Hedge Funds

Where next?

HUW VAN STEENIS, MORGAN STANLEY RESEARCH EUROPE

Absolute return funds are set for renewed growth as investors focus on risk-adjusted returns. We see the early stages of a turnaround in hedge fund flows with redemption pressures easing and inflows growing. Our research suggests sovereign wealth funds, foundations and pension funds have overtaken endowments and high net worth hedge fund of funds as the largest source of funds.

We think the market is underestimating the potential upsurge in demand for absolute return funds from private clients and smaller institutions via UCITS III. In the UK, in the third quarter of 2009 alone there were $2.1 billion in inflows into absolute return funds, three times that of the first quarter, and we see this as a growing seam for managers to mine. Our base case assumes hedge fund assets under management return to second quarter 2007 levels by the fourth quarter of 2010, although we see risks posed by performance, regulation and reputational issues.

Liquidity, transparency, not having gated, road-tested risk management, and institutional (quality) are the sine qua non for success today. Fundamentals will matter more (vs. arbitrage strategies), and the greatest interest going into 2010 seems to be in macro, equity long-short and commodity trading advisor mandates, although our work shows growing interest in distressed, emerging market and event-driven strategies.

Key risks include reputational and regulatory. The regulatory outcome is still fluid – and bad apples are not helping. But we believe some policymakers realize the supportive role providers of risk capital can play: we estimate that 30-40% of capital raised in 2009 by US and European banks came from hedge funds. Despite uncertainties of regulations, we see the minimum scale required to rise with incremental associated costs.

Growth Outlook
We think industry flows have turned positive in the fourth quarter after being flattish in the third quarter (leaders had been getting inflows but return of gated money or funds with reputational damage impacted overall flows). We think the sector is going through early stage recovery and our base case is for $1.75 trillion of AUM by end-2010, where we were in mid-2007. We nevertheless see risks, given the potential for reputation damage to the industry (e.g. due to Madoff, Galleon and so on) to damage fragile sentiment improvement, whilst redemptions from previously gated funds provide a drag to industry momentum.

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Favoured Strategies in 2010
Liquidity, transparency, road-tested risk management, institutionalized and not having gated are the sine qua non for success today. Fundamentals will matter more (i.e. vs. arbitrage strategies) and we think – much like in the late 1980s/1990s – the greatest focus for flows will be on macro, equity long-short and CTAs, although performance chasing will still drive much of flows. We also see growing interest in emerging markets, distressed and event driven strategies. After the market rout, we also see increased appetite for absolute return products (driving increasing interest in UCITS III product development among a number of providers). While opportunities exist in distressed credit, we see longer-term lock-ups as an obstacle for a number of clients.

Funds of Funds
US institutional appetite remains robust for hedge funds of funds; we see continued headwinds for high net worth focused firms. Consultant surveys indicate as much as one-third of US institutional allocations were still made to alternatives over the past 12 months, with funds of funds accounting for over 50% of these allocations. We see growth challenges for firms affected by Madoff, and for those who gated, though even here the ability to re-invent the offering (e.g. reconfigure to a managed account offering) presents the potential to reassert a growth dynamic.

We expect the high net worth offerings will continue to struggle near term as investor risk appetite remains subdued. Players like Man Group that have the infrastructure to offer managed accounts appear well placed.

Fee Compression
We see fees compressing to 50-100 basis points in funds of funds; liquidity rather than fee levels a greater focus in single (manager) strategies. We expect that vanilla fund of fund fees will continue to trend towards 50-100bps over time, though we also expect that those with the infrastructure to offer additional risk and liquidity management via managed accounts may be able to stabilise fees towards the upper end of this range. For single strategies, our view is that demand is more performance elastic, rather than price elastic, supporting fee levels for those with strong performance and capacity constraints, though we see better terms for longer-term and stickier asset allocators.

Regulatory Outcomes
Outcomes from US/EU regulations remain uncertain, though we expect they will likely further raise the bar in favour of players with institutional infrastructure. Potential US moves on position limits (and the related removal of swap deal exemptions) risk a reduction in market liquidity, thereby crimping opportunities. Risks from EU regulations centre on (i) leverage, (ii) marketing, (iii) prime broking/custodian arrangements and more recently iv) compensation.

