Hedge funds back on the menu for private clients

Having faced record redemptions during and post the financial crisis, hedge funds appear to be back in fashion with private banks, although the Madoff fraud and the issues surrounding side-pockets and gates are still fresh in private investors’ minds.

The average private banking client is still underexposed to hedge funds, having shied away post 2008, says David Bailin, global head of managed investments at Citi Private Bank. “Clients would be well advised to return to the hedge fund space, as many factors today are indicative of very good return profiles ahead,” he says. At Citi, private investors are recommended to be fully invested in these alternative vehicles and have an average weighting of 16 per cent in portfolios.

 “In the current environment, clients should have a full hedge fund exposure and be overweight in equities. They are going to have to act against their instinct. They are going to perceive we are telling them to take more risk, but we are not. The risk is in fixed income and in having too much cash,” states Mr Bailin.

In the hedge fund space, equity long/short has been one of the best performing strategies year to date, as it was supported by rising equity markets and decreasing intra-stock correlations. This created opportunities for stockpickers, which had hard time when activity in stockmarkets post crisis was largely dominated by risk-on/risk-off behaviour. As intra correlation drops, stocks start to trade more on fundamentals and performance begins to diverge.

“Hedge funds are more able to make money during market dislocations, as they are able to discern what securities to own and what not to own and to use their flexible structure to invest accordingly,” says Mr Bailin.

To meet client demand, Citi Private Bank recently started offering clients a fund of hedge funds providing liquidity every two weeks. In addition, the bank has 40-50 hedge funds on its platform, and clients can buy or build their own fund of funds. “We think clients should have broad exposure through fund of funds and should not invest in fewer than seven to 10 managers, with 15 being the average.”

Investors are still concerned about liquidity problems, side-pockets and gates as well as fraud, confirms Andreas Leukert, senior analyst premium solutions at Bank Julius Baer.

“However, sophisticated clients, knowledgeable about the asset class, are also ready to invest in less liquid strategies,” he says, explaining it is important that liquidity terms offered by a fund are in line with the underlying portfolio to avoid liquidity mismatches, which caused issues in the past.

Investors are looking at hedge fund strategies to access equity markets through an investment style that is less volatile and has less downside risk, he explains. They also look to them as a replacement for their long-only fixed income allocations, given today’s low yields, and supposedly the end of the 30-year bull bond market. Also, generally hedge funds are included in portfolios as they are believed to offer an uncorrelated source of alpha, providing diversification.

Historically, Julius Baer has always recommended its clients to only invest in a fund of hedge funds, but this year the bank rolled out a new premium fund offering, giving access to single manager hedge and private equity funds, to meet new demand. “Clients have been partly disappointed with diversified funds of funds during the crisis and with recent returns, in some cases, and are questioning the value added they offer, for the additional layer of fees,” says Mr Leukert.

While there have been withdrawals from funds of hedge funds, there have been “healthy” inflows into the single manager fund programme. But there is still “selective interest” in strategy specific funds of hedge funds like long/short equity. “Funds of hedge funds need to provide some interesting way of sourcing managers, active allocation between strategies and sub-strategies and need to serve some more specialized investment needs,” he says.

Consolidation, particularly within the fund of hedge funds industry, is expected to continue, as most face outflows while regulatory cost increase and fees remain under pressure.

The typical hedge fund fee structure, a 2 percent management fee and 20 percent of gains – is no longer sustainable for every manger and strategy, states Nils Beitlich, head of alternative investment research at Credit Suisse. There is the tendency for larger funds of funds to reduce it to 1/10 or even 1/5 and, on the other hand, clients are increasingly more demanding with regard to performance.

“Over recent years, most hedge funds of funds were not able to outperform, mainly because of the double layer fee and the difficulty to exploit the best managers,” says Mr Beitlich. “Investors slowly realise they often get average performance only, and then it would be better to buy a liquid index or replication strategy, rather than a hedge fund of funds.”

The growth of Ucits strategies, allowing small investments, in contrast to the minimum $1m  (Ä0.75bn) most hedge funds required before 2007, has made the asset pooling ability of hedge funds of funds redundant to some extent. “Investors no longer need managers pooling money for them but someone able to identify the best performers,” he says.

Single fund of funds managers are unlikely to survive in the increasingly competitive market, believes Mr Beitlich. On the other hand, banks with a large infrastructure, risk management skills and teams of specialists are in a better position to provide this offering, also from a cost perspective, and Credit Suisse recommends funds of hedge funds to its wealthy clients  for the broader exposure they offer.

Private investors are increasingly interested in regulated instruments, because of higher liquidity, transparency and lower minimum investment thresholds. “For liquid strategies, particularly long/short equity and managed futures, Ucits funds are gaining a lot of traction,” says Mr Beitlich, adding though that due to stronger investment restrictions, some strategies can only be implemented at additional costs, which may cause substantially lower returns compared to similar offshore funds.

Credit Suisse’s positive stance on equity driven strategies is based on a constructive view on equities over the next 12-24 months.

This is because most of the long/short funds are long biased to equities, with on average 20-50 per cent beta to equity markets, and therefore are affected by the broad equity market performance. Nevertheless, over the last 12-months long/short managers have been able to successfully adjust their equity exposure in times of short market stress in order to avoid larger draw-downs, explains Mr Beithlich.

