coming in from institutional clients than high net worth individuals (HNWs).

“The experience of 2008 is, to an extent, fresh in the high net worth individual’s mind,” says Francis Frecentese, head of hedge fund investments at Citi Private Bank. “Remember for the better part of the decade, flows to hedge funds were growing rapidly and the greatest number of high net worth investors entered hedge funds before the crisis.”

HNWs have become disillusioned with hedge funds because expectations for their returns are a bit outdated, says Mr Frecentese. “In 2000, you had 400 to 500 hedge funds and now there are 8,000 to 9,000 hedge funds. So you have a lot more managers competing for a finite pool of alpha and so, by definition, returns have become more relative instead of absolute and I think that’s where the discontent is.”

Potential investors, he believes, should not be deterred from hedge fund investing, but need to deploy them differently in their portfolios.

A study by Preqin, a data provider on the alternative investments industry, revealed that 61 per cent of hedge fund assets in 2011 came from the institutional sector rather than private individuals, a 36 per cent rise from 2008.

Yariv Itah, a partner at Casey Quirk, a US-based consultancy, feels high net worth individuals in Europe who invested in hedge funds through structured vehicles burnt their fingers during the downturn and are now wary of coming back. Thus, Europe has been slow to turn the trend around. “In other parts of the world, investments in hedge funds by individuals is continuously relatively strong and there is interest in the US, Middle East and many emerging markets as well,” he says.

Quant funds in particular are struggling to regain the market share they lost between 2007 and 2008, says Mr Itah. “When you talk about black box investing, those strategies have had a hard time attracting any kind of individuals. Today, you need to show very strong consistent returns and a return profile for investors to feel that the investment process is a sound one.”

Lyxor Asset Management’s global head of quantitative investments, Nicola Gaussel, agrees. “Earlier, just the name hedge fund was enough to attract clients. Today it’s totally different. We’ve seen a significant heterogeneity in flows,” he says.

Some managers with black-box strategies are not necessarily open about how their strategy works, as they don’t want others to replicate it. This can make investors nervous. As a result, there are more institutional investors interested in quantitative strategies than high net worth individuals, says Meredith Jones, director at Rothstein Kass, a consultancy. “The general rule of thumb is you should not invest in things you don’t understand, and I think that tends to push some of the HNWs out of these strategies,” Ms Jones says.

The reason she attributes more institutional investors are interested in quant strategies than high net worth individuals is that institutions are usually better equipped from a staffing and analysis standpoint to do due diligence and gain an understanding of how the models work, whereas a high net worth individual or family office may have investment staff that tend to be more generalist, and hence don’t necessarily have the capability to devoting themselves to a particular type of strategy.

Quantitative investing, on the whole, has been on a decline. Dominated by quantitative equity managers, who at their peak ran more than $1tn before the quant crisis of 2007, subsequent performance issues have led to substantial outflows.

Yet, hedge funds such as Man Group, the world’s largest publicly traded hedge fund, heavily biased towards quantitative investing, are coming up with new funds, having recently started a commodities funds and soon launching a fixed income fund. Hedge funds that use a quantitative investment approach can provide great opportunities, says Sandy Rattray, chief investment officer at Man Systematic Strategies, a $1.6bn venture established in 2011, following the merger of GLG with Man Group.

He believes only certain strategies can be run quantitatively and fund size should be limited. “The quant crisis occurred because managers were trading data and information; everyone had access to leverage positions,” he says, explaining how managers went to the same places, read the same journals, and when the market fell, they tumbled together.

To counter this effect, Man builds its own data, not published in academic journals, and reveals little about its funds. Mr Rattray says quant methods have invaded fund management firms, and pure discretionary managers use a lot of quant behind the scenes, be it in screening, risk models or performance attribution. “There are great opportunities in running quant strategies. The idea is to use more diverse strategies,” he says, reiterating for every strategy Man Systematic Strategies runs, there is a clear reason why somebody would want some of those products and why they are better done with quant techniques.

Hedge fund performance has suffered. According to Terry Tian, an alternatives analyst at Morningstar, two types of hedge funds are now finding it difficult to raise money. One is funds of hedge funds, because clients have begun to doubt whether they truly add value after the double layers of fees and the other is small and young hedge funds, because investors in hedge funds are now predominantly institutions, such as pension funds, which usually have minimum threshold on both assets under management and track records.

“I think the so-called “black-box type of strategy has always been there,” he says. “Some of them might not work as well as they used to, but I don’t think investors are getting wary about this type of strategy per se, because their lacklustre performance is in line with other hedge funds.”

Nevertheless, despite dismal performance, analysts agree the time is good for hedge fund launches. “The data in recent history shows it’s been stronger to launches,” says Ken Heinz, president of Hedge Fund Review. “We’re coming out of a period where exhibitors have displayed low levels of risk tolerance for a considerable period of time and the general trend is towards increasing risk tolerance.

“I think that’s a positive environment for capital raising and for launching of new funds because investors are focusing on prospects for return generation than more defensive posturing in the last few years,” he says.

Thus, hedge funds, such as Man Group, despite reporting massive outflows of $1bn in the past year, amid dismal performance of its flagship AHL fund, continue to launch funds.

Peter Leonardos, an analyst at RBC Capital says the two should not be linked. “If a company has surplus capital, like Man does, the only way for them to control organic growth out of marketing, is by using their capital to seek new funds,” he says.

Stating other high-profile fund managers, such as Schroders and Ashmore do the same, Mr Leonardos thinks it is an effective way to control organic growth. “The poor performance of AHL should not impact Man from launching new funds, which is what they are currently doing,” he says. “A fund launch is a way to offer the market products more suited to current customer demands.”

For some hedge funds, however, the situation continues to look rosy. Ms Jones at Rothstein Kass studied funds that indicated they used a quantitative approach in their strategies and came up with a list of 1,000 products, including separate share classes of some funds. Analysing their performance over the last 12 months, she found 9.2 per cent had generated returns of 10 per cent or greater, and another 28.4 per cent had generated returns that were positive. Thus, approximately 40 per cent had positive performance metrics.

“Quantitative funds of various strategies are quite successful and I think the reason is that the market shakes out a couple of ways in terms of the end investor,” Ms Jones says.

“The picture is not black and white,” says Lyxor’s Mr Gaussel. “If you look at successful hedge funds, many of them have an important quantitative colour in their investment process.” He gives the example of Capital Fund Management and Winton, pure quant hedge funds, which accrued significant amount of money last year.

There are two ways of creating performance in quants, says Mr Gaussel. One is through having more information than the average investor and the second is through generating more analytic capability to process this information.

Nevertheless, at a time when a limited number of resilient hedge funds, such as AQR, are attracting the maximum flows, analysts doubt whether the hedge fund industry will return to the market share it owned in 2007.

“The pricing structure is dead,” says an analyst. As hedge funds go more institutional, he feels these investors are more stable and therefore like reduced rates. “Maybe the 2 and 20 structure needs to be revisited,” the analyst says. “A lot of hedge funds have shifted to a 1 and 10 structure and have been quite successful in gathering assets.”

He thinks investors will pay premium prices if they get premium performance. “I don’t see the industry being hit hard, but I see a shifting of assets towards more reasonably priced, better performing assets in the industry.”

Ken Heinz, Hedge Fund Review