Market conditions, consolidation and regulatory developments are changing the landscape for hedge funds. Jean-Charles Bertrand explores the new topography
Hedge funds endured an ‘annus horribilis' in the market crisis of 2008 - but the industry has started to adapt and consequently the future looks less bleak. Recent research by Deutsche Bank and Greenwich shows that most institutional investors want to hold on to their hedge fund allocations. The announcement by China's sovereign wealth fund that it plans to invest in hedge funds shows that new investor interest still exists. The lessons learned from the crisis, mean that the environment in which funds operate will have to be radically overhauled from many different angles.
An industry overhaul
In the first place, the number of hedge funds will fall drastically. The winnowing began in 2008 with the closure of some 500 funds, as the rate of fund launches slowed sharply; the industry is consolidating. Elsewhere, it seems that the importance of funds of hedge funds (FoHFs) is likely to decline. Their reputation has been tarnished by the disclosure that some key players had exposure to Madoff. This is important because, for investors, the main attraction of FoHFs was their ability to carry out extensive due diligence, thus limiting the risk of failure, and there is now much less confidence in that ability. As a result, more US institutional investors are now using the services of specialised consultants.
In addition, recent events have speeded up the process of increasing the supervision and regulation of hedge funds. Numerous studies and reports, including those by Adair Turner and the G20, have stressed that, although hedge funds were not directly responsible for the crisis, they may have amplified it and should therefore be regulated.The G20 summit in April 2009 tasked various bodies, including the International Organization of Securities Commissions (IOSCO), with taking the necessary measures; the European Commission recently released a Draft Directive on alternative investment fund managers; and the question of regulating offshore funds was also addressed by IOSCO, which recommended the introduction of agreements and arrangements for sharing information among offshore financial centres and national regulators.
It is clear that regulation will continue to grow in importance, although the process will take time. It should also be noted that hedge fund managers are generally being co-operative, possibly because they have no alternative. Codes of practice are being put in place, with an increasing number of managers adhering to industry standards such as AIMA's and the Hedge Funds Standard Board. In general, stricter regulation is likely to contribute to hedge fund consolidation, since smaller players will find it hard to acquire the operational resources needed to meet the regulatory requirements.
In terms of operational risk, the crisis has highlighted the need to separate the manager's administrative functions, namely custody and valuation. This has been less common in the US than in Europe, but things are changing rapidly. Shortly after the Madoff affair broke, UBP Asset Management publicly called on US fund managers to use independent administrators or risk it withdrawing its investments. Many top managers complied. Meanwhile, managed accounts have developed considerably as they allow for greater transparency and better control of individual positions, cash management and valuation. It should be noted, however, that today's platforms rarely allow investors to access individual positions; they are equivalent to an independent intermediary between manager and investor, with fiduciary responsibility.
Investment strategies: back to the future
Noam Gottesman, one of the founders of GLG Partners, recently talked about the industry going ‘back to the future'. This aptly describes how hedge funds' investment strategies have evolved. The historically most popular strategies, global macro and CTA, which in 2008 benefited from greater liquidity and relatively satisfactory returns, are thriving - though the infatuation with CTAs has diminished with their lacklustre performance in 2009. Furthermore, single-strategy funds are back in favour, to the detriment of multi-strategy, which have been criticised for lack of transparency and significant correlations between performance drivers during the crisis.
Academic and practitioner research has shown that a significant portion of hedge funds' performance stems from their structural exposure (alternative betas) to a limited number of factors (credit, liquidity, volatility and to a lesser extent equity) - and the past two years confirmed this. The answer to the question "How are hedge funds likely to perform in the future?" is quite clear. To get a precise idea of expected returns, investors must predict what will happen to equity markets, credit spreads and liquidity premia. This will allow them to work out the average returns to the various strategies depending on sensitivity to the different risk factors.
Funds are deleveraging, a movement that harks back to the past. This deleveraging has fuelled investors' fears that hedge fund returns would fall sharply in future. In our view, this is far from certain. It is important to consider not only the size of fund positions but also their expected returns. Expected returns depend on risk, which will remain high, or at least, higher than it has been in recent years. Accordingly, there is no reason why hedge funds' returns should be significantly eroded.
On the whole, hedge funds fared poorly during the crisis: in an extreme environment, they provided spectacular evidence of risks and problems that had already been identified. Hedge funds are still attractive, but they need to evolve. They have already started to do so by deleveraging, implementing more liquid strategies, registering their managers with regulators, setting up independent administrators, and so on. The environment that is now taking shape bears a strong resemblance to the world of long-only investing, with the crisis acting as the catalyst for ongoing convergence between conventional and alternative fund managers. Long-only managers are increasingly using derivatives and short selling (within the UCITS framework in Europe), while hedge fund managers have recently developed ‘conventional' products such as UCITS funds in Europe and mutual funds in the US.
The hedge fund industry is thus in the process of redrawing the boundaries, which are likely to become more blurred because of an increasing resemblance to the long-only world. In doing so, however, the industry is creating the conditions for a successful transformation.
Jean-Charles Bertrand is global head of fixed-income and absolute return strategies at Sinopia, HSBC Global Asset Management