Winston Churchill once remarked that “an optimist sees the opportunity in every difficulty”. In that case, the hedge fund industry should enjoy a wealth of opportunities over the next few years. This was the implicit message to emerge from the EY London Hedge Fund Symposium, held at London’s Park Lane Hotel on 20 November. While acknowledging the economic, regulatory and competitive difficulties facing the industry, each of the event’s sessions struck a hopeful note. These ranged from an upbeat assessment of the industry’s plans, through cautious optimism over the UK’s competitiveness, to a strident call for economic cheerfulness from leading international economist Dr Gerard Lyons.
Pathways to Growth
The symposium began with a presentation on ‘Exploring Pathways to Growth’, EY’s latest global survey of hedge funds and investors. Presenting the results, EY partner Matt Price set the tone by highlighting the industry’s overwhelming strategic focus on growth. In the panel discussion that followed, moderated by EY’s EMEIA Hedge Fund leader, Julian Young, EY partner and former CFO of TT International Fiona Carpenter emphasised the importance of this finding, given the industry’s considerable focus on capital retention and cost-cutting over the last three years.
Hedge funds are investing for growth
The survey shows that hedge funds are investing heavily to diversify their product range. This investment has two motives, said Price. It is partly defensive, as differentiated products deflect pricing pressure from competitors. It is also the principal pathway to expansion, whether in the form of newly developed investment themes or the proven strategies of investment teams bought in.
The survey shows that most investors expect to maintain hedge fund allocations at their current levels, and new products are key to both attracting capital and boosting margins. Natalie Deak, a partner in EY’s US hedge fund practice, agreed that competition for capital is an increasing feature of the market and that diversification is a crucial weapon for managers competing for a limited pool of institutional assets.
However, investment by the industry is far from being purely defensive. Much of it is aimed at maintaining and developing the skills and capabilities that make hedge funds unique. Price stressed that investment is spread across front, middle and back offices. In the front office, the ability to attract skilled managers and even whole teams is receiving more attention than ever. Meanwhile many hedge funds are building middle and back-office platforms to give them a foundation for future growth. Price identified the ability to offer customised solutions to investors as a major focus of investment. This was echoed by Deak, who cited rapid US growth in quasi-managed accounts as evidence of larger hedge funds’ ability to leverage their infrastructure.
Distribution patterns are changing fast
Given the stability of hedge fund allocations, it is not surprising that hedge funds are placing increasing priority on distribution. The industry’s established sales channels are undergoing a revolution.
This is not just about funds of funds losing traction – although that trend is clearly continuing. It is also, said Price, a story of fast increasing direct investment. Endowments, sovereign investors and wealth managers are increasingly developing in-house due diligence capabilities. Hedge funds are generally happy with this trend, not least because direct investments tend to be larger and stickier. In response, firms are making further improvements in transparency and some now offer investors access to proprietary fund platforms. The survey confirmed that traditional funds of funds in particular are feeling the impact of this shift and, in consequence, building their own managed account platforms as well as more direct ties with start-ups and smaller managers.
Increasing direct investment is helping investment consultants to increase their influence on hedge fund distribution. EY’s EMEIA Hedge Fund leader Julian Young cited a view among some hedge funds that consultants can take a box-ticking rather than a substantive approach. Fiona Carpenter agreed that while consultants can be a valuable channel, they can also act as gatekeepers whose influence increases the cost and complexity for hedge funds of securing new investment.
Large and medium-sized firms face very different dynamics
Hedge funds’ investments in distribution, talent, diversification and customisation may be a welcome sign of confidence, but they come at a cost. The build-up of expenses is proving particularly heavy for mid-tier funds. Pressure on margins is at its greatest among managers with between $5 billion and $10 billion in assets. Emphasising this point, Price pointed out that this segment continues to have the highest ratio of back office to front office staff although it was clear from the survey that operational efficiency had improved across all managers surveyed between 2012 and 2013.
In particular, hedge funds with assets of $10 billion or more are benefiting from their size, reach and economies of scale. This segment captured the lion’s share of net inflows during 2012, and a majority are enjoying stronger margins than in the prior year. Among the smallest hedge funds, results are more varied. Some start-ups are achieving stellar growth, but firms that fail to gain traction during their first few years are struggling to get to the next level. As Carpenter put it, for this segment of the industry it is often a case of “up or out”.
The industry appears increasingly confident
The presentation and the panel discussion both concluded on a positive note, emphasising the current survey’s overall optimism. Young stressed that while hedge funds – especially in the mid-tier – face a range of challenges, it is still possible to build a successful firm at any size. Price signed off by commending the industry for the progress it has made in transparency, investor service and risk management.
UK competitiveness under scrutiny
The UK is a leading global financial centre. It is the world’s leading financial net exporter; London heads the Global Financial Centres Index and hosts 251 foreign banks; and the UK remains the world’s largest centre for foreign exchange and derivatives trading.
But how does the UK shape up in the hedge fund stakes? The UK is pre-eminent in Europe, managing some 85% of hedge fund assets. But despite doubling its global share of hedge fund business over the past decade, London has ceded further ground to New York. How will recent and forthcoming changes to tax and regulation affect the UK’s competitiveness? Will the UK defend or extend its European lead? Could it even gain ground on the US?
European politics increasingly dominate regulation and tax
These were the questions posed by Dr Anthony Kirby, EY’s executive director of regulation and risk, as he introduced the symposium’s second panel discussion. Dr Kirby was joined on the panel by Jirí Król, deputy CEO and head of government and regulatory affairs at AIMA; former FSA director and EY senior advisor Sheila Nicoll; and EY partner and hedge fund tax partner Russell Morgan.
