Clearing the hurdles
One hundred per cent allocation to hedge funds? This is not as silly as some may think. If an institutional investor were to simply put hedge fund return data into their asset liability model, 100% may well be the answer. The risk return characteristics of hedge funds are so attractive, at least when measured with traditional risk measures such as Sharpe ratios.
The next thing the investor will do is to ask his consultant. The consultant gives him an answer which always is different from what the ‘unrestricted’ standard model says: “Build up your hedge fund allocation to 5% gradually over the next five years”.
What is the right answer? And once this has been determined, how to go about filling the allocation? The question is especially difficult one for German institutions to answer, since hedge funds are a new area for them.
Even experienced consultants struggle with these issues. There are very few international, let alone German, consultants with the knowledge and resources to analyse hedge funds adequately.
The next port of call for of a German institutional asset manager could be to go to a hedge fund specialist. In fact, there are not many experienced players around. But since the investor may have already decided to invest in a diversified way into this new segment, they could directly turn to funds of funds. But apart from our group, it will be hard to find an experienced Germany-based fund of funds specialist.
Another approach is to turn to international funds of funds or banks for advice. But which hedge funds of funds to ask? For the sake of argument, we assume, that the web is researched for hedge fund databases. With a little luck, the investor could end up with site such as hedgefund.net, a database which was free until the end of 2003 but now charges several thousand $ per year. Using such a database, investors will find out that there are more than 1,500 hedge funds of funds available. At this point the investor just gives up or tells one of the analysts to search the database, perhaps for the European hedge funds of funds with the best performance.
If German institutional investors have been actively following the press, they know that hedge funds of funds have to comply with the new German investment law to be eligible for an investment. So the first question they need to ask is whether the hedge fund of funds with the best performance on the databases comply with German law. Unfortunately, by the end of January this year, only one fund of funds with a track record of just a few months undertakes that it fulfils German regulatory and tax transparency requirements.
Then some of the managers on their long lists of funds will tell them, that their funds are closed and that they are not interested. Most of the others probably will say: “Not yet, but we will check. If you commit enough money, say $50m (E39m), we will do anything, anyhow”.
German investors are known to be research and process focussed. This is even truer now since several have been badly burnt by ‘relationship’ type investments, for example in the new German venture funds during the years 1998 to 2000. These investors’ checklists may apply criteria such as research oriented and standard process approach to hedge fund investing.
A recent study by Edhec (Edhec European Alternative Multimanagement Practices Survey, Lille/Nice Nov 2003) shows, that there are not that many hedge funds of that type around. Apparently not many hedge fund of fund managers can pass institutional due diligence regarding these investors’ requirements for top-down economic model-driven hedge fund strategy allocation, systematic, not only quantitative, hedge fund universe screening, hedge fund strategy tactical allocation/rotation, and transparent hedge fund qualitative assessment.
At this stage, the investor will stop calling on funds of funds since most probably would give similar answers. The next sensible thing investors can do is to hire one of the limited range of consultants available to find hedge funds of funds which meet his requirements.
Alternatively, investors or their consultants can try to find single funds which fulfil most of their requirements. Here, they will find less than five German-based hedge funds (excluding managed futures funds or programmes, of which many more are around) with track records of a few months and the commitment to comply with the transparency requirements. They will also find that most of all existing international and principally open hedge funds are willing to comply with German transparency if they invest some E10m to E25m per fund.
Since we are talking about several hundred funds with attractive track records and acceptable minimum size here, and there is no hedge fund rating on most funds publicly available yet, the consultants probably have to be used again. In addition, monitoring the hedge investments on a permanent basis, which is best done daily, requires too many resources internally for all but the largest institutional investors.
Another approach for institutional investors is to try to invest through one of the 100 plus structured products currently available on the German market, most in the form of so called hedge fund index-linked bonds. One of the problems in doing so in the past was the lack of market transparency. Since the Absolut Report (Absolut Report Quarterly, Hamburg) started to publish its quarterly performance overview, these issues have become less relevant.
The publication covers more than 100 products currently and also will start to include the new funds of funds and single funds, as they become available. It leaves out a significant number of private placements, though.
Once German institutions start to evaluate these products, they will find that the funds differ significantly in performance. The good news is, that very few of them show significant negative returns over longer periods, so most deliver the promised absolute returns. Attractive mid-term hedge fund index like returns such as published by Van Hedge, Hedge Fund Research (HFR) or CSFB are rare, though. They will soon find out that of those which are referred to as index-linked, none are linked to one of those indices. When reading the product documentation, they will learn that most of the products are in some way linked to standard, more or less actively managed funds of funds.
Their hedge fund of fund research will also show that these do not comply with German regulatory and tax requirements. Conservative legal and tax experts will confirm that investment in such a certificate may involve some risk, and would not be tax efficient, with the risk of inducing punitive taxes set at 60% of performance or, a minimum of 7% of NAV under the new German investment tax law.
They will find out also that most products are not really transparent in respect of hedge fund strategy allocation, fund selection, and fees. Once they obtain the information about the transparency they want, they will see that most products will show too broad a diversification or a significant long equity market bias, high fees as well as an overlap in the underlying funds, such that ‘certificate diversification’ is of limited use.
In summary, today the relevant and attractive hedge fund market for German institutional investors is still very small. Despite hedge funds’ attractive risk return characteristics, these investments will not grow “like crazy”, as some speculate in the near future, mainly due to the restrictions in terms of transparency and the requirements to publish detailed data. Even the legal breakthroughs with the liberal new German investment laws, as well as the anticipated 5% quota for capital reserves of insurance investors (Anlageverordnung), does not change this perspective.
A potential positive impact on German investors may be expected by the recent European efforts to harmonise hedge fund investing. The realisation of this and thus the impact, may take a very long time, though.
Dirk Söhnholz is managing director of Feri Trust based in Bad Homburg