By Simon Gray
By Simon Gray
More than four years after the meltdown of the US sub-prime mortgage market sparked the onset of the financial crisis, allocators and investors still face a market environment that stubbornly refuses to return to ‘normal’. In fact, if anything the crisis is intensifying, not diminishing.
In 2008 some of the biggest and best-known names in the investment banking industry –Bear Stearns, Lehman Brothers, Merrill Lynch – collapsed or were swallowed up. Three years later, MF Global has just shown that it can happen again.
But the biggest risk overhanging the investment industry today is that whole countries might, effectively, become insolvent – as Russia and Argentina did in the not-too-distant past. But the implications of a country of the size and global economic standing of Italy defaulting, or of the break-up of the euro currency zone, are beyond any experience.
These are uncharted waters for fund allocators, who not only have to take decisions against a backdrop of uncertainty and fear, in which forecasts and predictions are limited in value, but have been doing so for much of the past four years.
Do market participants need to rethink their approach for an environment that isn’t going to return to ‘normal’ any time in the foreseeable future, in which volatility extends over not just months but years, and traditional assumptions about risk and return, correlation and market behaviour that largely held good until 2007 no longer do so?
Alternative investments, particularly hedge fund strategies, could offer one answer. Have they proven in recent years that they can consistently outperform long-only investment? If traditional asset classes are delivering mediocre returns, or worse, should alternatives play a bigger role in allocation models?
The traditional hedge fund model has itself been called into question over the past couple of years, not so much because of performance issues but questions of regulation and governance. One response on both sides of the Atlantic has been to offer absolute return strategies within retail fund structures for ease of establishment and investor acceptance. But can they deliver returns comparable with those of offshore funds?
Alternatives also apply to investment markets as well as strategies. Today it’s fashionable to vaunt emerging markets, not just the famous BRIC countries but a host of other more or less memorable acronyms, but how do they match up to North America, Europe and Japan not only in terms of performance but stability and consistency? Is it time for a rethink of standard geographical allocation criteria, or are emerging markets still too volatile to be core investments?
A volatile market environment
Despite a modest recovery in the second half of 2009 and 2010, the clouds have closed in again on the global economy and markets. There are continuing fears of double-dip recession in US and Europe, and the European Commission recently cut its growth forecast for the EU in 2012 from an already anaemic 1.8 per cent to just 0.5 per cent.
The financial markets are as volatile as ever – witness the S&P 500, Dow Jones Industrial Average and Nasdaq Composite all declining 6 to 7 per cent in September, then rebounding by some 10 per cent in October. European markets have been bouncing up and down with every twist of the sovereign debt crisis.
Alongside the European crisis, there has also been doubt about the creditworthiness of the US government and confidence in the dollar as a safe haven – fuelled by political wrangling over the US debt ceiling and deadlock over the relative merits of tax increases and budget cuts as a means of reducing the deficit.
Despite this climate, some parts of the private sector continue to churn out profits. But problem debtors, legal issues and moribund investment banking activity continue to weigh on the financial sector, not only in Europe. Small businesses are suffering more than most from reduced levels of bank credit, negating the potential impact of low interest rates on the wider economy.
This should be an environment – volatile, and with traditional assets producing meagre returns – to showcase the benefits of alternative investments. Hedge funds became the poster child for counter-cyclical investment strategies during the 2000-03 implosion of the stock market bubble. Between 2001 and 2007 the industry’s assets under management grew from a guesstimated USD800bn to more than USD2trn, although the nature of the industry is not conducive to statistical certainty.
According to Sizing the 2010 Hedge Fund Universe, PerTrac’s annual analysis of the industry’s composition and size aggregating data from 10 alternative investment databases using the PerTrac Analytics investment analysis and asset allocation software, at the end of last year there were 9,572 single-manager hedge funds with around USD1.6trn in assets under management, 3,196 funds of funds with USD518bn and 1,997 CTAs with USD234bn.