While our base case assumes a pragmatic approach will be taken, as we believe regulators will seek to avoid unintended consequences (activities moving offshore or to new venues), we nevertheless see this significant uncertainty as posing risks. We believe scale is the best hedge to regulatory uncertainty – we expect that compliance costs and capital creep will favour players with strong capital and institutional scale. Charles River estimates a potential one-off cost impact for the industry of $1.4bn.

Flows Turnaround
We see early stages of a turnaround in fortunes in hedge fund flows with redemptions largely normalised to historical levels for most, although we expect funds to rotate away from the gated or reputationally damaged.

We see improving inflows, too, from our stock coverage and investor meetings. Our research suggests sovereign wealth funds, foundations and pension funds (both direct and via funds of funds have overtaken endowments and private client funds of funds as the largest source of funds, underscoring the need for institutionalisation. Our meetings with Swiss private banks suggest interest in hedge fund of funds is still subdued, while a good number of endowments that over-extended in illiquids are still digesting these. We see a seam of growing opportunity to offer absolute return product sales into private clients and smaller institutions via UCITS III (this was the best selling product category in September) as investors look for better risk-adjusted returns. France and Asia both show the strong demand by private clients for absolute return products.

In our base case we expect 3-6% inflows in 2010, returning the industry to $1.75trn, or back to mid-2007 levels. We recognise a broad range of potential outcomes given regulatory and reputational risk and as the path is dependent on performance.

Our bear case sees AUM at $1.25trn by end-2010. For the industry as a whole, we believe flows passed the inflection point into inflow territory in September, and we expected further progress in the fourth quarter of 2009, albeit redemptions from previously gated funds and pressures on smaller players, plus reputation risks (e.g., Madoff, Galleon), continue to provide some offset.

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Institutional demand
Sovereign wealth funds, foundations and pension funds (both direct and via funds of funds) have overtaken endowments and private client funds of funds as the largest source of funds. This has played to the strength of the top 30 platforms with scale, ability to digest institutional investments and robust back offices. This reinforces the need for robust risk management and greater institutionalisation across the business, from fund reporting, investor relations to operational due diligence. As we argue below, some institutional investors may also wish to invest via managed accounts.

In the US, a recent Eager Holmes Davis survey suggested some half of all alternative mandates went to hedge fund of funds in the first half of 2009, or, put another way, 19% of all US institutional mandates in the 12 months to June 2009 (admittedly a stressed period) were allocated to funds of funds, up from 3% in 2007. To be clear by value the percentage would be lower given fixed income allocations are far larger than those to alternatives. This trend fits in with what we know from our coverage of listed players, as well as our conversations with investors. We also can see institutionally focused funds of funds have fared far better than private-client-driven players. This is not to say they might not see growth over time, but we are struck by managers’ focus on the quality of capital. This trend by pension funds is the strongest in the US, but we see clear signs of this from our conversations in Europe too.

UCITS III underestimated
We also see a material opportunity in absolute return funds to private clients in Europe (often in UCITS III format), and Asia. We have long suggested the opportunity for “convergence” strategies would be interesting. From the client point of view, greater downside protection of absolute return can make a lot of sense given disappointments over many long-only strategies as well as fears of a correction from the sharp upswing in markets this year. Meanwhile cyclical and structural issues in the retail structured notes market and desire for onshore regulated product could also fuel this demand. On the other hand, for an asset manager desirous of sticky money and disappointed with the stickiness of Swiss private-client hedge fund of fund, this could be a reasonable opportunity. We have met with heads of retail of French and German banks recently and they see huge demand for this type of product. It also strikes us from meeting some managers who have enjoyed success in this channel that this is likely to be a very meaningful opportunity.

The UK market stands out as a testbed for new absolute return products. One of the most successful funds has been the Blackrock UK absolute return product run by Mark Lyttleton which now has £1.8 billion AUM. In 2009, there was a crescendo of inflows as demand for risk-adjusted product increased as risk appetite returned to the market.

