The tide turns, again
1999 is set to be the year in which the fledgling European hedge fund market comes under its closest scrutiny yet.
And the consensus is that if the Long-Term Capital Management catastrophe of 1998 has had a knock-on effect, it has been to focus European minds on the real issues of hedge fund activity and put the market clearly into context.
As Bill Dykes, partner at Stockholm-based RPM Risk and Portfolio Management, explains: If you're looking at the driving interest in the European hedge fund market, it's safe to say 1997 was the year of experimentation, 1998 the 'year of fear' - whereby everybody felt an absolute necessity to be diversified in alternative investment - and 1999 is the year of uncertainty, where everyone is asking themselves what exactly the alternative diversification market is, what they are holding, and why."
However, perhaps even more important to the market is the increasing interest in hedge products being shown by institutional investors and pension funds.
This is not only causing existing managers to sit up and take notice of the potential flows, but also prompting traditional investment managers to explore fund of funds and in-house hedge strategies.
David Duncan, director, institutional, at Global Asset Management, managing a range of hedge instruments, explains: "I think interest rates in developed countries are at a lower level than investment professionals expected, alongside minimal inflation. And I believe that sooner or later we will see a reversal to equal the UK situation, circa 1972, when interest rates suddenly rose, equity markets plunged and bonds were just not producing a positive return. However, hedge funds now exist to take up this sort of slack and are attractive as a protection for institutions against market fallout."
He adds: "Above all institutional investors see equity-type returns and bond-type volatility through hedge funds, with nothing like the risk in straight equity investment." GAM offers its worldwide distribution network to European clients via its Zurich and recently opened Berlin offices.
The present global ratio for hedge funds stands at around 80% of the market in the US and 20% in Europe, with 80% of these based in the UK. And, during 1998, the consensus is that sufficient volatility of currencies created the atmosphere for European hedge fund success. In the third quarter, as the market nose-dived, hedge funds were touted by all and sundry, including prominent institutions, as the answer. Then LTCM struck and the trend reversed as fickle European investors cleared out their hedge exposure.
The tide now appears to be turning back again in the hedge funds' favour. Investors are better prepared this time around, and aware of the diversity of fund typesunder the hedge fund label.
London-based Argyll Investment Managers is one of a growing number of managers with specialist European products. "We have just released a European fund of funds portfolio of about 10 investment funds with assets in different categories of European markets," explains Richard Hills, managing director. "Demand for such vehicles is strong, and if anything the supply side is where the market is short."
Hills adds that there are around 40-50 European hedge funds being managed by around 15 groups. On the institutional side he sees increasing demand from insurance companies and pension funds, particularly in Europe, with business in the UK much slower.
Hills believes the bond culture of continental European investors means they have grasped the concept of hedge funds quicker than those in the UK. "If you consider the risk side, hedge funds are no more dangerous really than FTSE stocks. Look at Maxwell and Polly Peck which both went belly up in the last 10 years. There should perhaps be a health warning on the highly geared style of hedge fund like LTCM, but otherwise there is no greater risk than equity investment."
Luke Ellis, managing director at London-based Financial Risk Management, adds: "Once you open your mind to the story on hedge funds, the argument is good, because you can look at them as a high-yielding debt replacement, a new and better style equity manager or a new asset class. Watson Wyatt have also recommended hedge funds as an alternative uncorellated asset, when using relatively small weightings."
And, Ellis says, traditional investment managers are beginning to look carefully at hedge fund products in a quest for better fees. "Certain traditional managers have produced very good hedge products, but on the other hand, many have not. They will have to learn how to do it properly and apply their own processes to the domain.
Alliance Capital, for example are already very active and I know that Mercury are thinking hard on the topic."
One major hindrance, he believes, is that elements of hedge funding don't always fit restrictions placed on traditional managers by investors in terms of tracking error against a particular index. "Continue down this road and you automatically start to impose constraints on investment style - the nemesis of hedge funds," he adds.
On the macro side, Ellis says the euro is certainly making the European market broader and deeper, an essential element for successful hedge fund strategies. "There isn't a high yield market yet in Europe, though, so we will need to wait for this before distressed and high yield European hedge funds can run, but things are moving along this line."
At the riskier end of the European market lie products such as the London-based Fabien Pictet Emerging Markets Hedge Fund. CEO Fabien Pictet says the company is marketing to the advanced UK pension fund market, drawing on experience in the US market. "Only larger funds are really hedging, because of the possible downside risk, so exposure is still small compared to traditional investment - perhaps things are still a little complicated in the field."
Frankfurt-based Copernicus hedge fund is arousing more continental institutional interest, however. Sy Schlueter, managing partner at CAI, adviser to the fund, explains: "We currently have one product - long/short European equities, and within that we try to be where the action is, because countries and sectors change and company characteristics fluctuate depending on where you find value. Ninety per cent of our clients are institutional and majority European at present; predominately banks and fund of funds, some of which already have pension fund money on board. However, only banks really have the experience and due diligence to invest directly in hedge products at the moment."
Schlueter believes pension funds themselves will probably look to defensive hedge styles - either market-neutral or guaranteed products. "There are still probably only a dozen managers on the continent with three to five-year records to be credible enough though for the business around. Also, in Europe you have to be sure you know something no-one else does before you set up a fund operation, so the number of players is still small. This tends to mean, however, that the quality and maturity of European hedge companies is high, and overall I hear that managers here are outperforming their US counterparts, although this could be a question of the aggregates used."
Schlueter predicts a similar variety of hedge products as in the US springing up eventually in Europe, although he argues financial market regulations in terms of borrowing capacity and stock lending will be crucial here.
Another possible stumbling block to hedge fund development, he says, is European mistrust of younger managers, incongruent with the cutting-edge technology of hedge funds, and certainly not the case stateside.
John Seilern, senior managing director for Europe and Middle East at Alpha Asset Management, manager of the Buchanan European hedge fund, Europe's first in 1992, also has some words of advice for institutions eyeing up the domain. "Pension funds and insurance companies are looking at alternative investment with a beady eye, but must be careful about excessive hubris and the inherent risks. There is a need for due dilligence, education and detailed risk analysis.Institutions can't afford to be slipshod about this. Transparency, leverage and risk awareness in performance must become de riguer, but without stifling the present liberal regulatory environment."
A new arrival on the hedging scene is the continent's first multi-manager futures fund aimed solely at the German investment market. The fund, launched in August 1998 by Zurich-based Swiss manager Fisch Asset Management (FAM) has received permission from the German authorities removing it from previously imposing tax restraints, although it has had to be registered as a limited partnership under German law.
"This is the first time German investors have been able to participate in such a multi-manager fund," explains Pius Fisch, CEO at FAM, "although single manager funds have been present for a while now. Institutional clients can now use products such as arbitrage, where interest is certainly increasing, particularly from pension funds, although the DM13m we presently manage is mostly private and other institutional money. However, the future for pension funds seems to be in the hedge direction."Although FAM currently uses no European hedge managers, Fisch adds that this is on the cards for the near future. As Europe's hedge fund and traditional managers prune themselves for the business on offer, the thicket of European investors appears to like what they see. The warning seems to be: just watch out for the thorns."