During the first quarter, most alternative investors spent their time rebalancing their portfolios, redeeming with current managers, and waiting for the market to correct itself. This process freed up capital and uncovered gaps in portfolios, ultimately leading to a significant increase in alternative investment interest in the second quarter. Fixed-income strategies and volatility arbitrage were sought after, and experienced a significant boom in interest, as investors looked to take advantage of pricing inefficiencies created by rebounding markets (see Fig.1).
Fixed-income hedge funds are not typically a highly demanded strategy by institutional investors. Riskier investments that have exposure to equities, commodities, and alternative asset classes such as private equity and venture capital funds, usually dominate investors’ portfolios. However, the economic crisis of 2008 caused a flight to quality and many investors abandoned such strategies. Instead, they focused on high-quality, long-term fixed-income funds. Usually a core portfolio holding, fixed-income securities generally fall into two categories: preferred stock and debt obligations, which include bonds, variable annuities, and mortgage-backed securities. Investors’ goal was to protect and preserve their wealth.
Not all debt instruments proved safe, however. The errors and misjudgements by rating agencies coupled with the toll of the downturn resulted in an unprecedented number of defaults. Unsure where to turn, investors sat on the sidelines.
Investors remained wary coming into 2009, but the performance of bonds caught their attention. As the latest data from Hedge Fund Research (HFR) show, HFRI Fixed Income Indexes all gained year to date (see Fig. 2). Once again, investors became interested in fixed-income strategies.
An example of such an investor is a top US fund of hedge funds. According to the managing director, the firm has been searching for fixed-income strategies while equities have been in flux. It views the bond market as a more stable environment.
One reason for this view is that the US government’s effort to stabilize the largest banks has been effective. Although spreads on corporate credit and other asset-backed securities remain historically wide, they tightened in the second quarter.
Given institutional investors’ recent focus on “vanilla” strategies that can be easily understood, as well as their focus on capital preservation, low volatility levels, and absolute returns, it was no surprise to see an increase in demand for fixed-income hedge funds. Institutional investors were looking for a way to add exposure to their portfolios that not only let them sleep at night, but also helped them outperform equities with less risk.
During the second quarter, investors continued to focus on hedge funds that could effectively provide ample liquidity. Some strategies that remained popular included global macro, commodity trading advisers (CTAs), and other funds which utilized high-frequency trading methods. One strategy that saw a sharp increase in interest was volatility arbitrage. Of investors who indicated an active interest in hedge funds, 20.43% indicated a willingness to consider volatility arbitrage. This is an increase or nearly 50% from the first quarter when only 13.63% of investors indicated an interest.
Interest came from across the globe and from a wide array of investors; large institutional investors as well as small independent firms were researching volatility arbitrage funds for potential allocations.
One reason for investor interest is the capability of volatility arbitrage funds to take advantage of market swings. Global economies were still experiencing volatile markets, and many investors saw volatility arbitrage funds as a way to capitalize on market fluctuations. Attractive liquidity terms were another reason for the popularity of these funds. Most volatility strategies take advantage of rapidly shrinking or widening spreads between related assets. Therefore, trades are often held for extremely short periods of time. As a result, many funds that actively trade volatility have been better ableto navigate current markets without sacrificing liquidity – something investors continued to stress as an important qualifier for a potential investment.
Finally, investors looked to volatility arbitrage strategies as a way to diversify their portfolios. For investors with traditional equity and fixed-income portfolios, volatility arbitrage funds have the capability to provide alpha and uncorrelated returns.
A fund of hedge funds based in Amsterdam indicated it had an interest in volatility arbitrage for the first time. While the fund of funds had maintained a diversified exposure to equity, fixed-income, and commodity funds historically, it decided volatility arbitrage funds presented a unique opportunity in the current market.
While markets rebounded during the second quarter, many investors remained leery of the markets’ fundamentals. In response, they dedicated additional resources to finding funds that were nimble enough to take advantage of market fluctuations in the short term without sacrificing portfolio manoeuvrability in the long term. Many volatility arbitrage funds set themselves up to do both and investors took notice. It will be interesting to see how such funds continue to fair as markets continue to move.
Hedge funds: preferences for minimum assets under management
The tremendous level of redemption requests seen during the last quarter of 2008 and the first quarter of 2009 began to slow in the second quarter, and investors were, once again, gaining confidence in alternative asset classes as a way to diversify their portfolios. The surging equity market produced excellent returns; however, hedge funds still have a long way to go before recovering from double-digit declines in 2008. As investors returned to the market, an increasing number expressed a bias towards funds with less than $200 million in assets under management. The prevailing sentiment was that smaller funds often have more attractive fees, and are more willing to offer a higher degree of transparency.
Assets under management
During the second quarter, 57% of investors profiled by BHA analysts maintained minimum asset requirements of $1 million to $200 million for potential funds, and 19% looking for funds with a minimum of $21 million to $75 million (see Fig. 3).
This requirement brought to light a larger set of investor concerns, specifically fee structures, performance, and transparency. Hedge funds’ fee structures became a popular discussion topic among investors following the poor industry results of 2008. Exalted multibillion-dollar hedge funds, which charged the standard management fee of 2% – or more – and suffered some of the worst results were suddenly seen by many investors as nothing more than asset-gathering powerhouses. Upset with their performance, investors balked at paying high management fees.
Investors were, however, willing to pay for performance. In the second quarter, many investors expressed an interest in managers that have a vested interest in their funds by having a substantial amount of their personal assets invested in the fund. Investors think that portfolio managers who have a substantial amount of personal capital invested in their funds are driven to produce outsized returns; and are not as likely to be content simply collecting management fees.
