A phenomenon, not a fad
The hedge fund industry is at a turning point in its evolution as it faces the challenge of becoming a fully-fledged asset class. Some professionals believe that hedge funds will soon become plain vanilla products, like mutual funds, while others argue that the recent spectacular increase in demand for alternative investment strategies is only a temporary fad, a fashion trend.
Nevertheless, in Europe it is quite clear that the hedge fund phenomenon is only just beginning. At this time of difficult market conditions increasing institutional involvement is likely to continue to grow at a rapid pace. Are we likely soon to see hedge funds moving towards retail investors and the mass market? It is too early to predict; recent initiatives in the UK and French markets will have to be monitored closely.
However, we can already see financial institutions across Europe including hedge funds in their product range and developing distribution capabilities to diversify their product offerings. Our objectives in this article are to present an overview of the demand for alternative strategies in Europe to rank market places by levels of exposure to hedge fund strategies, including funds of hedge funds, and thus consider where future developments are likely to be seen.
The numbers speak for themselves: 40% growth in hedge fund assets in Europe in 2001 to $64bn (e65.3bn) under management and an estimated $571bn globally as of the second quarter of 2002, according to HFR. In the latest report published by Goldman Sachs and Frank Russell Company (Alternative Investing 2001), European survey respondents said they planned to move from direct allocation towards the employment of funds of hedge funds. Their strategic allocations saw hedge funds strategies increase from less than 2% of their portfolio in 2001 to 3% by 2003. Finally, net assets inflows globally were mainly in distressed securities and event driven, according to HFR. However, after enthusiasm in Europe for convertible arbitrage strategies, in the past year institutional demand has mainly been for funds of hedge funds, offering a larger diversification in investment style, especially for new investments.
The concept of portfolio management at both retail and institutional levels has considerably changed in the past two years. We are moving from an indexed, relative performance-driven model to a more active investment management concept where the term ‘absolute returns’ is becoming standard. Retail investors have come to understand the meaning of the Sharpe Ratio, and stock markets’ increasing volatility has made a strong impact on their investment decision-making process.
These changes are reflected in the way financial institutions now promote their investment products. Investors of today are more sophisticated and are being offered new alternatives to traditional mutual funds.
This evolution is automatically directing financial institutions to the expansion of their product ranges at a time when competition between banks is so crucial. Therefore uncorrelated and absolute returns are logically becoming the product in demand. Therefore, logically, hedge fund strategies are potentially in high demand and that demand is likely to increase still further.
When it comes to mapping European institutional demand, countries fall into three groups: the leaders, the movers and the late entrants. First, the leaders:
q Switzerland has historically been the foremost marketplace for hedge fund strategies. Some Swiss pension funds recognised the need for portfolio diversification and have built up product knowledge and investment exposure over the past five years, with the assistance of specialist local consultants.
q France has been another centre of remarkable development for hedge funds’ management style since the mid-1990s. The demand for cash enhancement from insurance companies, corporate and saving banks led to the development of ‘hedge funds à la française’, mainly bond and enhanced money market products, and more recently funds of hedge funds.
q Italy is the most recent entry into the leading group in the European hedge fund industry, with two interesting legal initiatives: a tax relief for offshore investment and a legal framework for onshore hedge funds. About 10 financial institutions have launched mainly funds of hedge funds and more recently single managers. They have raised an impressive e1.7bn since June 2001.
The movers are:
q The Netherlands, where pension funds have reviewed opportunities to add exposure to hedge funds in the last year, actively meeting leaders in the industry and selecting funds of hedge funds. Due to the importance of their allocation (2–3% initially between 2002 and 2003) and the amount considered (e1bn–2bn over three years), their initiative is being closely scrutinised by professionals, who see these moves as critical for the evolution of pension funds’ demand for hedge funds across Europe.
q The UK market is opening up to the concept of hedge funds. London is the traditional marketplace for hedge fund management, but there has been no real institutional demand so far. UK pension funds now recognise the necessity to diversify assets, following Myners’ guidelines and also seeking alternative risk profile from their traditional high exposure to equities.
q In the Nordic countries some pension funds recently announced investments in hedge funds and they are inclined to add exposure if needed.
Late entrants are:
q Spain and Germany, seen as the most difficult marketplaces for hedge funds in Europe. Germany has been difficult, mainly for tax issues and the lack of initiative from the regulatory body, despite recent initiatives of guarantee notes linked to the performance of funds of hedge funds.
We understand that Spanish institutions do want to diversify into hedge funds but the regulator is responding with a firm veto of all recently suggested initiatives. While Spanish institutions focused on their Latin America exposure, hedge funds were not a priority, but they may become a hot topic soon as the performance of the stock market is forcing them to look at alternative investments.
The real challenge today is one of education and asset recognition by institutional investors.
Most trustees and investment committees reckon they have only seen the negative side of hedge funds through articles in the press. The LTCM scandal still affects the image of an industry perceived as opaque and non-transparent. But what are the main benefits of investing in hedge fund strategies? Relatively few managers start their presentation by making the effort to position their products with traditional investments. Except in Switzerland, most traditional consultants have not developed a competency in hedge funds and have ignored their potential as an asset class. Today some gatekeepers are recruiting to fill that product gap with the risk of having young and inexperienced staff.
Therefore, after two difficult years for traditional investments, some investors still doubt that the 2002 year-to-date performance of 3–5% for funds of hedge funds is enough to shift significant assets. However, no one doubts the benefit of diversifying risk and it is only a question of time, perhaps several years, until the acceptance of hedge funds as an asset class in institutional portfolios.
Sophie van Straelen is managing director of Asterias in London, a consulting and fund-raising operation specialising in funds of hedge funds