Fear of a bubble unfounded
The global hedge fund market has grown at a rate of circa 20% over the last four years, total assets under management reaching an estimated $1trn (e793bn) by year-end 2004.
Inflows did slow, however, during the second half of 2004, not least because of the comparatively modest performance experienced in the preceding two quarters. Strong historical growth, combined with the recent slowdown, has sparked a debate around a possible hedge-fund ‘bubble’. The term ‘bubble’, however, is misleading in this context, as a slowdown in new sales, or even isolated redemption activity have nothing in common with a bursting bubble since this would require self-reinforcing downward price dynamics which are clearly not present.
Other alleged weaknesses of the hedge-fund industry may, on the other hand, be worth more serious consideration.
One of these concerns is the perceived tendency that too many hedge funds are chasing too few ideas, thus inevitably depressing average returns through increased competition. Another is that, as correlations between equity and fixed income returns have fallen, so might have the need to further diversify a portfolio using hedge funds.
While neither of these arguments can be entirely dismissed, they do not amount to a structural weakening of the hedge fund market. The argument of decreased return potentials only holds for a limited number of hedge fund strategies and the currently low correlation between equity and fixed income returns does not alter the long-term diversification potential of hedge funds, particularly given that we have seen times of high correlation between fixed income and equity returns and low correlations between equity and hedge fund returns.
However, a slowing down of global growth should be expected as some investors are reaching optimal allocation levels.
We do, on the contrary, observe a number of structural trends supporting further growth of the hedge fund industry:
q Firstly, we note increasing popularity of the “core-satellite” investment approach, leading to an increased differentiation between the more passively managed core investments and the actively managed satellite investments. Hedge-funds should benefit from this trend, while less differentiated products are set to lose out. In continental Europe in particular, this transformation process is far from completed.
q Secondly, we note that the broad trend of increased regulatory activity combined with a more recent demand for more transparency, has now reached the hedge fund industry. Although this might dampen the potential of excess returns, we expect this to also provide access to new sources of funds, in particular from European institutional investors.
q Thirdly, European investors still have relatively limited exposures to hedge funds and a significant catch-up potential compared with US investors.
We expect consolidation among small and medium sized players in the fund of hedge funds (FoHF) business, triggered by regulation, competitive pressure on fees as well as economies of scale. On the other hand, at the top of the market, we expect to see a concentration decrease due to diseconomies of scale, such as those created by concentration limits imposed by top class single hedge funds, making it difficult for large FoHFs to efficiently allocate their funds, as well as due to large banks with a more captive customer base which are leveraging their significant distribution potential.
Germany: The German market held high expectations for 2004, triggered by revision of investment legislation, and indeed the market as whole, certificates in particular, showed significant growth. Nevertheless, sales of the new, regulated products did not quite reach the over-optimistic 2004 targets. Although not putting this entirely down to the inevitable initial difficulties of introducing a new type of investment product to the market, we consider 2004 to be a warm-up phase for 2005. We anticipate demand for hedge fund products to continue to show strong growth, driven mainly by demand from institutional investors, insurers in particular. We estimate the market will grow from currently e15bn to circa e30bn by year end 2007.
While investment through certificates will continue to grow and play an important role, we expect regulated products to make the break-through as they facilitate access for many investors. Because of similar regulatory treatment of foreign and domestic funds, we expect foreign players, currently lacking domestic infrastructure, to continue to service the market from abroad, using their existing infrastructures (eg in Luxembourg). German players, however, are likely to use their German platform, as this significantly cuts time to market and avoids having to register products abroad only to then have them certified through BaFin, the German regulator. With regard to business models, we expect Managed Account Platforms to emerge alongside the traditional FoHF structures, as they offer a high degree of transparency and high efficiency in the middle and back office.
UK: Despite most European hedge funds being managed from the UK, few funds are legally domiciled in the UK. While the introduction of the Qualified Investor Scheme (QIS) now allows to create authorised domestic hedge funds, there are two important drawbacks associated with the QIS: Firstly, QIS-based funds have to comply with numerous investment restrictions, for instance a maximum leverage of 100%; and secondly, QIS can only be distributed to retail clients if certain conditions on investor sophistication are met. Current demand for hedge fund products in the UK totals e50bn, and we expect this figure to grow to e80-90bn until year-end 2007, again driven mainly by institutional demand. HNWI and retail markets are unlikely to match continental growth rates, as the HNWI market is more mature in the UK and IFAs are still perceived by many managers as lacking the necessary skills to successfully market hedge funds to retail investors.
The French market: France has seen a fundamental overhaul of hedge fund regulation over the past two years. Single hedge funds domiciled in France can now be publicly marketed, including restricted access to retail markets. They face very limited investment restrictions in comparison to funds domiciled in other European countries. FoHFs are generally permitted for public distribution. Demand by French investors currently totals e30bn, which is a tenfold increase on the equivalent 2000 figure. Supply has grown even faster, currently totalling e70bn. This is due primarily to progressive market regulation and the prevailing quantitative fixed-income culture. As the French supply is concentrated on few banks which also control a large fraction of the distribution network, it is not surprising that demand increased on the back of supply. We expect demand to continue its strong growth, with totals reaching e55bn by year-end 2007.
The same factors which have lead to the quite diverse development of investor demand for hedge fund products in Germany, the UK and France will continue to govern to what extent market potential, which doubtlessly exists in all three markets, can be tapped going forward:
q Taxation: Legal security with regards to taxation of funds as well as investors is a prerequisite for sustainable market development. The tax differentials between different hedge fund products will have a marked impact on relative product demand.
q Regulation: The regulatory environment will be an overriding factor in deciding which type of vehicles will attract which customer base but will only have a limited effect on the realisable market potential. On the other hand a minimum level of regulation seems necessary to tap additional institutional funds
q Distribution: The French market shows that an effective distribution network is a prerequisite to opening up market potential fast and effectively
q Product characteristics: The example of some unsuccessful German FoHF launches in 2004 shows that matching product characteristics to (sophisticated) investor demand is critical.
Asset managers therefore face a number of complex and interdependent questions when considering their market positioning.
Particularly traditional asset managers often have unrealistic expectations of their ability to enter the alternative market space and often fall short of adequately characterising their target investors and
product/distribution requirements. Many tend to assume that substantial hedge fund assets can be
gathered at marginal expense.
This is exasperated by a lack of
realistic risk assessment, in particular the considerable reputational risks involved, leading some to take an overly optimistic view on expansion into the hedge fund business.
Foreign hedge fund specialists on the other hand have often approached European markets as just an extended distribution opportunity. Unfortunately the development of these markets will require more custom-tailored solutions and distribution channels due to a variety of regional specificities, such as regulation, taxation and existing embedded distribution channels.
Christian Edelman is a consultant with Mercer Oliver Wyman, based in Frankfurt. He is one of the authors of ‘The end of the warm-up phase’, an overview of the German, French and UK hedge funds markets