New launches signal a revival of fortunes

The market for new hedge funds is burgeoning. Numbers are back to 7,000 – short of the 7,600 high in 2008, but a recovery from the 6,800 recorded last year, according to figures from research consultancy Investment Quotient.

Many new launches have been driven by the closure of investment banks proprietary desks under the “Volcker rule”, named after the former chairman of the Federal Reserve who instigated the regulation clamping down on the extent to which banks can bet with their own capital.

Big names can still raise substantial amounts of money. Goldman Sachs star trader Morgan Sze’s is raising over $1bn (E750m) for an Asia venture, Azentus Capital, which will have a team of 30, one of the largest hedge fund launches since the credit crisis. Nine members of Goldman’s proprietary trading team have already joined KKR, while a former Credit Suisse commodity trader has poached colleagues to set up a hedge fund. A proprietary trading desk at an investment bank can effectively be a fully-functioning hedge fund business from day one and several banks such as Morgan Stanley are also spinning out their prop teams.

The consolidation of the market into fewer hands is continuing, with around 80 per cent of hedge fund assets held by the top 50 managers, according to Charles Krusen, chief executive officer of Krusen Capital Management in New York. The largest hedge funds are monitored by consultants, which gives investors comfort and helps attract new money.

Investors also expect more. “An existing big name is more likely to open a new strategy than a completely unknown manager because of the requirement for the manager to have institutional quality infrastructure, albeit without institutional bureaucracy,” says Mr Krusen.

This flight to quality may soon be played out, however. “Over the next year or so the trend to large players may come to an end,” says Chris Wyllie, a partner at Iveagh Private Investment House. “We’ve seen an institutionalisation of the hedge fund space with the big boys getting bigger, and making acquisitions, and starting to morph back into broadly-based asset managers, the very style they moved away from 10 years ago. Leading names in the hedge fund space are starting to look and feel more institutional in their approach, albeit with good returns.”

Mr Wyllie anticipates a split in the hedge fund universe. “Investors can choose the largest managers’ Ucits and their steady Eddie approach, or can go for more esoteric strategies of smaller boutiques with more targeted risk.”

Private bank investors certainly continue to be heavy supporters of hedge funds; they like the notion of talented traders and uncorrelated investments. “The DNA of private bank and other high net worth investors has not changed,” says Pascal Botteron, Deutsche Bank PWM’s global head of hedge and mutual fund investments. “They are ready to go back to absolute return but are demanding greater due diligence and better liquidity.”

For some private bank clients, Ucits III funds have great appeal, offering the stamp of regulation, better liquidity and an advantageous tax treatment in the UK. Minimum investments are as little as $10,000 rather than the more typical hedge fund’s $1m. Several groups are growing their presence in the Ucits III market, taking advantage of Ucits passporting for distribution across Europe. Deutsche, for example, now has 22 Ucits III absolute return managers on its approved list. Its fund of Ucits III has taken $100m since its launch in July and a fund of managed accounts was launched in January.

However, the additional layer of Ucits fees is seen as a drawback. “While the retail investor may be wooed by the liquidity of the funds, we are of the belief that the cost of liquidity has never been higher,” says Rhian Horgan, international head of alternatives at JP Morgan Private Bank.

“The high yield market may be trading at spreads of 600 but private credit markets, particularly in the small/mid cap space are pricing in the mid teens. Within the context of clients’ asset allocations, they need to think about their liquidity budget and we can then allocate to managers who have shown a proven track record of extracting returns in less liquid markets.”

Andrew Popper, chief investment officer at Société Générale Private Banking Hambros, also sees “little interest in Ucits III from us as a private bank.” The real choice, he says, is offshore hedge funds registered in places like the Caymans, and managed accounts, which are becoming more predominant and are by far the main area of growth.

“Managed accounts offer liquidity, transparency, and safety. We are using them in a number of ways – in order to create funds which we can then unitise, to create the underlying for structured products, and, for large clients, to create bespoke portfolios.”

Investors in managed accounts effectively enjoy investment bank-level risk monitoring on all positions. The platform managers have an ongoing means of control, as trade settlements are accomplished through the platform, and can follow activity on a day to day basis with no risk of strategy drift or assets disappearing.

“There is no shortage of funds moving to managed accounts,” adds Mr Popper. “We don’t feel there is any narrowing of opportunities as there are more funds than before. Initially the well known ones were concerned that the world would know their strategies, so in the early days managed accounts only attracted the second tier. In 2008 even the best funds lost through redemptions and now they are much more amenable.”

Certain strategies do not adapt easily to managed accounts, however, such as investing in distressed assets, and any assets where liquidity is challenging, including fixed interest, commodities and micro cap. Total return swaps matching these instruments are expensive and costs may not stack up.

Liquidity impairment was undoubtedly the big shock that frightened clients in 2008, rather than poor performance. However, while a managed account platform will own the securities and an investor may believe he is the owner, whether redemptions could in practice be accommodated easily is more doubtful.

The promise of liquidity and security also comes at a price. “Investors pay a price for managed accounts but do they really need line by line transparency?” asks Arnout Snouck Hurgronje, director, alternative investments, at Axa Investment Management. “I don’t think so. For very large funds it may cost an additional 40-60 basis points, for smaller funds around 1 per cent. That is quite a burden.”

Lyxor, an early mover into this space in 1998, now has 100 managed accounts and assets of $10bn on its platform, and boasts a broad range of strategies including distressed and event-driven strategies, convertible bonds, and more complex alternative strategies. “The crisis of 2008 was a litmus test for investors, and we started to see huge inflows,” says Stefan Keller, head of research and external relations for managed account platforms at Lyxor.

“As competition grows, so we and other providers are adding greater service in terms of diversification, bottom up research and reporting, and monitoring and managing risk.”

Some private banks involved with Madoff have been more or less forced to use the full transparency of managed accounts to stay in business. However, investors still do not always scrutinise the right things, says Bob Gelfond, CEO of MQS Asset Management, who points out that Madoff offered monthly reports and full registration. “Investors should focus on things the manager can’t control such as the independent auditor and administrator who can validate what is going on,” he explains.

“People are learning the questions to ask,” says Randy Shain, executive vice president of First Advantage Investigative Services, which undertakes background checks for funds of hedge funds and consultants. “Investors are beginning to understand there is no free lunch, and that it is rare for someone to always beat the system. Foundations, family offices and endowments were traditionally the groups that thought due diligence services were too expensive, but they are also coming round.”

Looking ahead to 2011, global macro strategies should do well as the uptick in corporate activity creates cash that businesses attempt to use constructively. “On the risk arbitrage front, today corporate cash balances are at their highest levels in 50 years, with over 15 per cent of tangible book value in cash,” says JP Morgan’s Mr Horgan. “While many companies have performed well in the last two years, it’s typically been driven by cost cutting rather than growth on the revenue line. With organic growth harder to come by CEOs will look to M&A to drive growth.”

A flurry of funds have come to market with event-driven strategies, such as the Morgan Stanley fund managed by P. Schoenfeld Asset Management.

Long/short equity, which has been out of favour, is expected to perform well. Just 16 per cent of AUM on the Lyxor platform is currently long/short equity, down from 40 per cent three years ago, but it is expected to recover as the drop in equity market correlations supports strong stock pickers.

Many of the best managers are now closing funds again. “Most of the money is going to the established names but at some point they will close up,” says Mr Gelfond at MQS. “Getting into a good manager now is important as opportunities to do so may be gone in a few years.”