These figures reflect decline in the size of the industry since 2008, when hedge funds lost an average of around 20 per cent, although assets have recovered since. Minuscule interest rates and the volatility of equity market performance have sparked a revived interest in alternative strategies only been partly dampened by a return to disappointing performance this year. At the end of November, average hedge fund performance was down between 4 and 5 per cent overall for the year to date.
Long/short equity strategies have struggled to deliver positive returns in 2011, although generally they have proved their worth as an effective way of obtaining equity market exposure with less volatility than long-only investment. Another beneficiary of the crisis has been CTAs, thanks to impressive performance in 2008 and the generally low correlation of managed futures to other hedge fund strategies as well as to the main asset classes. Nevertheless, they are not a sure-fire bet under all market conditions, either. The Barclay CTA Index was down some 3 per cent over the first 11 months of this year.
Keeping the faith
Until the resurgence of equity markets in October, hedge funds were well on their way to proving, as they did in 2008, that hedge funds can mitigate market downturns, even if the boast of being able deliver positive returns in all market conditions has failed to stand up to extreme tests.
It appears that investors still appreciate these qualities of hedge funds even if overall performance this year remains negative in stark contrast to 2008 and 2009, when the industry’s losses were followed – not just for performance reasons – by massive redemptions.
Hedge fund administrator GlobeOp’s Capital Movement Index, based on the funds the firm services, reported hedge fund inflows of 2.05 per cent for November, the third highest level in 2011, while outflows fell from 3.25 per cent in October to 0.72 per cent – the lowest year-on-year outflow figure for November since the GlobeOp index records began in 2006.
BarclayHedge and TrimTabs suggest investors are more cautious, redeeming USD5bn from hedge funds in September – albeit following USD6.1bn. But the indications are that, at least for now, investors are keeping faith with the ability of hedge funds to protect their capital in unfavourable market conditions.
A survey for the 2012 Preqin Hedge Fund Investor Review found that 38 per cent of investors were planning to increase the amount of capital they invest in hedge funds in 2012, while only 9 per cent planned a decrease. Although 40 per cent of investors surveyed were dissatisfied with the returns of their hedge fund investments this year, more than 85 per cent said they had the same or higher level of confidence in hedge funds as in 2010.
However, hedge fund firms are facing regulatory challenges that may affect performance over the medium term. In both Europe and the US new regimes are taking shape that will subject managers to significant additional reporting burdens and new requirements covering operations, capital, risk management and other areas.
The European Union’s Alternative Investment Fund Managers Directive, which will take effect in July 2013, will affect not only managers and funds domiciled in Europe but any alternative investment firms targeting European investors. It includes the requirement on funds to appoint a depositary, whether or not they invest in assets susceptible to custody, that will take on increased responsibility – and liability – for the loss of assets under their custody or oversight – at a cost ultimately to managers and investors.
For the time being non-EU firms will be able to continue to distribute funds in Europe through national private placement rules, but this route too faces extensive new regulatory reporting requirements. After 2018 non-EU managers may need to comply fully with the directive, unless they can rely on “passive marketing” – investors seeking to place money with managers on their own initiative. Meanwhile non-US managers will be obliged to comply with provisions of FATCA, the Foreign Account Tax Compliance Act, by identifying US-resident investors or face a 30 per cent withholding from income from their US investments.
Private equity’s burdens
Private equity has its own set of burdens in the AIFM Directive, including special portfolio company reporting requirements but also so-called asset-stripping rules designed to restrict the ability of private equity firms to take dividends or benefit from share redemptions or repurchases by a portfolio company that would reduce its capital base or exceed its distributable profits and reserves.
Private equity has suffered over the past few years from a reduction in holdings by some institutions to stay within their allocation limits as the negative performance of other asset classes has shrunk the size of their overall portfolios. But in the current environment private equity enjoys an upside of historic outperformance of other asset classes and a long-term perspective particularly attractive to institutions with compatible time horizons, such as pension funds, insurance companies and some family investment vehicles.
