2010 Round-up

Financial environment helps hedge funds provide value

Originally published in the December 2010 issue

The Hedge Fund Journal asked eight industry players to provide their thoughts on the state of hedge funds in 2010.

Here is their round-up of the year.


Mark Bliss


We have seen an extraordinary amount of growth in the UCITS absolute return fund market this year, and we expect it to continue next year. As with any fund market, we expect the industry will see new funds opening and some failing to deliver. But as a fund manager we will be continuing to look at hedge fund strategies that would be appropriate for UCITS.

We’re seeing a broad mix of investor interest in our UCITS absolute return funds, including institutional investors looking to come back into hedge funds, but also seeking funds with that UCITS brand. Those clients that are newer to this market have a steeper learning curve, of course, but they find the liquidity and transparency that UCITS brings them reassuring. Many investors are being drawn back by the attractive levels of return hedge funds can still offer them.

We are reaching the point now where the market is mature enough that some UCITS absolute return funds are closing to new investment. This is a good thing, as it shows fund managers are aware of their own capacity limits, particularly for UCITS. At BlackRock we have always applied the same high degree of risk management processes across our funds, and feel it is a good business practice to have this capacity awareness.
We expect to see retail distribution of UCITS absolute return funds continuing to grow apace, but feel this must happen in conjunction with investment in education, particularly helping the IFAs whose role is to explain the funds and their advantages to clients. There will be more of an onus on groups going forward to explain what they are doing, and produce the sort of material that gets this message across. Some products are, of course, a lot more complicated, and just because they fit the UCITS wrapper does not mean they are suitable for retail distribution.

It is still difficult to assess whether the AIFM Directive will have a measurable impact on the growth of the UCITS market. Things can still change substantially in the level two and level three implementation of the Directive. We won’t see that come into force until 2013. It may in fact create as-yet unforeseen opportunities for the industry as the UCITS directive did after it arrived in 2003.

I don’t expect the overall strategy composition of the universe to change much. Regulators are unlikely to approve funds that they feel are too risky or too illiquid. We nevertheless expect to see some widening of strategy choice as some groups look to push the envelope and more investors come back into the market.


Tony Gannon


For 2010, the real issue for the managed futures industry has been the risk on/risk off trades that dominated the market. For managed futures funds the difficulty was the lack of follow through. Instead, there were often complete reversals. This occurred until the end of July. The only trade that worked in managed futures was long bonds. Energy, in particular, was very difficult. Post-July a few trends developed, particularly in commodities. Gold hit new highs and cotton provided strong returns. Dollar-real also provided good opportunities, however, energy markets remained difficult through this period. In November, the Ireland debt crisis fed into the euro and brought about a reversal against the dollar. Net-net the industry has done reasonably well; the Dow Jones Credit Suisse Managed Futures index is up 11% to the end of October. Investors have begun looking at the long term return profile of managed futures more than just the short term performance. The returns in 2008 led many institutions to consider managed futures as a slightly separate asset class to hedge funds and as a very different diversifier. We’ve seen increased interest primarily from institutional US and Asian investors and we expect that to continue in 2011.In 2010, managed account platforms grew as both high net worth and pension funds demanded more transparency and greater liquidity. This is a trend that will continue in 2011. My view is that it is next to impossible to forecast long-term returns in the managed futures area but that applies to any long-term financial forecast. Typically it is the trends you least expect that deliver the strongest returns. We structure our funds of funds portfolio (which only invests through managed accounts) as follows: 55% of the portfolio is in trend following; 45% non-trend following, including discretionary macro, relative value such as FX carry and futures-based yield curve trades, as well as short term trading. The best way to invest long-term in managed futures is to gather exposure to all the various asset classes or styles of managed futures and maintain that exposure. Just when it looks like there is no trend, that is often when trends begin and can drive very strong price movements. When I look to 2011 it is clear that three are big stories. One is whether US quantitative easing will work and how this feeds through in price inflation. The second is China’s economic growth rate. The third is the euro and whether it will be successfully managed. Managed futures strategies love inflation because it creates by definition, strong market trends. Conversely deflation also provides trending opportunities. In contrast, choppy trading is a more difficult investment proposition.


