The trade-off between higher returns and greater liquidity

While the hedge fund industry is showing healthy signs of recovery, hedge funds of funds are still facing significant redemptions this year. It is undeniable that the raison d’être of funds of hedge funds, which lies in their ability to carry out a rigorous due diligence and pick the best managers, has been put under severe scrutiny during the financial crisis, as many of them were invested in Madoff strategies. Illiquidity and lack of transparency have become major issues for investors, who increasingly prefer to use hedge fund advisory platforms to funds of hedge funds, as they want to be more involved in the fund selection process.

Moreover, the modest performance generated by funds of hedge funds, just 2 per cent on average year to date, is certainly not very attractive.

The priority for hedge fund managers is today to focus on very liquid, transparent and flexible strategies, to meet client demand and adapt to the uncertain environment.

“What we think is attractive in the risk reward space is allocating across all styles of managers who are very liquid and very transparent,” says Anthony Lawler, head of portfolio management for Man’s $14bn (€10.5bn) multi-manager business. “Part of the reason for that is that we feel uncertainty in the world is still underpriced in the markets. We are still in a financial crisis that keeps evolving, credit availability is still restricted for middle market companies and consumers, but the governments are pouring very significant amount of capital into the system to try to increase growth rates and economic activity. We believe there is uncertainty in what the outcomes and the path of asset prices are going to be.”

Man’s preference is for proven, nimble traders, who can change their positioning very quickly, such as global macro traders or long short traders who have a history of going completely cash or going net short, if they need to, explains Mr Lawler.

A growing number of funds of Ucits III hedge funds are now being launched to respond to increasing client demand for higher liquidity, transparency and regulatory oversight.

A fund of Ucits hedge funds is the latest addition to Schroders’ regulated hedge funds platform, Gaia, which has gathered around $400m of assets since its launch more than a year ago. The fund, which is the regulated version of Schroders’ offshore fund of hedge funds with eight year track record, was launched largely in response to client demand, explains Gavin Ralston, global head of product at Schroders.

“Most offshore products still operate with either monthly or quarterly liquidity but there is a large client base that wants the ability to access their investments more frequently than that,” he says. “What is key is that we make sure the liquidity terms of the fund of funds are aligned with the liquidity terms of the underlying hedge funds we invest in.”

One of the main issues in the Ucits III space remains the limited size of the industry. Greater diversification in terms of manager and higher returns is needed, states Pascal Botteron, global head of the fund research group at Deutsche Bank. While the hedge fund industry can count on 200 to 500 good hedge fund managers, depending on research criteria, in the Ucits III industry there are currently around 20 good names. As a consequence, the 60 funds of Ucits III funds currently available are doomed to have similar allocations.

Deutsche Bank currently offers three different lists of absolute return funds, including standard hedge funds, managed by around 50 managers, managed accounts, sourced from 25 managers, and Ucits III absolute returns run by a mix of 25 managers in the long only and hedge fund space, as the mutual fund and hedge fund research at the German bank are run by the same team. Mr Botteron highlights a difference on the average performance between the three platforms. Year to date, standard hedge funds are the best performers, while managed accounts and Ucits III are behind by 26 and 170 basis points respectively. The gap can be attributed to different factors, such as Illiquidity premium, instruments available or leverage.

Defensive strategies

The lower performance of Ucits III funds observed in the market can be partly explained by the fact that a few of the managers are managers operating defensive strategies, almost cash plus strategies. Also, it has to be taken into account that some of the first movers in the Ucits III space were more conservative to adapt to the new regulatory environment, explains Mr Botteron.

The key challenge for the Ucits III industry is to boost performance to attract more investors and a portfolio manager needs to compensate for the underperformance of Ucits III funds with active management to add alpha, he says. In six months, as more managers come to the market, the performance gap between onshore and offshore hedge funds will decrease, expects Mr Botteron, as it has decreased over the years the performance gap between offshore funds and managed accounts.

Mr Ralston at Schroders is more optimistic and says there is enough breadth to build a diversified portfolio. “There are now more than 500 Newcits hedge funds to select from and the universe is expanding all the time.

“We have a preference for managers coming from the hedge fund side, because they have more experience in running absolute return type strategies. The majority of the funds we own within the fund of funds are run by recognisable hedge fund names,” says Mr Ralston.

“A compensating factor for the narrowness of the universe is the ability to asset allocate more dynamically, because of the greater liquidity of the underlying funds” he says.

Long horizons

Nicolas Campiche, CEO at Pictet Alternative Investments believes that trading strategies in hedge funds is not that important. “The dispersion of returns within one strategy is so large that it is more important to pick the right manager than to pick the right strategy. Eighty per cent of our outperformance comes from manager selection. We invest in people talent and we are targeting long-term trend, not short-term trends,” says Mr Campiche.