France shows a similar trend, albeit with a slightly different set of strategies. Carmignac’s strong position in absolute return asset allocation strategies has helped it to scale the leaderboard of winners in continental European mutual fund sales – being the second best selling fund group in Europe in September and having grown swiftly in the last 18 months to €30 billion AUM. Cazenove, Blackrock, Sarasin, Fidelity (via its FAST funds)and others have all benefited from this trend so far. In a bid to benefit from this trend, we note that a number of major players have launched absolute return products in UCITS III format (including Cazenove, F&C, Henderson, GLG, BlueCrest, Man Group, Lansdowne, Cheyne and Marshall Wace). We think this trend has legs and provides a rich seam for asset managers to offer service into this channel notwithstanding liquidity constraints.

We do not think this is purely a European phenomenon and we know from our coverage of Man Group that Australia and Japan have been very fertile markets for absolute return strategies. Man also reported it raised $200 million in its regulated onshore Taiwan product in two weeks during the third quarter of 2009, and we see momentum building in UK and European onshore offerings with Latin American onshore product in the final approval stages. We think this is one of the most exciting areas of the market and will be hard fought by both so-called “traditional” and modern asset managers. We also think because of some difficulties with investors executing redemptions last year, the offshore hedge fund model is being questioned due to a lack of liquidity, transparency, gating and so on, and in turn investors are open to UCITS III funds. We also see material dissatisfaction with the structured notes sold.

But there is one clear knock-on for strategies. Given UCITS III funds offer frequent liquidity this will constrain the types of strategies that managers can run confidently in this structure without running mismatches. This means that UCITS III will not be everyone’s cup of tea and managers will want to believe the funds are sold to sticky money after some poor experiences of Swiss private client hedge fund of funds which had extremely high redemptions around the crisis.

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Managed accounts
Investors’ increased demand for transparency, liquidity and control is helping to fuel interest in managed accounts. Man Group recently reported a 50% increase in AUM on its managed account platform in the past 6 months to $6 billion, chiefly driven by existing clients moving from a standard fund of funds offering. Management see a significant pipeline given inquiries of interest. We think that the three largest providers of managed account are European financials – Soc Gen (via Lyxor) with $10 billion AUM, Man Group with $ 6 billion and Deutsche Bank with $4bn.

Infrastructure requirements mean that this opportunity is likely limited to scale players. This said, managed accounts are not for all and while we expect growth from here, we do not expect this to dominate the industry. There are two issues that come up frequently in our meetings. First, the additional data that management accounts provide may be too much for all but the most sophisticated investors to process. Many investors asked to have managed accounts to give themselves greater control and improve transparency. And many hedge funds are responding to these needs with far greater transparency than ever before by offering regular access and invigilation. The second issue is some managers are reluctant to run managed accounts as they wish to treat all customers identically – and feel managed accounts could disturb this.

Reputation and regulatory risk
Our meetings suggest regulatory outcome is still fluid, and bad apples are not helping. Significant uncertainties exist, but our base case is that pragmatism will win out. We think most regulators understand the importance of providers of risk capital and we think the extension of credit to small-to-medium sized enterprises will be one of the dominant issues for 2010 and private equity could represent an alternative source of finance to mid-size businesses. We were also struck by a recent paper co-authored by Andrew Haldane, Executive Director, Financial Stability at the Bank of England who wrote: “Hedge funds started this crisis in the doghouse. Yet they are the dog that has not barked.” He goes on to argue that hedge funds represented “important lesson for other parts of the financial system” including banks given their structure. With many policy makers thinking this, we think the odds of a balanced approach are growing, although never underestimate the unpredictable nature of the political process.

We do not want to now rehearse the arguments of this debate in full. Rather we will say we expect that cost pressure from additional compliance requirements will likely raise the barrier to entry and that additional regulation plays in favour of scale players with strong capital and infrastructure. Charles River has estimated a potential one-off industry cost of $1.4bn for the hedge fund industry (chiefly from the need to re-domicile funds due to marketing restrictions, which accounts for around two-thirds of the cost impact), though again we recognise that in a ‘pragmatic’ outcome, this is likely to materially overstate cost pressures.