As so often when regulation is involved, the session generated more questions than answers. In particular, the panel identified European regulation as playing a perennially opaque role. The measured approach of the FSA and its successors to the AIFM Directive was welcomed, but there was a warning that the effects of UK pragmatism can easily be offset by the effect of other regulators’ more literal interpretations.
Panellists urged UK regulators to maintain their realistic approach by focusing on hedge funds’ accountability and fiduciary behaviour, and resisting the temptation to apply constraints at a product level. The question of whether, and how, hedge funds are identified as being of systemic importance was predicted to be a major issue in 2014.
If anything, tax has become an even more politicised issue than regulation. The panel stressed how hard it is for hedge funds to upgrade their tax capabilities when the environment is so unpredictable. This is less of a domestic problem than an extra-territorial one, typified by the Financial Transaction Tax (FTT). Economic arguments may have convinced the UK government to reject the FTT, but politics could yet trump economics at a European level – with inevitable effects on many UK hedge funds.
Government support could give the UK a boost
Looking at the UK as an overall hedge fund venue, there was a degree of scepticism over the focus placed on fund domicile in the Treasury’s Investment Management Strategy. Some panel members questioned the practicality of promoting UK domiciles or fund administration given the lack of commercial appetite to change existing Cayman – London – Dublin arrangements.
All in all, however, the panel saw the Strategy as a positive statement of intent. It has the potential to reinforce the UK’s existing advantages of incumbency, legal framework, regulatory pragmatism and professional skills. Even if the cup of UK competitiveness is hardly running over, it is closer to being half full than half empty.
Reasons to be cheerful
The symposium was concluded by keynote speaker, renowned economist Dr Gerard Lyons. Dr Lyons’ confident predictions for global growth were given additional weight by his stellar reputation as a forecaster.
Untangling economic uncertainties
DrLyons began by grounding his speech in today’s economic realities. He explored current economic uncertainties, illustrated by concerns over global growth and recurring bouts of financial market volatility. He sees the current situation as the inevitable result of pre-crisis imbalances in savings, debt and capital flows, together with the tangle of pro- and anti-business policies announced around the world since 2008.
Dr Lyons drew attention to a range of disconnections in developed markets, including the contrasting health of large and small companies, widely varying rates of unemployment, and low wage inflation at a time of high price inflation.
Emerging markets are faring better, but good news has been fully priced in and the unwinding of carry trades is provoking occasional periods of volatility. Some emerging economies could also be at risk of falling into a middle income trap.
The result is a global economy that is not so much operating at two speeds – East versus West, or developed versus developing – as at multiple speeds. Each country’s outlook depends on a mixture of fundamentals, confidence and investment flows. Added to that is the unpredictability arising from the policy dilemmas facing politicians, regulators and central bankers.
Policy responses are proving paradoxical
Dr Lyons stressed the conflicting effects of current policy initiatives. Most developed markets have seen little in the way of structural reform since the crisis. Instead, exceptional monetary stimuli have acted as an economic shock absorber. This has created a policy paradox: the belief that a crisis triggered by easy money and leverage can be resolved in the same way. A view that all countries should become net savers is another paradox; the last thing the world needs is two hundred versions of Germany or China.
Dr Lyons also pointed to an unhelpful paradox in financial regulation. Having moved too far towards laissez-faire before the crisis, the pendulum has now swung back in the opposite direction. Individual initiatives are multiplying to create an excessive burden on the financial industry.
What happens next?
Dr Lyons outlined the primary challenge for policymakers. In developed markets, this is to reintroduce appropriate risk pricing without strangling a sustainable recovery. In emerging markets, the goal is to avoid excessive inflation without putting a brake on development.
Dr Lyons conceded that Europe’s economic and structural problems remain stubbornly unresolved. He balanced this against the improving performance of the US, recovery in Japan under the ‘three arrows’ of Prime Minister Abe, and the resilience of China. Looking slightly further ahead, he predicted beneficial effects from the current boom in infrastructure investment. Dr Lyons also expects companies to benefit from a replacement cycle as consumers in developed economies upgrade ageing cars, household appliances and other consumer durables.
Emerging markets hold key to long-term growth
Casting his eye further forward, Dr Lyons forecasted strong global growth over the next 20 years. Emerging markets will be the engine of expansion, and Dr Lyons predicted that global trade growth will recover from its current comparatively low rate.
Dr Lyons was particularly bullish on the possible effects of new trade agreements such as the planned Trans-Pacific Partnership. Dr Lyons singled out China for particular attention. He predicted that China’s economy would become harder for Beijing to manage, and conceded that China faces some demographic risks. Even so, he expects the package of economic and social reforms announced at the recent Third Plenum of the Central Committee to have a lasting, positive impact by furthering the goals of higher consumption, improved social welfare and greater sustainability enshrined in the 12th Five-Year Plan.
Looking beyond China, Dr Lyons identified two other factors supporting his forecasts. One is the effect of demographic growth and, in particular, the expansion of the consuming classes in middle and low income countries. The other is the rapid acceleration of urbanisation, which triggers higher levels of consumption.
Dr Lyons concluded by telling his audience that current economic disconnections may not be as hard to overcome as some economists fear, and that sustained growth in the 3-4% range is more than enough to deliver strong global development. His parting words were unmistakably bullish: “Good investment opportunities are out there.”