Siren morphs into girl next door
Promising alluring returns from investment processes that are sometimes mysterious and seldom transparent, hedge funds have been the recent sirens of the global asset management industry. Recent reports estimate assets in such vehicles have grown to $1.5trn (€1.2trn) worldwide, $325bn in Europe alone.
While double counting is even more of an occupational hazard in this opaque market segment than in the traditional long-only world, clearly hedge funds and funds of hedge funds (FoHFs) represent investment management’s fastest-growing product set. No wonder, then, that buyers are snapping them up. We estimate that in 2005, acquirers – a number of them traditional asset managers – spent at least $6bn buying nearly 30 firms representing a record $140bn of alternative assets, the bulk of which sat in FOHFs.
The pace of such transactions has been brisk during the early part of 2006 and we expect robust activity to continue for the near future
Hedge funds always have appealed to wealthy individuals, but a growing number of both retail and institutional investors require the absolute returns that these products promise their clients. Increasingly focused on liability-driven investing, pension funds worldwide need constant and positive returns to fund obligations for retiring baby boomers. Individuals, concerned about post-retirement income, will require a wider range of all-weather products that guarantee a yield regardless of market conditions.
In theory, hedge funds and FoHFs can satisfy these demands, especially as technology and regulation make it easier to offer such products to a wider band of smaller investors. Continental Europe, in fact, has been a leader in making these vehicles more available to a wider universe of investors.
Many ’traditional‘ managers – focused on actively managing long-only portfolios – are admittedly ill prepared for this shift.
Simply beating benchmarks, particularly during lacklustre markets, will no longer suffice; higher interest rates worldwide and skyrocketing demand for global bond products are raising the risk-free bar for all active managers. The proliferation of structured notes, now competing with funds in Europe’s retail distribution channels, further underscores this point.
Asset management firms worldwide are realising they require significant innovation – in both portfolio management and product packaging – in order to survive and compete.
A number of long-only firms have built single-managed hedge fund capabilities, both to take advantage of client demand and retain talented portfolio managers who might otherwise depart to start their own absolute-return vehicles. Increasingly, traditional firms are electing to acquire existing hedge fund managers, and their standing track records, in the marketplace. This is particularly true regarding FoHFs. While single-managed products are more about skill than scale (and actually suffer if they grow too quickly), assembled asset management products such as FoHFs benefit from size. De novo efforts to build such vehicles from scratch cannot generate the economies of scale already realised by large complexes such as those run by the acquisitive Man Group, the world’s largest listed hedge fund company, or Bank Julius Baer’s GAM unit.
Consequently, traditional asset managers have bought, and will continue to buy, their way into the hedge fund sector. Further deals such as ABN Amro AM’s acquisition of InternationalAM, Close Brothers’ deal with Fortune Group and Schroders’ purchase of NewFinance Capital are quite likely. Pricing should also remain firm as acquirers attach strategic premiums to the fund managers that best match their existing operations and client bases – although buyers also are discounting the more volatile performance-based fee streams inside hedge funds.
Transactions involving alternative managers can prove to be winning solutions, if well planned and well executed. Integration issues are tricky enough among long-only asset managers let alone between traditional and alternative firms. It takes management finesse to combine entrepreneurial, performance-driven hedge fund managers with their long-only brethren who may be more accustomed to asset-based compensation.
And some FoHFs, often pitched to customers (and regulators) as a way to sponge risk away from a set of highly concentrated underlying portfolios, do come with issues of their own. Those without strong information flow from underlying funds will be susceptible to closet indexing pressure, possibly forced to buy larger numbers of opaque sub-funds in order to mop up institutional inflow.
Buyers – traditional managers and wealth management firms – will prize FoHF structures that solve these problems by assembling products based on custom-designed and transparent separate accounts, rather than off-the-shelf hedge funds already struggling with capacity issues and lack of transparency.
Guggenheim Alternative Asset Management, a New York-based FoHF that recently sold a majority stake in itself to Bank of Ireland Group, has differentiated itself by designing such products.
As traditional and alternative asset management firms merge they will start to influence each other’s core businesses, we hope with some salutary effects. Pension funds and retirees, core clients for many long-only firms, will prize low volatility well above skyrocketing returns when evaluating hedge funds and FoHFs.
Consequently, some newly acquired alternative asset managers will need to consider adding lower-risk, lower-return strategies to their existing high-octane offers. This will dampen returns and consequently apply more pricing pressure, particularly to the thickly compounded fee structures within most funds of hedge funds. But it also will win attention and assets from a wider range of clients necessarily obsessed with reducing risk.
Conversely, adding alternative product arrays will impact a traditional asset manager’s modus operandi. Influenced by the business models of hedge funds, long-only fund managers will re-engineer their existing products to provide absolute returns where possible – bending restrictions on short selling and derivatives usage in many public-offer retail funds to the breaking point.
Additionally, traditional fund managers are finding appeal in the performance-based fee structures hedge funds use. Such systems align client and manager interest and allow both to benefit dramatically from excess returns in well-managed products.
As more traditional and hedge fund managers combine forces, the lines between their product arrays will disappear. A number of prominent fund managers already are attempting to rub out the demarcation lines, describing their products as long-only and long-short equity portfolios, not unit trusts and hedge funds.
In a world where markets correct arbitrage opportunities with lightning speed and investors seek deeper, and less correlated, sources of alpha, alternative investments are quickly becoming mainstream. Hedge funds, once exotic sirens, are becoming the girls next door.
Kevin Pakenham is a managing director and regional manager of the London office of Putnam Lovell NBF. Ben Phillips is a New York-based managing director and head of strategic research at Putnam Lovell NBF