The industry also faces a more difficult climate for exiting investments successfully, especially for IPOs. The buyout funds business model has been forcibly changed by the disappearance of much of the deal leverage available four years ago. And, as the AIFM Directive’s strictures on asset stripping suggest, private equity’s reputation in some European countries, notably France and Germany, remains sub-optimal.
The looming introduction of the European directive reflects a push for greater regulation of alternative investments, but it’s not the only route. Both in Europe and the US it is driving the popularity of alternative Ucits funds and mutual funds respectively.
That reflects the availability of a tried and tested regulatory regime, as well as contrasting with the uncertainty still surrounding various aspects of the AIFM Directive and Dodd-Frank. Some investors are anyway more comfortable with onshore-domiciled funds after the pressure put on offshore centres over tax and regulatory issues, starting with the G20 initiative on tax information exchange in 2009.
In fact alternative products offered through fund structures primarily designed for retail investment predates the crisis. Witness the mid-2000s boom in 130/30 and similar ‘active extension strategies identified by academic studies as an optimum design for portfolio efficiency, but which fell out of favour after performing poorly when they ran into the liquidity crisis of mid-2007.
In Europe the enthusiasm for Ucits funds reflects their ability to increase exposure to hedge fund strategies among institutions whose allocation rules restrict their investment in lightly-regulated offshore funds. Many European institutions have almost unlimited freedom to invest in Ucits funds. Many alternative Ucits funds discourage retail investors through high minimum initial investments, although others openly target mass affluent individuals who fall short of the criteria for sophisticated investors.
Absolute return strategies are also offered through US mutual funds aimed at high net worth and even retail investors. Mutual funds can also offer access to assets such as precious metals and commodities. These are not considered eligible assets by Europe’s Ucits rules, although there are ways around this using financial indices.
Offshore funds still far ahead
Ucits must also use derivatives to achieve the effect of short selling (the US rule restricting short selling within registered products was abolished in 1997). Ucits can emulate other hedge fund strategies through derivatives including futures, options, total return swaps and contracts for difference.
However, alternative Ucits must meet the regime’s diversification rules. Securities from a single issuer may not exceed 10 per cent of the entire portfolio, and holdings from issuers each amounting to more than 5 per cent may total more than 40 per cent. In addition, all Ucits funds must offer at least fortnightly liquidity, and most do so daily or weekly. These rules make Ucits unsuitable for some strategies that involve highly concentrated investments, or depend on high levels of leverage.
According to Swiss firm Naisscent Capital, there are now more than 1,000 single manager alternative Ucits funds and more than 100 funds of funds, managing assets of between USD80bn and USD120bn. Some 65 per cent of these so-called ‘Newcits’ were launched after the crisis, including 350 in 2010. Naisscent says long/short equity strategies make up 22 per cent of alternative Ucits, absolute return funds (which mostly track a Libor-plus benchmark) 18 per cent and equity market neutral 7 per cent.
There are different estimates from other industry players. Geneva consultancy Alix Capital, which identified 705 alternative Ucits funds with assets of EUR121.7bn euros at the end of September, says long/short equity funds account for around a third of all Newcits launches in 2011, followed by global macro and managed futures. ML Capital, which runs an Irish-domiciled fund platform, says CTA and global macro strategies have attracted most investor allocations this year.
Whatever the exact numbers, alternative Ucits have a long way to go before they start to approach the volume of assets held by traditional offshore hedge funds, although they are edging closer to the level of alternative funds domiciled in EU jurisdictions such as Luxembourg, Ireland and Malta.
The issue of fund assets matters because the cost of establishing and running a Ucits fund is significantly higher than for a Cayman fund, or even an EU-domiciled fund aimed at sophisticated investors. Fund administrators say that Ucits fund with less than EUR50m in assets will struggle for viability.
