Whilst on the face of it, little appears to have changed to widen the appeal of this asset class to the pension funds and insurance companies – who are still by and large absent – the hedge fund industry has continued to demonstrate exceptional growth.
In Europe, the offshore fund world has become the chosen conduit for cross border investing. And, along with hedge funds (exclusively offshore funds) has become an important product offering of the mainstream European institutional managers.
The European hedge fund industry has been characterised by a number of well-publicised institutional developments in recent months. Some of Europe’s biggest banks have paid rich sums to tie up access to the ever increasing ranks of high net worth investors. These are now as likely to be ‘dot com’ millionaires as the scions of Europe’s grand families. HSBC bought Edmond Safra’s Republic National Bank of New York and the Safra Republic Investments, whilst UBS gobbled up Global Asset Management, a London-based firm that has been advising wealthy folk since the early 1980s.
Yet, the stark absence of pension fund investors continues to puzzle many who had heralded a wall of money set to truly revitalise the industry. Relative performance and benchmarks may enable traditional managers to look at their competitive position relative to their peer group. But, consistent long term returns – independent of market movements – make a compelling reason for embracing the world of absolute return for both individual investors and their pension fund advisors. “There is actually a lot of hedge fund management going on, concealed within closet indexing styles of long managers”, said Colin McLean of Scottish Value Management at a recent industry event in Barcelona. “It may be that you can replace this with lower cost passive management, combined with genuinely sustainable and portable alpha.”
There are also, of course, different risk control and liquidity management considerations in the hedge fund world and it does take a period of time with different market conditions for managers to become genuinely seasoned in the running of these types of strategies. Advisers need to be able to demand and receive detailed performance analysis to identify exactly how a manager is making money and what risks are being taken. Yet most of the traditional consultants are conspicuously absent in this role.
The high profile problems at LTCMs was a seminal experience, giving rise to the introduction of regulatory controls, greater transparency, and to increasing accountability for their methods of operation and the risks they run. It has also helped differentiate between opaque trading styles and the more widely acceptable long short equity hedge funds.
Notwithstanding the absence of the pension funds and insurance companies, the hedge fund industry has continued to demonstrate exceptional growth. In 1988, when the recently retired Stanley Druckenmiller took the helm of the Quantum fund, the industry had $42bn (E69bn) under management. Ten years later, the figure was estimated to be $311bn – now somewhere in excess of $500bn. Over this period, the number of hedge funds has increased fivefold to in excess of 5,000 funds worldwide.
The main factors that are contributing to this growth have been brought about primarily by the ongoing structural changes in both the supply and demand sides of the professional money management business. With onshore funds entering the maturity phase of their lifecycle, the professional money management industry is becoming commoditised with standardised products and severe price competition. In this context, offshore funds have become an extremely valuable proposition. For example, a lower level of regulation makes it easier to establish and administer the offshore funds, significantly reducing operating costs. Lower costs mean that funds can be offered at zero or low load and with competitive management fees. A lower level of regulation implies greater flexibility in terms of fund structure and investment portfolio. The cost efficiency of offshore funds also allows the creation of a series of funds, custom designed for different client needs or profiles. The product flexibility leads directly to higher returns. Furthermore, hedge funds, many of which are domiciled offshore, historically have achieved (on average) higher returns than traditional funds. Tax exempt status in the offshore jurisdiction can also allow offshore funds to reinvest profits and gains whilst deferring the payment of taxes.
We forecast that the global hedge fund industry (onshore and offshore) could grow over the next 10 years from the current size of 5,000 funds with assets of $500bn to 15,000 funds managing $1trn of assets. The following factors explain this radical projected growth rate:
o Inflow of institutional capital – While hedge funds have historically been targeted by sophisticated individual investors (up to 75% of hedge assets, according to some estimates), in recent years a variety of institutional investors have begun to invest in these entities. In the US, for instance, institutional investors accounted for nearly 30% of new money flowing into hedge funds in the past few years. University foundations and endowments are among the most aggressive institutional investors. Pension funds are also starting to allocate capital to hedge funds, being under pressure to constantly look for new ways to diversify their holdings. Currently, institutions allocate less than 1% of their assets to hedge funds. What is relevant here is that a 1% increase would release a huge amount of money into hedge funds.
o The performance fee structure of hedge funds allows fund managers to greatly increase management compensation. This has created a so-called ‘flight of investment talent’ from the traditional funds to the hedge fund universe, further fuelling the rapid growth of the alternative investment market. This in part accounts for the new influx of hedge fund offerings from the big names of the mutual fund industry. Although the very nature of hedge funds often runs counter to the big company investment culture which discourages star managers.
o Growth of the high net worth individual segment – Still high net worth individuals are set to remain the main sponsors of hedge funds and the growth of this investor segment will really make the greatest impact on the expansion of the industry. Research sources in the US suggest that accredited investors allocate less than 2% of their assets to hedge funds. Any increase in this figure will significantly increase the demand.
Ironically, these changes may predetermine a very different shape for the hedge fund industry of the future. As the offshore industry shifts from the introductory phase into the growth phase, there is a growing challenge for offshore funds to expand the investor base of high net worth individuals while targeting the much larger institutional investor base. The continuing integration of the global economy and the focus of offshore funds on international investors are forcing investment managers to view their business on a global basis. This will further intensify the competition in the industry. Consequently, the evolution of investment products looking for cash, and, in turn, precipitating more institutional investors, will finally succumb to the undoubted attractions of alternative investments.
Already, the demands on offshore fund managers are rapidly increasing and include greater oversight of the process, higher liquidity and more transparency. The bigger groups are able to offer rigorous attribution analysis, sophisticated web-enabled client management systems as well as live and independent risk monitoring. Small one-man bands are simply unable to compete here.
The risk of key man defection has not been properly addressed yet although many of the successful, traditional investment groups have managed to hold on to talented staff for years with share options and participation. Why should we assume that this is not going to be so easy in the hedge fund industry?
GFA reviewed the five top performing global equity hedge funds and the five top US equity hedge funds selected over three years on the basis of risk adjusted return earlier this year. The names included Alliance Capital, Gabelli, Caisse des Depots, Lazards and Forstmann-Leff – hardly names one would label as high risk. What is more, the development of the e-world will create greater demand for offshore services and information, now available globally through the internet, blurring the borders of the onshore and offshore worlds. We have subscribers in over 30 countries that access our research in the field. So offshore tax efficient investing is not going away despite the concerns of the revenue services on how to manage this. Regulation will become increasingly less relevant, as in future true investors protection will hang more specifically on whom you have placed money with and not where.
Simon Hopkins is co-founder of Global Fund Analysis in London