Customers returning with altered appetite

Charles Baillie, global head of alternative investments valued at $90bn (€60bn) within Goldman Sachs Asset Management (GSAM), can see a light at the end of the tunnel. After a mass rush to liquidity during 2008 and the early part of 2009, he is witnessing some improvement of sentiment and private client money returning to hedge funds. His dedicated unit constructing customised portfolios for high net worth individuals investing more than $15m – whose specialists were twiddling their thumbs in something approaching a ghost office earlier this year – are now working closer to capacity. Flows from Europe and the Middle East, admittedly generated by a small number of high net worth clients, are at last back to $100m per month, compared to zero at the start of 2009. While there is now a natural reluctance among liquidity-conscious customers to put money behind lock-up strategies like credit and distressed debt, commodity-led traders remain popular, as are directional equity long-short and global macro funds. Mr Baillie is even surprised by how quickly some groups of investors have returned to the hedge funds market, despite having lost money in 2008. While very few clients are allocated at the 20 per cent level, recommended by many private banks still clinging to an outdated notion of efficient portfolio theory, there has definitely been a change towards a more positive mindset in alternatives, he believes. In January and February of 2009, there was still a huge disappointment with hedge funds prevailing among investors, because they had lost so much money in a mistaken bet on absolute returns, and were unable to withdraw what was left over. “The promises which made hedge funds better than public markets were clearly not true,” laments Mr Baillie. But by the middle of the year, they saw hedge funds had lost only 20 per cent, while the broader market had fallen 40 per cent, and started to re-examine the asset class in a new light. “Over any extended period of time, people have realised that hedge funds have grown twice the market, with half the volatility,” he adds. The trend he is seeing among private clients, the segment which has been responsible for a much greater rate of redemption across the industry than institutions, is that investors do not want to go back to the kind of vehicles they saw two years ago. “Instead, they are going back where they can see more transparency, liquidity and control. We aim to get better deals for them with managers.” This concern about transparency means investors are actually concerned about prospects for and holdings of individual stocks within hedge funds, rather than just leaving everything to the fund’s manager. A clear picture “People increasingly want to drill down within the portfolio,” reveals Mr Baillie. “They want to better understand the process flow of what is happening to their dollar when they give it to Goldman – what stock or hedge fund is it going into? They want to know where overnight money is going to, when securities are leant and to which counterparty. People are a lot more interested in operational risk than they were before. Previously, it was just market risk.” There is also an all-pervading theme of keeping things simple. “So many clients say to us: ‘I don’t want to invest in anything unless I can clearly understand what it is doing.’ This is a natural reaction to coming out of a period like 2008.” GSAM is currently busy upgrading its HFS separate account platform for investors in hedge funds, in parallel with a new risk management system, which allows every underlying position within a multi-vehicle fund to be broken down and analysed for its risk characteristics. Although Goldman has been notoriously sensitive in the past about discussing any of its proprietary hedge funds, this policy is changing, now that investors’ money is no longer so easy to come by and because clients are demanding more information. Flagship funds which are part of the GSAM offering include the credit focused Liberty Harbor, featuring a team recruited from Amaranth, after the US fund collapsed, the equity long-short GSIP and the quantitative macro oriented Global Alpha fund. One of the questions currently occupying the minds of larger private clients is how to deal with inflation. Half of the client base is currently pre-occupied with the prospect of 1970s style inflation rearing its head within three years, while the other half is more worried about massive deflation, along the lines of a Japanese scenario. In order to cope with the inflationary spectre, protect against a falling US dollar and take advantage of potential growth in emerging markets, Mr Baillie sees benefit in investing in real assset, predominately commodities related, strategies. Many clients are also more comfortable with strategies that can be packaged into a Ucits III mutual fund format, whereas historically clients could only access private vehicles, with limited liquidity. The Ucits III directive has always resonated loudly through GSAM’s offices at London’s Christchurch Court, because the management decided at a very early stage to tie their colours to the mast of the European directive, in order to be able to market investments to both institutional and mass market investors. So it is natural for Mr Baillie and the GSAM product development team to highlight this particular market segment. The problem of closed-ended hedge funds trading at a discount is one that can be overcome. “A lot of our underlying funds are thinking of or already offering Ucits compliant vehicles,” says Mr Baillie. “With Ucits vehicles, there are no discounts. It limits the strategy, but in the UK the offshore tax regime allows flexibility for making the funds tax efficient.” For a wealthy client, whose affairs are based in the UK, investing in a hedge fund through a Ucits III structure can mean the difference between paying 18 per cent, rather than 50 per cent tax on capital gains. Many high net worth individuals will therefore access hedge funds through Ucits III vehicles. Return differential While there are already 40 to 50 prominent groups, usually considered as underlying funds by Mr Baillie’s manager selection team, which have launched Ucits III compliant hedge funds, he still says it will be “interesting” to see the return differential over time between the real and replicated strategy. “In most of these vehicles, the fees are higher and given certain investment restrictions, particularly in the more complex strategies, returns could be lower than those achieved in the main fund,” he believes. “But the tax and liquidity benefits are so great in most countries, that people will decide it’s a better way to invest in hedge funds.” There may be more flexibility if the clients buy the funds through a separate account, rather than directly. He is watching the rise of competing managed account platforms, such as the one established by Lyxor in France, with a keen professional eye and notes that if investors do opt for a core in exchange traded funds (ETFs), linked with high alpha-chasing satellites, as the investment banks are advocating, this will free up a much greater budget, so they will be more willing to allocate fees for hedge fund management. “In 2008, traditional active management did very poorly, with 60 to 65 per cent of active managers underperforming the benchmark,” says Mr Baillie. “This year, on the other hand, we are seeing quite the opposite. Generally speaking, at the beginning of 2008, investors were not being paid appropriately for the risk they were accepting. Many managers took on increasing levels of risk in an attempt to enhance returns and beat the benchmark. The trend was very apparent in fixed income, where anyone taking on risk was severely penalised in the latter half of the year.” The move towards indexation of a passive core may have been premature, he adds. “Volatility is coming down and active management has done very well at a time when everyone is moving their money to passive investments.” On the topic of regulation, Mr Baillie has heard funds talking about potentially changing their domicile, so that they can be sold into European markets in future, with the latest draft of the Directive on Alternative Investment Fund Managers still proving highly restrictive for funds domiciled outside the EU. Although the content of the directive is changing rapidly, he has some concern that EU investors may be restricted to investing in a small portion of the available universe of hedge funds, thereby severely limiting their options.