Still, there have been some impressive success stories. The Ucits version of its Diversified Trading Program launched by managed futures firm Winton Capital in June 2010 had USD1.44bn at the end of October this year.
The biggest question is whether Newcits can match the performance of comparable offshore strategies. Most alternative mutual funds and Ucits have limited track records so it’s difficult to make firm judgements on their relative performance, and industry surveys tend to be inconclusive.
According to London consultants Kepler Partners, last year the Absolute Hedge index rose 4.11 per cent, compared with 10.95 per cent for the Dow Jones Credit Suisse Offshore fund indexes, and only market-neutral Ucits funds outperformed their offshore counterparts.
According to the latest data, BarclayHedge’s Ucits Index was down 8.09 per cent in 2011 up to the end of November, compared with 4,54 per cent for the Barclay Hedge Fund Index. The firm’s Ucits CTA Index was down 7.73 per cent compared with 3.02 per cent for the mainstream CTA benchmark.
However, meaningful comparisons can be elusive. At the latest count 111 reporting funds made up BarclayHedge’s Ucits index for November, compared with 1,145 for the Barclay Hedge Fund Index. In these circumstances, the jury is still out.
Emerging markets into the mainstream
Alternative markets are also an option for allocators. The crisis has highlighted the performance benefits of emerging markets and their relative lack of correlation with markets in Europe and North America. Emerging markets now account for around one-third of global GDP, according to the International Monetary Fund in April, and are forecast to reach as much as half of the world’s economic output by the end of this decade.
To some degree the shift into the investment mainstream is already underway for many countries, as the BRIC phenomenon and its spin-offs indicate. Another indication is the emergence of the term of ‘frontier markets’ to describe countries characterised by the high levels of volatility in both risk and returns that used to be ascribed to the emerging market universe as a whole.
The growing focus on emerging market investment can be partly attributed to the fact that volatility and risk are relative. Sovereign debt problems in developed market economies have drawn attention to the improved quality of bonds from many emerging market countries. These now include local currency and dollar-denominated sovereign and corporate bonds. According to AllianceBernstein, some 55 per cent of the Emerging Market Bond Global Index is now rated investment-grade.
Emerging market financial systems have become more stable and sophisticated in recent years. In many cases they offer managers access to asset management tools to mitigate risk, such as derivatives and stock borrowing, that are part and parcel of developed markets. Also important is improvement in areas such as legal systems and corporate governance. However, for many emerging market countries that’s still a work in progress.
The volatility of equity markets remains an issue among many allocators, significantly exceeding that in developed markets between 2007 and 2010. However, AllianceBernstein argues that it can be mitigated without sacrificing emerging markets’ return potential by using multi-asset strategies.
Bonds and currencies, as well as stocks of developed market companies doing substantial business in emerging markets, can all be part of the mix to obtain exposure to emerging market growth, the firm says. Investment-grade emerging-market bonds behave like developed-market investment-grade corporate bonds and are effective in offsetting the volatility of emerging-market stocks.
In conclusion, in the current environment, alternatives are a useful tool, but not necessarily a panacea. The strategy that makes money at all times and under all market conditions doesn’t seem to exist, but hedge fund strategies can and do reduce losses on the downside. What is likely to be important in the coming months and maybe years is the freedom and flexibility enjoyed by hedge fund managers, who may have a greater ability to respond to or anticipate events than their counterparts constrained by long-only strategies.
It’s easy to see why regulated Ucits fund appeal to institutional investors as vehicles for alternative strategies, but it’s too early to conclude that they can deliver the same performance as offshore funds over the long term. Some allocating institutions may be ready to accept a performance trade-off to compensate for Ucits’ investor protection mechanisms and liquidity, but it seems too early to write off Cayman as the epicentre of the hedge fund industry.
Emerging market equities remain volatile, but that may be as much about investor skittishness as fundamentals. Emerging market bonds certainly seem to be becoming as trustworthy as their developed market counterparts, although that’s not saying much. But overall, emerging market investment can only go one way in the future – up.