Offshore hedge funds of funds at Pictet have a quarterly redemption policy but the firm is aiming to launch its first Ucits III fund of hedge funds in the first quarter of 2011, to meet client demand for liquidity. “But liquidity comes with a price,” says Mr Campiche, expecting that over the long term a regulated fund of funds will underperform its offshore version. The Ucits fund of hedge funds will invest in a mix of long short strategies and CTAs (commodity trading advisors), the only two strategies conducive to Ucits III, according to Mr Campiche, and will be run by managers Pictet already invests in, who have launched Newcits already.

“People are building expectations for Ucits that won’t be matched, as it is a very constrained environment. But the trend in Newcits or alternative Ucits is an important trend, which will develop and stay. They are filling the gap between the traditional asset management and hedge funds.”

Business pressures and uncertainties about the Directive on Alternative Fund Managers, in particular with regards to the distribution of foreign hedge funds to European investors, have been indicated as one of the main drivers for hedge fund managers to launch regulated products. However, the final text approved by the European Parliament in November, is not as severe as the original proposal and was welcome with relief by parts of the industry.

“The vast majority of the Newcits launches have not been about the directive, but to fit market circumstances right now, as more investors are demanding more regulated products and greater liquidity,” believes Martin Cornish, senior partner at law firm Katten.

After all, the rules allowing to create Ucits funds have been in place for the past five years, but these products have only really taken off over the last 12 to 18 months, he points out.

“We may well see a swing back. These Ucits products are more expensive to set up and to run, you can’t get any significant level of leverage in them, so it is almost certainly the case they are going to underperform an equivalent offshore structure. The question is whether investors are happy with trading more protection and greater liquidity for less performance, once they see numbers coming through,” believes Mr Cornish.

A potential signal that the climate may change is in the decision taken by BlueCrest Capital, Europe’s third largest hedge fund, to liquidate its BlueCrest BlueTrend Ucits fund launched last year. The decision was taken officially because the $630m onshore fund was failing to track the performance of the firm’s offshore, computer-driven $9bn BlueTrend fund.

No free lunch

Although the number of fund launches increased and the assets raised in Newcits are estimated to have reached more than $100bn in assets, it may be just a matter of time before investors realise whether the trade-off is worth it or not, believes Laurent Reiss, head of advisory at UBP Alternative Investments.

“There is no free lunch – if you want liquidity, you’ll have less risk-adjusted returns. But that is an experience investors will have to go through. Like in any new venture, some Ucits III funds will perform very well, and others will not, so you will be able to measure exactly the liquidity premium that you pay,” he says.

Still, to meet client demand, UBP AI is also in the process of analysing a few Ucits III funds, which will eventually be added in the firm’s approved list.

“I don’t know whether better liquidity is better for the investor. In my experience, the more liquid you are, the more you are going to buy when prices are high and the more you are going to sell when they are low.”

The more constraints a hedge fund has, the more it will move away from the optimal point on the efficient frontier, and expected returns will be lower, explains Mr Reiss. Constraints can be liquidity or strategy constraints. A managed account is a constraint too.

“Historically, the best hedge funds have not given you fully transparency, because they did not need to provide full transparency and full liquidity. Also, the size of the universe of managers who agree to open a managed account and give full access of his positions to a third party is limited, and the very best ones will not go into that direction,” Mr Reiss believes.

“You have to find a balance, you do not want to go with daily liquidity, and full transparency, but equally you don’t want to go with a 5 year lock up and no transparency. Right now the pendulum is swinging in favour of transparency and liquidity, but there will be a lot of people who will be disappointed with the returns.”

The use of managed accounts is also on the rise to meet investors’ demand for liquidity, full transparency and control of operational risk. Man has recently announced the launch of its long/short Europe Ucits III equity fund of funds, where managers are selected from the full European equity long/short universe of hedge funds, as opposed to the smaller universe of Ucits III funds or Newcits. Almost every manager is invested in through a managed account.

Permal, the $20bn fund of funds group, recently launched its first Ucits III product, an active trading fund, built entirely of underlying managed accounts, which are Ucits III compliant, offer weekly liquidity, full transparency and with independent risk controls. The $250m product, launched to meet demand from institutional investors, is now drawing interest from family offices and private banks too, says Roberto Giuffrida, director Emea at the firm. None of the managers that run the fund are recognisable hedge fund names that have launched publicly available Newcits, but they have been chosen among those already employed in Permal’s offshore managed account platform.

“Even within the same strategy buckets,” explains Mr Giuffrida, “the individual manager brings their own characteristics, enabling us to achieve great diversification in our portfolio.”

Laurent Reiss, UBP