A partner at a southern US-based multifamily office mentioned that he strictly looks at funds offering a 1% management fee. In addition, the firm focuses the majority of its efforts on sourcing managers operating funds with $10 million to $50 million in assets, and has seeded managers with exceptional pedigrees. It has found that young, highly motivated managers offer the greatest potential for returns, and are driven by incentive fees rather than management fees.
While the economic crisis of 2008 turned the spotlight on fee structures, the largest Ponzi scheme in history orchestrated by Bernard Madoff brought another issue to the surface: transparency. Gone are the days when investors did not require validation or disclosure of investment activities and considered statements proof of investment returns. The balance of power has shifted from fund managers to investors and, during the second quarter, investors increasingly demanded higher exposure and increasing details on position levels.
Investors reported that smaller funds tend not to be shrouded behind large investor relations staffs, giving investors the opportunity to develop closer relationships with portfolio managers and a better understanding of portfolio particulars. Portfolio directors at a Connecticut-based single-family office and an Illinois-based tax-exempt institution expressed interest in funds with smaller asset bases in order to obtain a more in depth view of the portfolio holdings.
Heading into the third quarter, BHA sees hedge funds with under $200 million in assets under management – a substantial portion of which is personal capital – in a strong position to capture investor interest. Funds that combine this with increased transparency have an even greater opportunity to attract investors looking to distance themselves from firms that are solely driven by raising as much capital as possible.
Funds of hedge funds: investor interest
Q2 has blossomed new investor interest into funds of hedge funds. As the global economy showed signs of stabilization, so to did investors willingness to accept lock-up periods which they were unable to stomach in the first quarter. In addition, investors increasingly considered single strategy funds of funds. As global markets recover from the past years dismay, investors are once again becoming comfortable with utilizing funds of funds as a vehicle to diversify not only across different strategies but also across risks within a single strategy.
Renewed investor interest
The second quarter of 2009 was very strong for alternative investment funds. Funds of hedge funds in particular saw an increase in investor interest after a disastrous Q1. In the first quarter, BHA received 108 mandates for funds of funds from investors; in the second quarter that number jumped over 40% (see Fig. 4). Several factors contributed to this change, including increased investor tolerance for lock-ups and longer redemption periods, increased investor interest in single-strategy funds of funds, and various investor types looking to increase their funds of funds exposure.
Investor willingness to endure lock-ups coupled with longer redemption periods was an important factor that led to an increased number of investors looking to allocate to funds of funds. During the second quarter, investors began to emerge from their bunkers and seriously consider funds that had less favourable liquidity terms. In the first quarter, credit markets were frozen, and investors were concerned they would be unable to withdraw money at a moment’s notice should the global economy take another nose dive. With the second quarter came a more positive investor outlook as the market rebounded almost 11% from the end of March. In addition, the US and European credit markets began showing signs of loosening. Investors were encouraged that the worst might be over and business could resume.
A substantial increase in the percentage of investors looking for single-strategy funds of funds – 15% during the second quarter – was another reason for their popularity. In the past, most investors used multi-strategy funds of funds as a way to diversify their portfolios. When compared with single-strategy funds, multi-strategy funds of funds let them receive a better return with less volatility. During the second quarter, however, BHA noted investors looked to gain diversity and hedge risk within a single strategy. By investing across many managers that executed the samestrategy, investors limited their exposure should one manager fail.
In addition to diversification, investors sought out single-strategy funds for liquidity. Of the investors looking for single-strategy funds of funds, most were interested in CTAs/managed futures and currency/FX funds of funds. Interest in these two strategies increased by 84% and 350%, respectively, from the first to the second quarter. While some investors became more comfortable with lock-ups and longer redemption periods in the second quarter, many still sought more favourable liquidity terms. Investors looked at active trading strategies as they typically offer much greater liquidity, giving even the wariest of investors peace of mind that their money is available for withdrawal if need be.
The second quarter proved to be a positive one given all that has gone on in the past 12 months. Investors began to come out of their cash positions and take advantage of the many new opportunities that have arisen amidst the economic ash. Funds of hedge funds served as stepping stones for many investors, giving them the ability to invest in the alternative space and still maintain broad diversification among strategies and geography. As the world markets continue to rebound, it is safe to say the number of investors looking to expand their allocations to funds of hedge funds should continue to rise.
Optimism reigned throughout the second quarter as investor sentiment thawed and many investors began reallocating capital to alternative funds across the spectrum. Investors’ concerns were evident by a push for greater liquidity, transparency, and access from managers of alternative funds. This shift manifested itself in conversations BHA analysts had with the global investor community.
Many investors who spent the first quarter on the sidelines outlined active mandates while others committed capital to funds. Investors reported interest not only in funds with which they had long standing relationships, but also in new funds to which they were introduced in the past few months.
While many strategies realized increased interest during the quarter, volatility arbitrage and fixed income were two of the most intriguing. The rise in interest in volatility arbitrage is of little surprise. The push for liquidity, focused investors on highly liquid, short-term trading-orientated funds.
Investors also increasingly favoured the relative stability and predictable returns that fixed-income funds provide.
Investors and managers are hoping to build on the momentum created during the second quarter and carry it forward into the second half of the year.
Dennis Ford is President and COO of BHA. His expertise is in database marketing, using the Web to create interactive dialog, and using analysis and profiling to understand customer prospects. He is the author The Peddler’s Prerogative.
Brighton House Associates is an alternative investment research firm that speaks to investors across the globe about their current interest and activity in alternative investment funds. Brighton House works with a network of over 100 fund managers and assists in indentifying qualified investors for their internal marketing campaigns.