Reconditioning hedge funds

The world of the hedge fund manager has never been a dull or staid one. But the seismic changes now taking place, to both long-short and traditional managers keen to populate the alternatives space, may prove the most significant in the short history of this often controversial asset class, now worth a record $2,000bn (€1,400bn), according to Hedge Fund Research.

Prompted by regulation, a broad dissatisfaction with fee and performance levels amidst the still smouldering embers of the financial crisis and the widespread need for more innovative products, the latest chapter of the hedge fund saga promises to leave no corner of the colourful industry unturned.

James Bevan, who has invested in a variety of hedge funds, in both his current role as head of investments at charity fund managers CCLA and previous job as CIO at Spanish bank Santander in the UK, proclaims a profound disillusionment with large swathes of the industry, particularly some high profile quantitative players.

According to research consultancy Create, only 12 per cent of hedge funds typically make positive returns gross of fees and this number shrinks to 9 per cent for net returns, with assets increasingly concentrated in the hands of a small coterie of larger managers.

“Some of those hedgies whom I respect, and who I thought I understood their processes, did not do well in the crisis,” recalls Mr Bevan, picking out the quant funds within the alternatives arm of Goldman Sachs, for particular criticism.

“Commitment, a clear well-understood risk adjusted process, high calibre individuals and constant attention to detail: I thought Goldman had all of those. But subsequent returns from their alternatives business suggest their models were deeply flawed. It is not credible to suggest we are living through an exceptional period and much more appropriate to say ‘we simply got it wrong’.”

He talks also about the unexpected problems encountered at Axa Rosenberg, where legendary Californian finance professor Barr Rosenberg was an undisputed quant guru for several decades.

“Barr Rosenberg, I thought, was one of the most talented equity analysts of his generation and I would never have predicted the demise of the Axa Rosenberg model,” comments Mr Bevan, who outsourced significant assets to both Goldman Sachs Asset Management (GSAM) and Axa during his time at Abbey and later under Spanish parent Santander. GSAM has more than $150bn in alternative assets and sources say it would be wrong to apply any misgivings about quant funds to the rest of its hedge fund and alternatives business.

“Somebody recently told me: ‘I used to be funny, now nobody laughs at my jokes any more.’ There is an element of that in some of these asset management and finance models,” adds Mr Bevan. “My concern is that it is difficult to determine what is genuine skill and what is purely good fortune.”

If funds such as those in Goldman’s quant stable – which gave investors regular access to one-time quant king of New York Bob Litterman – are not infallible, what hope is there for the rest of the universe?

“There are still a lot of hedge fund managers who present on the basis of a track record,” says Mr Bevan, citing the Madoff funds as a particular example which astute investors could have avoided. “They are not prepared to open the lid on their process. We send them away, but a lot of people are prepared to give them money on that basis.”

There are voices in the industry, however, including previously vociferous critics, who believe the situation is changing, and increasingly swinging to investors’ favour.

“Opacity – in both business operations and investment strategies – has always been the hallmark of hedge funds, but that is now going,” says Amin Rajan, founder and chief executive of the Create research consultancy, which regularly surveys institutional investors about their attitudes to investment strategies and asset allocation.

“There won’t be transparency around daily positions and transactions, as that would be giving away the game,” but clients, post Madoff and Lehman, are demanding a much more detailed picture of daily business operations if they are to keep their money with some of the more secretive groups. “Investors are simply saying: ‘I want to give my money to somebody who runs this as a normal business.’”

The most striking change is an overhaul of the hedge fund industry’s long ingrained charging system, the so-called “2 & 20” model, which levies investors 2 per cent of invested assets plus 20 per cent of any profits made on an annual basis.

The “2 & 20” will now remain purely the preserve of the tiny minority of groups delivering stellar returns – the likes of Brevan Howard, Thames River, Halcyon, Sloane Robinson and the Man Group/GLG – rather than an accepted industry norm for those providing leveraged beta, believes Mr Rajan.

