Fund of funds slow to adapt to new world

The concept of the “gate”, established by more than 15 per cent of hedge funds during the crisis of 2008, restricting investors’ access to their money, has left a lasting scar through both the single strategy and fund of hedge funds arena. A series of incidents where major investors, including famous individuals, fell out with friends in the hedge funds industry when their withdrawal requests were refused, led to what Paul Marshall, founder of UK hedge fund group Marshall Wace, called the industry’s “Hotel California moment”, referring to the Eagles song of 1977, with the lyrics: “We are programmed to receive./You can check out any time you like,/But you can never leave.” Gates and lengthy lock-ups have been a key problem for the fund of funds industry. Investors, particularly private clients, who have been sold this model as key to the glitzy, exclusive hedge fund world, have been particularly disappointed in recent times. While the average single strategy fund returned 20 per cent during 2009, the average fund of hedge funds achieved 13 per cent, according to fund performance measurement and analytics experts HFR. This relative underperformance was particularly pronounced in the first part of the year, when both single strategy and funds of hedge funds were licking their wounds and consolidating after the 2008 meltdown. But single manager funds achieved a quick turnaround, despite losses averaging 19 per cent – and nudging 30 per cent in some cases – during 2008, and began to generate performance as markets began to recover. The same cannot be said of the funds of funds, struggling to liquidate losing positions in emerging markets and merger arbitrage and other strategies, which ironically were about to recover. “As the single strategy managers began, almost immediately, to generate performance as markets recovered, the funds of funds were still active in the rebalancing process, trying to withdraw capital from certain funds and redeploy it with others,” explains HFR’s President, Ken Heinz, leading to the performance shortfall. But funds of hedge funds have been operating a flawed model for some time, and this is just another example of them being unable to adapt to fast-changing circumstances, he believes. “People began to say that funds of funds were under pressure due to their exposure to Madoff. But the effect of Madoff was only incremental, as funds of funds had already lost 22 per cent in 2008 even before the Madoff fraud was discovered,” he comments. The future of the fund of funds business model, he says, must take account of the evolution of the industry, embracing transparency, and offering investors “intelligent pricing, institutional analytics and a level of due diligence that extends to service providers of the funds they choose to invest in.” greater regulation The move by many investors towards funds structured under a highly regulated Ucits III, EU-friendly format, is given the thumbs up by Mr Heinz, as part of this new focus on transparency. “Ucits is a rapidly expanding structure that many funds are conforming to,” and that both investors and managers will continue to exploit, he feels. But at London-based fund of funds player Culross, principal Nigel Blanshard is sceptical of the new trend, despite the fact that 80 per cent of established funds of hedge funds plan to launch products investing in Ucits-compliant, so-called hedge funds “lite” products, during 2010. Leading players such as Marshall Wace, Brevan Howard and GLG have already started raising money for locally regulated, onshore Ucits funds, of which around 160 have already left the launchpad, according to hedge funds platform Lyxor. “We are not restructuring our vehicles for Ucits III and in many cases, this is bordering on the impossible,” scoffs Mr Blanshard. “Those funds that have provided a Ucits III offering are selecting from a restricted menu, and at present, we don’t want to restrict our menu of hedge funds. Ucits III is about fashion rather than necessity when it comes to hedge funds. We want our managers to be able to eliminate market risk by going short, but you can’t do that in a Ucits III fund, in case someone had forgotten. Ucits III is not the universal balm that fixes all.” Distorted data He is sceptical of recent criticism of the traditional fund of hedge funds model and the notion that investors are paying higher fees for lower returns. “If performance is poor, then that is unsatisfactory, and investors should not pay two levels of fees,” reckons Mr Blanshard. “But one needs to look quite carefully at the 2009 hedge funds performance data, as it includes many funds that benefited from the rebound effect. You could argue about a positive distortion to aggregate data and surely funds of hedge funds should also have enjoyed the rebound effect. But a large number of them didn’t, as they were forced into liquidating portfolios to give money back to clients.” There is a also a huge problem with ‘sidepocketing’, he argues, referring to the practice of creating a pre-agreed legal structure within a fund which enables the manager to ringfence sections of the portfolio so that the negative (or sometimes positive) impact on performance is isolated. These practices have led to significant data interpretation problems, believes Mr Blanshard. “Sidepocketing has left a legacy, which all future analysts of hedge fund and hedge fund of funds data will have to be very careful of.” Yet despite these problems, he believes the most powerful argument in favour of funds of hedge funds, that they offer access to a complex landscape which shows no sign of simplifying, remains current. “It is logical to go to an informed and credible manager or adviser and to pay him for that,” he claims. “But the investors need to see that the guidance they are getting is good and that it keeps them away from problems and guides them to the industry’s more successful, better performing funds.” At the moment, many of these opportunities are in the global macro arena. “The credit market landscape is very interesting,” he says. “There are conflicting currents and arguments, with some predicting that credit is too expensive and others too cheap.” This naturally leads into distressed debt opportunities, he believes. “Three years ago was far too early to invest, when distressed debt funds were traipsing through Europe, peddling their view saying now is the time to buy. But now really is the time to buy and every investor needs to time these things in the broad sense.” Analysts at Lyxor, which values the cloned funds listed on its platform at $11bn (E7.8bn), down from a peak of $13bn in 2008, are particularly keen on distressed debt and long/short credit funds, and see some mileage in short-term fixed income arbitrate, short-term commodity trading advisers (CTAs) and global macro funds. They advise clients to slightly underweight long-term CTAs, long/short equity and convertible bond arbitrage and strongly underweight volatility arbitrage strategies. Lyxor has seen demand for Ucits III regulated strategies and is planning to launch a fund of funds investing in them, for wider distribution, but has been slow to react to the trend, perhaps waiting to gauge longer-term investor interest. The story has been a different one at some of the household name managers, which have raced to enter the field. HSBC, for example, which has more than $30bn of private bank clients’ assets invested in alternatives, has recently launched a sterling class of its HSBC Ucits AdvantEdge fund of funds. Admittedly, the aims for this appear to be as much to reduce tax bills for UK investors – who will be taxed at capital gains rather than income tax rates on disposal of assets – than increase transparency through access to regulated vehicles. Schroders has huge expectations for its new Gaia platform, planning to launch two or three funds every year, managed by third party managers, offering a range of strategies compatible with the Ucits rules and envisages there will be little significant performance lag. “The onus is on firms launching Ucits products to ensure they are not second best to the unregulated version. In any event, more favourable liquidity terms and greater transparency are significant advantages for clients investing in the Ucits versions. We plan to work only with well-known managers who have a long and robust track record,” says Schroders’ global head of product, Gavin Ralston, who still sees mileage in the fund of funds model. “The Madoff events of 2008 have, if anything, underlined the value of the due diligence performed by funds of hedge fund managers. And there are still many ‘star managers’, who are difficult to access independently.” Mr Blanshard at Culross is convinced private clients will return to the fund of funds model. “There is no question that wealthy investors were most effected by last year’s events, so it is reasonable to suppose that they will be slow to come back as clients will take time to adjust. But there is no doubt that hedge funds will be getting back into private client portfolios,” he states. His hope is that rather than thinking of the title track of the ‘Hotel California’ album, private clients will increasingly relate to the title of another classic on the same disc, ‘Try and love again’.