Philippe Gougenheim


Currently there is a strong push for transparency. It has many benefits, not least helping fund mangers keep allocations. If investors have a better understanding of what managers do it should make everything operate more smoothly. The issue is more with the long-established managers because they have always been able to raise assets without transparency and some of them see no reason to change.

We don’t believe the AIFM Directive will directly affect our business in 2011. It is only in the first phase – the implementation phase. There should be one regulated body set up to discuss implementation, which will be time-consuming. Once the industry is regulated we may attract more investors. We don’t feel the directive will change the way we work. But overall, we feel that more regulations mean more costs for everybody and lower returns for investors.

We are not strong supporters of UCITS. We feel that many hedge fund strategies cannot fit in the format. Many investors are assured by the UCITS name but we are very worried about what is within those products. Single managers are raising assets under UCITS but mostly from retail money which is not what we are looking for. Additionally, there is always the risk of mismatch between assets and liabilities.

There is a strong positive consensus about investing in emerging markets. In my experience, a positive consensus about emerging markets has always turned bad – notably in 1997. Beware of consensus and beware of emerging markets! The economic and geopolitical environment is one where markets will remain volatile. Thus we like traders who can change their minds and rebase positions quickly.

We like tactical trading strategies – global macro and CTAs – because there are a lot of changes taking place in the world. These economic and financial conditions will create opportunities. There is a very good environment for arbitrage strategies where there is a lower level of risk. The wave of refinancing over the next two to three years in the US will create opportunities and corporate activity should increase.

Equity and credit hedge strategies will face more difficulties in 2011. With the market remaining volatile, it will be a difficult environment for market timers. Mangers with direct exposure to equities will have to focus too much on the direction of the market. Stock-pickers and market neutral managers should be better positioned. Though opportunities for credit hedge strategies are reducing, some still exist in the long/short space and in distressed.


Hugh Hendry


The world of investment has parallels with theology. Repetition and the passage of many years, especially a decade, can transform the rational into the fanatical. I think we are approaching the end of a chapter that began with much cynicism directed towards China and commodities and is closing with fervent devotion.

As an example, the gold price has risen more than four fold since 2002 and has climbed every single calendar year for the past decade; only the twelve year sequence of consecutive up years from 1978 to 1989 in the Nikkei can beat it. I have no beef about gold, but how likely is it to be the next big trade?

A number of western economies have yet to surpass their nominal GDP highs of 2007. Far from a typical economic recovery, it feels like a mild depression to me. The debt of the private sector remains too high and as the events in Ireland highlight it can even hobble the security of the sovereign. Why is it so contentious therefore to declare oneself cautious if not downright pessimistic? Could the next great trade be a bear trade?

We have a number of such trades that all have asymmetric payoffs and are largely predicated on the notion that there are no policy prescriptions for a debt deflation. Accordingly the astonishing profits of the carry down trade in Japan in the 1990s remain our fascination and focal point for our rate trades. Simply put, we think the market is overstating the risk premium of the term structure: official policy rates are unlikely to rise for some time in Europe and the US.

I find the very vocal Chinese admonishment of the Americans strange. The true nightmare for the Chinese must be a prolonged Japanese style recovery in the west where US nominal GDP fails to grow beyond its debt fuelled peak of 2007/8. The Chinese have been the global economy’s magic tooth fairy these last two years, absolving us from our economic sins and making the fallout from the crisis of 2008 more manageable than bears like myself thought possible.

But it is just about possible that their benevolence is changing as they seek to rein in their own domestic price inflation. The danger is that a credit bubble when starved of its marginal credit soon exhibits a sudden and sharp reversal in asset prices. So the time is nearing when we might experience the world’s two most successful creditor nations, Germany and China, seeking, if not a purge of the rottenness, then certainly its moderation.