VARYING PROFILES

Hedge funds, keen to manage risk, are also taking measures to broaden their clientele, with the idea of a private investor-dominated, liquidity-obsessed asset base, ready to redeem at the first sign of trouble no longer attractive since the 2008 crisis, claims Joe McDonnell of Morgan Stanley's Alternative Investment Partners, which has an AUM of $20Bn.

According to figures from Create, wealthy individuals accounted for 60 per cent of hedge fund assets in 2008, but made up 90 per cent of redemptions in the chaos that followed, with Madoff further undermining their confidence. “These funds don’t want too much money from the private wealth sphere or a particular geography,” preferring diversification between family offices, endowments and pension funds with varying liability profiles, believes Mr McDonnell.

There is much disagreement within the industry about whether the liquidity driven Ucits III, or ‘hedge funds lite’ vehicles, used to approximate the structure and performance of Caribbean-domiciled offshore fund by using a European registered, toned down version, will ultimately prove successful.

“You see a lot of hedge funds in this space compromising their investment process to create liquidity,” says Mr McDonnell, who expects much of this business to evaporate, as private investors question why they are being charged such high fees for underperforming, onshore-regulated versions of traditional hedge funds.

Instead, those investors prepared to accept rigorous, institutional-style due diligence procedures and to give up liquidity of 30 per cent of their portfolio for three or four years could benefit tremendously from the changes occurring in the hedge funds world.

“It was once fashionable for wealthy investors to say they had a lot of money invested in hedge funds,” says Mr McDonnell, who believes the whole Madoff debacle was a huge wake-up call for private clients. “Now they are finally appreciating the risks. Institutionalisation of hedge funds will prove highly beneficial for the wealth management industry.”

LIQUIDITY

But there are other hedge fund managers and asset allocators who believe the ultimate success of the asset class will be determined by its liquidity. “We prefer Ucits III funds for our clients,” says Gerard Piasko, chief investment officer at Sal. Oppenheim’s Zurich office. “They are giving the benefit of liquidity, the lack of which proved a big disappointment in 2008.”

John Webster, CEO of $2bn special situations group Altima Partners, shares Morgan Stanley’s concerns about liquidity and “dumbing down” investment strategies, but believes Ucits ultimately increases access to hedge funds. “Ucits is an opportunity, but the Ucits structure is just one of a number of structures that a fund can employ,” comments Mr Webster, whose firm sponsors a number of Ucits funds.

“There is a concern about the possible tracking error in a Ucits version compared to other structures employing a similar investment strategy. In emerging markets for example, there are a number of places where there are underlying liquidity issues, while in agriculture, exposure to commodities themselves is restricted. But if the product fits into a UCITS wrapper, then it works.”

Yet, seeking full compliance with European rules, including the forthcoming EU Alternative Investment Fund Managers’ Directive (AIFMD), is now central to the business plans of many groups, concerned about being marginalised in an increasingly regulated world.

“Regulatory compliance is going to be a costly process, but this is the world in which we live,” says Mr Webster. “You can go to a sandbar in the Caribbean if you like, but if you really want to be regulated, then you should stay in London and put up with it.”

The world of hedge funds, which Mr Webster was very cynical about as a “gatekeeper” in his previous role at consultancy Greenwich Associates, is continuing to evolve he says. “On joining Altima, I was very relieved to see that board meetings were not held over a coffee in Starbucks,” he remembers. “That can’t be said for some other parts of this industry.”

BRUTAL DARWINISM

The new focus on running a hedge fund as a responsible business is all about a transformation in the way portfolio managers see themselves, prompted by client expectation as much as regulation.

“In the past, this was a lifestyle business, a cottage industry,” claims Create’s CEO Mr Rajan. “It was never that clear where work ended and life began. I used to subscribe to the theory that hedge funds were just an elaborate compensation scheme, designed to make their managers very rich. That may have been the case in the very benign environment of the last decade, but now a brutal Darwinism is taking shape.”

Right across the industry, there are reports surfacing of a different breed of individual entering the hedge funds world, much of this prompted by the fast changing regulatory environment. “A lot of the people who come to us are used to having two secretaries; they talk about entrepreneurship, but they can’t even buy their own bus ticket,” complains one well-placed city headhunter. “These people can no longer survive in the new world of hedge funds.”