We nevertheless expect that investor demand for protection and transparency will lead to increased UCITS III style hedge fund launches, and clearly some firms are looking for this optionality in case Europe puts regulation around the vehicle rather than managing via prime broker. Given the uncertainties of US/EU regulations, we see outcomes likely favouring scale names, given the potential for incremental compliance and prime broking costs to impact small players. US proposals for position limits in commodities trading represent a threat to trading strategies, though our conversations with industry participants have led us to a base-case conclusion that any caps are likely to be set sufficiently high that, outside of some large ETFs, risks are likely manageable.

However, risk does exist that removal of swap dealer exemption-from-position limits could have implications for overall market liquidity in the US. The ability to transfer trading to other markets will be critical in this scenario. We should also say that the current draft proposals for Solvency II would make the incentives for insurance companies to own hedge funds less interesting.

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Asset Managers: broader view
We see five broad themes that drive our structural views in the asset management sector. Some are longstanding, but nonetheless continue to be relevant today.

Yield Thurst
The thirst for yield is driving outsized flows to fixed income and income-yielding strategies. US and European data point to material inflows to corporate bond product as investors look to access yield in a low rate environment. Lipper FERI data point to more than €40 billion of corporate bond inflows, with the product category heading the leaderboard in eight of the first nine months of the year. US data equally show strong greater than 20% annualized net new money into fixed income funds, while equities have seen less than 1%.

Winners include the fixed income heavyweights like Blackrock and PIMCO, although within Europe, Schroders and BlueBay have been strong beneficiaries. We still think the market underestimates flows to Schroders.

Barbell Affect

Asset management barbell is driving continued outsized growth in ETFs and specialist fixed income/equities. Global ETF AUM has grown by more than 30% in the 10 months to October to $942 billion, and 45% since the March lows. Global net flows in the first eight months of the year amounted to $77 billion compared to $155 billion of sales of mutual funds (ex-ETFs). We see demand for low cost beta as a positive for the large players (e.g., Blackrock-BGI, State Street and Vanguard).

But we also see pronounced growth in more specialist fixed income mandates (emerging markets, distressed, active) plus more concentrated or thematic equity mandates (e.g. EAFE) or alternatives (hedge funds, commodities) making headway.

Performance as ever remains critical to sustained growth, though Ashmore, BlueBay and Man strike us as beneficiaries. We do note, though, that the failure of enhanced index to perform over the last two years has eased the pressure on some core providers, and in addition the demand for super concentrated strategies has also waned a little. But to be clear, we still expect this ongoing theme to drive disproportionate growth, even if the weight of assets remains in core mandates.

Risk Adjusted Returns
There is strong desire for better risk-adjusted returns and this is driving opportunities in absolute return products sold to European/Asian private clients. We expect increased focus on risk-adjusted returns following the market downturn to continue supporting growth among hedge funds able to demonstrate liquidity, transparency and strong risk management track records. This equally supports accelerating growth in absolute return products sold via UCITS III wrappers into Europe and Asia as retail clients seek to access slices of risk with downside protection. Obvious beneficiaries include Blackrock, Man and Carmignac.

LDI & Inflation Hedging
Liability-driven investing and inflation hedging offer opportunities (e.g. longer duration fixed income product, infrastructure, commodities.) A growing focus on liability matching is driving demand for LDI, offering opportunities to fixed income specialists (e.g. Blackrock, PIMCO) as well as to those with capabilities in inflation hedging product (e.g. commodities, infrastructure).

Opening distribution
We believe the dramatic shifts in US broker distribution and, more broadly, through the continuing exit of captives from the industry will continue to open up distribution to best of breed providers. However, we also note moves to concentrate preferred lists of providers among distributors, likely placing pressure on distribution costs over time. We believe winners over time will be those players with sufficient scale and product waterfront to tap into these growth opportunities within open architecture platforms (e.g. Schroders, JP Morgan, Blackrock).

Where could we be wrong? Notwithstanding our view that a lower rate for longer environment will prove supportive for investment banks, we remain concerned that the exit from unconventional policy measures carries with it major risks. For the hedge fund industry, we see risks that a performance drawdown could damage recovering investor appetite, while reputation risks to the industry (e.g., insider-trading charges) remain a further potential headwind. While we expect regulation to be guided by pragmatism, we do see risks surrounding political elements of the debate.