Dimitri Kryukov


We have seen a lot of interest from investors to discuss the opportunity that Russia presents. There was very little capital available in the early part of 2010. But as the year went on liquidity and risk appetite improved. For us this culminated in an allocation from Mubadala Development Company. I think it is telling that Middle Eastern capital is flowing into Russia. It also shows that Russia isn’t all about oil—if it were, why would an oil-rich government be investing here?

Generally investors are in the process of rebalancing their portfolios. We are also seeing strong interest in managers that are on the ground compared with before when investors used global managers who made emerging market allocations. This year, Russia has been a laggard in terms of fund flows but we see that starting to change after the massive flows into other emerging markets. Investors are evenly split between long/short equity and long only in their emerging market allocations. Our conviction is that investing in Russia has a great deal of volatility and our proposition is to preserve capital.

However, a lot of investors aren’t worried about capital preservation and believe that outperformance can be generated in a long-only fund.
We see 2011 as a continuation of 2010: a fight between the inflation and deflation camps. Investors are going to be influenced by how the euro crisis unfolds. There is concern about how US interest rates may play out given the sharp rise in US yields recently. There is also worry about how China will contain inflation and whether this will derail its strong economic growth. Obviously, for Russia this is important as it could impact commodities prices and the theme underlying the cycle. The Russia specific factor is that 2011 is the year before the 2012 election. We would expect domestic political rhetoric to increase. We are likely to see relatively loose monetary policy with a continuation of a budget tilted towards social provision. We don’t expect sharp tightening.

Reform will be a theme in Russian economic policy with privatization and trade liberalisation. Interest rates should keep falling so benefiting domestic oriented sectors like banking, consumer goods and real estate. We are cautious on the oil and gas sector, however. Though oil prices are increasing and Russian oil companies are cheap on fundamentals, tax policy is uncertain. Tax incentives to develop new reserves to maintain production levels may not occur ahead of an election. This theme is controversial and is not as clear cut as other investment themes we favour.


Pierre Lagrange


In 2010, GDP growth has been revised on the upside. Economic growth is continuing to come through from the rest of the world. We see a lot of export demand and it is a fiction that consumption is outpacing export demand. With respect to Ireland, it is better to focus on opportunities rather than problems. This is because the broad, indiscriminate sell-off in Irish shares has left some stocks looking very cheap.

In Europe, we have found that financials haven’t led the market for some time and we don’t expect them to do so anytime soon. Bank margins are under pressure purely from increased regulation. We would expect to be short levered banks on the periphery of the Eurozone while having long exposure to northern European banks with less leverage. Meanwhile, the corporate sector has gone into the current economic period very strong. Cost cutting in 2008 in reaction to the credit crisis prepared companies well. There are a lot of sectors to be bullish on without including financials.

Eurostoxx offer a different way to invest cost effectively to capture growth in emerging markets. Sectors that we like to express this theme include UK engineering companies, European luxury goods makers, education publishers and German exporters. There is plenty of opportunity around to fuel long/short equity strategies.

On China, we believe that monetary tightening by the central bank is going to be ramped up significantly. Government policy generally has an impact in China as it is a very ‘dirigiste’ economic system. Differences among Chinese authorities have eased. It is clear that excessive liquidity is fuelling concern on the part of the People’s Bank of China about speculative stock piling of commodities and how this is spurring inflation. We see a rise in the cost of capital for Chinese banks toward the long-term average; this will cut speculation and lending growth. The market has been remarkably sanguine about this tightening and the recent adjustment in Chinese equities probably has further to go.

The AIFM Directive won’t have a big impact on London in the long term. Regulation works in a feedback loop: regulations test something and then adjustments are made. The risk isn’t of losing firms, both financial and otherwise, to other parts of Europe but rather to Mumbai, Shanghai or Rio de Janeiro. The whole evolution of Europe is about intellectual capital. Right now we have a crisis that someone has to pay for. But it is only a matter of time before the authorities realise that this is the key to job creation.