The Swiss bank favours long/short funds focusing on the US, whose equity market is particularly promising on a strategic horizon, as well as Japan. 

In Europe, convertible arbitrage strategies look interesting too. “While convertibles in the US are relatively expensive, we expect hedge fund managers to focus on Europe to have promising outperformance, as convertibles are still relatively cheap, due to the lagging equity market performance.” With yields rising higher, attractiveness of convertible issuance should increase, setting a better investment universe in the coming years,” says Mr Beitlich.

Although the current environment favours global macro strategies, over the last 12 months, their performance was not satisfactory. “It seems macro managers, either because they are too big or are in crowded trades, are not able to play the market as expected, even if there are lots of opportunities out there.”

Manager selection is the most important factor driving performance, with strategy allocation being a secondary factor, says Peter Rigg, CEO of HSBC Alternative Investments Ltd (Hail), which manages $30bn (€22bn) of alternative assets globally. But in global macro this has been particularly relevant, he explains.

Despite many “great trends” in the markets, with moves in currencies, equity markets and interest rates, the index for global macro has been just slightly positive. But the managers selected by the firm, particularly those with exposure to the broad range of asset classes, have done “a lot better”, claims Mr Rigg.

In equity long/short, Hail favours managers with low net exposure to the equity market, so they do not just move up and down with it.

One of the weaker performers this year has been managed futures or so-called CTAs, which use computer models to automatically spot and ride market trends. Many of the largest quant hedge funds, such as AHL, the $16.4bn flagship fund of Man Group, suffered steep losses at the end of May/June following the sell-off in global bond markets, as investors anticipated an end to the Federal Reserve’s measures to stimulate the US economy. This rapid fall led some commentators to believe these strategies may be ‘broken’. But long-term investors remember their ability to generate performance in difficult markets, due to their low correlation with other strategies. The HFR Macro Systematic Diversified/CTA Index was up 18 per cent in 2008 while the Fund Weighted Composite Index was down 19 per cent.

“CTAs have interesting long-term characteristics and we strongly believe there is a good case for holding them in portfolios,” says HSBC’s Mr Rigg. “There is potential for some volatility in the short-term, but the position in our portfolios is such that we can tolerate it. We keep the allocation exactly at the neutral level we have always had.”

Keith Haydon, chief investment officer at FRM, the hedge fund investment specialist responsible for Man Group’s open-architecture hedge fund solutions, has a different view.

“We have had a low allocation to CTAs for quite a long time and we have reduced them to the lowest level we have had in the history of the firm.” However, he considers not having them “quite a big bet” because in the right circumstances they can clearly perform very well.

 “I don’t like the opportunity set for most CTAs, with respect to fixed income, in particular. There is more money chasing what I think is a diminishing opportunity set, and therefore the alpha is going to get spread very thin, and I suspect the sign on the alpha might be negative,” says Mr Haydon, explaining many debates are taking place on this topic with his colleagues at AHL.

In the equity driven space, an element of concern is that the positive performance of long/short strategies depends on continued rises in equity markets, particularly now after they have risen and are “a bit more stretched” than they were at the beginning of the year. This is particularly more relevant when portfolios, like the ones run for institutional investors by FRM, are constrained to have a target of zero beta to the equity markets, says Mr Haydon.

Moreover, investors having a positive view on equity markets could just buy index futures or ETFs, and not bother paying 20 per cent in management fees, he says. “What we do like are equity long/short strategies, which employ reasonably short holding periods. There are lots of quantitative signals about micro inefficiencies in the equity market where they can do lots of these trades. The markets have become less efficient as a result of the banks deploying less capital in this space, and therefore there is still more opportunity for market neutral quantitative higher frequency,” he explains.

Significant returns

Looking to the next three to five years, event-driven managers have the potential to offer significant returns, predicts Charles Stucke, chief investment officer of Guggenheim Investment Advisors, whose business unit Guggenheim Investment Advisory is part of US financial services giant Guggenheim Partners, which grew out of the Guggenheim family office.

Guggenheim Investment Advisory supervises $70bn for UHNWs, HNWs, families, endowments and foundations and supports an alternatives platform providing access to about 50 external managers. “Companies globally are holding high level of cash balances, which are earning nothing,” says Mr Stucke. “Since the crisis, leverage has come down dramatically, so they have dry powder to perform a variety of different transaction types.”

Between 2009 to 2012, leverage on corporate balance sheets fell but return on equities rose. “For several years now, CFOs were getting a free ride, with rapid earnings levels, declining leverage and increasing ROE.”

That trend started to shift at the end of 2012. ROEs have begun declining, competition has started heating up and earnings are coming under pressure. “We think the combination of these factors indicates a more robust economic environment and may encourage CFOs to look for other ways to maintain or grow earnings and ROE,” says Mr Stucke. Such tools available for these companies include spin outs, divestitures, recapitalisations, special dividends, share buy backs and mergers.

However, event-driven strategies do not necessarily offer the best risk-adjusted return, as they are more aggressive, on average, than most long/short strategies and tend to be less liquid, he says. “Long/short equity, today, represents the largest allocation in our portfolios, as the liquidity, simplicity and transparency these strategies provide are favored by many HNW clients.”