Most agree that the successful new players will be the recently spun-off 15 to 25-strong proprietary trading desks of investment banks such as Goldman Sachs, Morgan Stanley and JP Morgan.

“I don’t know how small players will really thrive in future, as $5bn to $10bn of capital will flow to each of these new start-ups over the next few years,” says Morgan Stanley’s Mr McDonnell. “This has been forced by regulation and it will be the biggest trend in the hedge fund industry. It will be quite profound and something we have not seen before.”

The fact that private clients can now access the top proprietary trading desks will be a huge positive development, he adds. Portfolio managers currently in vogue are the product specific players, with expertise in relative value, convertible arbitrage and long-short credit strategies, reports Adetola Oyegbite, senior recruitment consultant at headhunters Carrington Fox.

MULTI-ASSET SKILLSET

Lockwood Gibb & Associates reports three types of prominent searches which currently dominate the hedge funds sphere. Firstly, there is a huge demand for multi-asset players. “There are simply not enough global macro people to go round,” says Sarah Dudney, a partner in the firm. “Every private bank wants that multi-asset skillset. Fund managers have grown up in silos: either you are corporate bonds or Japanese equities. Getting somebody who can speak about and manage all asset classes is what everybody is after today.”

Secondly, there is a nascent demand for risk professionals, as hedge shops begin to prepare themselves for the regulatory onslaught. “Selling a hedge fund is far more complex than in the past and prospective clients are much keener to meet the risk manager, because of the nature of where we have been,” she says.

“Concern about operations and investment risk has become enormous in the last 12 months. Specialists in these areas now need to be able to communicate with clients, and good luck with finding one of those.”

In addition to bringing a “bag load of quant skills” to the table, the new-age risk boffin also needs to be able to walk the aisles of the business and “sniff out” any operational problems, leaving these experts in high demand.

The final piece in the jigsaw is the product specialist, who has enough technical knowledge to act as a link between fund manager and client, able to explain the innards of product machinery and also facilitate the sales process. “This is somebody who can talk like a fund manager and walk like a salesman,” explains Ms Dudney.

“You don’t want somebody as a product specialist in a hedge fund capacity who just spouts Vars and Sharpe ratios,” she says. “You need somebody who can conclude a meeting on a commercial note and tell you what happens next.”

This emphasis on product innovation, sales and delivery has become the key consideration in 2011 for both institutional investors and the managers who promise to extract “alpha” from their assets, believes Create’s Mr Rajan. While private individuals and wealthy families may have briefly fallen out of love with hedge funds, following the crisis and the widespread Madoff losses, there is a growing recognition that “you are not going to get absolute returns form a long-only manager investing in domestic equities.

“Traditional groups are likely to go on expanding to absolute return funds. They are not actually calling them hedge funds, but these are clearly long-short strategies,” he says. “And these big groups have a key advantage which the hedge fund boutiques do not. Their institutional clients are clamouring for transparency and they are probably best placed to provide it.”

VIEW FROM Bovill

The latest AIFM developments

Marketing

The marketing passport is a helpful step but it does not go far enough. It only relates to “professional investors” , a definition which effectively excludes high net worth and sophisticated individual investors because of the way in which the “opt up” criteria are determined. The requirements to provide copies of marketing material to regulators will slow down fund raising by effectively banning pre launch marketing as well as imposing significant burdens on regulators.

Remuneration

It is difficult to see where the justification for these proposals lies. It is common practice for managers to invest in the funds that they manage and it is therefore unnecessary to impose requirements that 50 per cent of bonuses must be so invested.

Delegation

Under the directive, management may only be delegated to another authorised AIFM – this could have unintended consequences of bringing many firms into AIFMD.

Capital

Not a massive issue for most but will be for some. Particularly those choosing to opt in or those caught at the margins.

ESMA

The directive delegates significant powers to Esma – the new pan European securities regulator. How these powers will be exercised in practice remains to be seen.

Ben Blackett-Ord, chief executive at Bovill. The AIFMD will be transported into national law in January 2013