Miriam Muller


At Bank of America Merrill Lynch we have seen significant growth over 2010, with a large increase in reverse enquiries from hedge fund managers interested in adding a UCITS eligible fund to their product offering.

Our UCITS client base has also expanded to over 400 clients. We have launched seven new strategies on our MLIS UCITS platform this year and have a robust pipeline of new managers, with the expectation to launch a further 10-15 funds in 2011.

Post the 2008 crisis, investors are seeking regulated products while still having access to more complex strategies; also managers are seeking a more diversified client base. Both the AIFM Directive and specific interest demonstrated by investors have been the final catalyst for many hedge fund managers.

One challenge for the sector is to penetrate the true retail investor base. The "Newcits" product type is well understood and widely invested in by the institutional investor base and more sophisticated retail investors, but has yet been embraced by the wider retail market. However, when selling to this market segment, distributors must position the products carefully and ensure that investors fully understand the risks.

We are confident that the growth will continue into 2011 and beyond. As previously mentioned, Bank of America Merrill Lynch expects to more than double the number of funds on the MLIS platform next year.

Many strategies can already fit within the UCITS framework, albeit with some tailoring for more complex strategies. On the MLIS platform our initial funds were predominantly equity based, but our next launches include relative value, multi-strategy, emerging credit and CTA strategy funds. We expect to further diversify our product offering throughout 2011 and offer our investors a choice of top quality managers from across the spectrum.

We are also seeing a lot of interest from US-domiciled managers who are anxious to penetrate the European investor base and see UCITS as an ideal vehicle to achieve that goal.

Luxembourg is still the market leader in terms of preferred domicile for UCITS funds, although we are seeing a recent increase in Dublin domiciled funds. There will always be a market for both UCITS funds and offshore funds as they target a different investor base. Within UCITS we expect to see a lot of growth and are targeting AUM of $4-5 billion by the end of 2011.


Bill O’Neill


Investors should seek secure income growth in 2011 as global recovery settles into a ‘new normal’ pattern led by emerging economies. Global economic growth is likely to slow to 4% in 2011, from 4.5% in 2010. Recovery in the US and continental Europe is likely to disappoint but strong domestic consumption should ensure a soft landing in China. As the world economy recuperates investors should favour commodities and equities over government and corporate debt. Within equities the focus should be more on dividends than capital growth. Investors should also treat emerging market debt with caution, taking care to avoid overvalued assets.

Quantitative easing has seen $1 trillion flow to Asia and is fuelling price inflation in China. If China doesn’t let the renminbi rise and uses higher interest rates to fight inflation, QE won’t benefit the West as much as it might. Diversification, including within equities, is important to provide a hedge against any inflationary resurgence. Among government bonds, index-linked US Treasury bills look a well-priced low-risk option. In case of any resurgence of US inflation, Japanese equities are likely to outperform as they have in the past.

The euro should depreciate owing to the weakness in peripheral economies across the region. But other Eurozone countries, particularly Spain, France and Italy, continue to overestimate growth prospects. The European Central Bank is likely to play a large role in events henceforth. It appears that some form of monetisation around the peripheral countries' debt is almost inevitable. Our December 2011 euro forecast of $1.25 holds downside risk but QE II and possible additional bouts of quantitative easing will serve to break the euro’s fall. We anticipate an August tightening in UK interest rates, but G5 2011 economic growth of about 2% isn’t enough to spark inflation.

We are focused on several investment themes. High liquidity is paramount. Investors need to be waryof bubbles and crowded trades. Spreads should remain higher than in the pre-Lehman period, but lower than one year ago. Default risk looks to be declining, but the risk now may be duration. Among currencies, Turkey and Brazil are potentially vulnerable to inflationary pressure later in 2011. With equities, we have a bias to the UK and emerging markets. The solid gains in smaller Asian markets like Taiwan and Thailand, and in some Latin American markets, may continue. We are indifferent on US equities and Eurozone equities are our least preferred option. Gold looks to be near the top, but copper could hit $12,000 on a China soft landing and oil looks to be heading to $100 on an 18 month view.