IFSL Hedge Funds 2010

Recovery begun in 2009 looks set to continue

MARKO MASLAKOVIC, INTERNATIONAL FINANCIAL SERVICES LONDON

Overview
Global hedge fund assets under management posted strong gains for much of 2009 following sharp falls seen in the previous year due to conditions brought about by the global economic downturn. This report by ISFL provides an overview of the global hedge funds industry with particular emphasis on London’s role as the second largest global centre for hedge funds.

Assets under management of the hedge fund industry increased by 13% in 2009 to $1.7 trillion. This followed a 30% decline in the previous year. Redemptions continued for the second year running, albeit at a slower pace. The 19% return in 2009, the best hedge funds’ performance in a decade, more than made up for the $85 billion in net outflows. The number of hedge funds totalled around 9,400 at the end of the year, a reduction of more than 1,000 from the peak seen two years earlier. New hedge fund launches however exceeded the number of liquidations in the second half of 2009. Growth of hedge fund industry assets is likely to continue in 2010 barring further economic turbulence or major regulatory changes. The fund of hedge funds industry has been particularly affected by the economic downturn and the reputational damage following the revealing of the Madoff fraud in 2008. Assets of fund of funds totalled around $500 billion at the end of 2009, down 17% from the previous year, and over 40% below the peak seen two years earlier. The proportion of single manager hedge fund assets originating from fund of funds fell to 30% in 2009 from 40% a year earlier.

Flow of funds
The surge in redemptions which started in the latter part of 2008 continued in the first half of 2009. Hedge funds more oriented towards institutional investors have fared better in this environment as they have been less inclined to redeem assets. Some hedge funds were forced to suspend redemptions towards the end of 2008 because selling illiquid assets would have exposed remaining investors to bigger potential losses. More than a half of these impaired assets were returned to standard liquidity terms by the end of 2009. The asset raising environment slowly improved during 2009 with a return to net asset inflows in the second half of the year.

Number of hedge funds
The number of hedge funds totalled around 9,400 at the end of 2009. Three-quarters of these were single manager hedge funds and the remainder fund of hedge funds. This 2009 total represents a reduction of more than 1,000 from the peak seen two years earlier (see Fig. 1). The fall was caused by funds closing due to losses, lack of liquidity and redemptions as investors looked for safer investments. New hedge fund launches however exceeded the number of liquidations in the second half of 2009.

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Employment
According to the Alternative Investment Management Association (AIMA), the UK hedge fund industry employs around 40,000 people. Around 10,000 of these are directly employed by hedge funds and the remainder among the industry’s advisers and service providers. The hedge fund industry employs some 150,000 people worldwide.

Geographical distribution of funds
The domiciled hedge funds can be registered in onshore or offshore locations. Around 60% of the number of hedge funds in 2009 were registered in offshore locations. The Cayman Islands was the most popular registration location and accounted for 39% of the number of global hedge funds. It was followed by Delaware (US) 27%, British Virgin Islands 7% and Bermuda 5%. Around 5% of global hedge funds are registered in the EU, primarily in Ireland and Luxembourg.

Location of management
Hedge funds are predominantly managed from onshore locations. The US is by far the leading location for management of hedge fund assets with over two-thirds of the total. Its share, however, was well below its 80% share at the start of the decade. Europe doubled its share during this period.

New York is the world’s leading centre for managers of hedge funds, followed by London. IFSL estimates that 41% of global hedge fund assets were managed from New York in 2009, down from over 50% at the start of the decade (see Fig.2). London’s 20% share of the global total was unchanged from the previous year. A breakdown by management location of the largest 100 hedge funds shows that New York accounted for 47% of assets in 2009, followed by London 21%, Boston 7% and Greenwich 6%. London is the largest centre in Europe for the management of hedge funds. According to Eurohedge data, at the end of 2009, 76% of European single manager hedge fund assets totalling $382 billion were managed out of the UK, the vast majority from London (see Fig. 3).

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London’s share was up slightly from 75% in the previous year. If fund of funds’ assets are taken into account, London probably accounts for close to 90% of hedge funds assets managed in Europe. There were nearly 1,400 European-based hedge funds in 2009, of which two-thirds were located in London. Other important locations for hedge fund managers in Europe include France, Switzerland and Sweden. Many hedge funds in Europe have recently launched UCITS III compliant stand-alone onshore fund vehicles which are allowed to be distributed throughout the EU to institutional and retail clients. These funds employ a range of strategies that use derivatives and limited leverage within a regulated framework. A Deutsche Bank survey recorded a 50% growth in 2009 of UCITS assets under management and found that 35% of investors in its survey plan to allocate to such funds in 2010. The UK is the dominant centre in this area and accounts for about a half of assets under management and number of funds.

Despite the global economic slowdown, London retains its structural advantages which make it an attractive location for hedge fund management. These include its local expertise, the proximity of clients and markets and a strong asset management industry. London is also a leading centre for hedge fund services such as administration, prime brokerage, custody and auditing. With around a half of European investment banking activity conducted through London, it is a natural location for prime brokerage services. Asia, and more particularly China, is taking on a more important role in the global hedge fund industry more as a source of funds than a location for management. The UK and the US are leading locations for management of Asian hedge funds’ assets with around a quarter of the total each. Other important centres include Hong Kong, Australia, Singapore and Japan.

Returns and investment strategies
Hedge funds’ 2009 return globally averaged 19%, the highest for a decade. This comes just one year after hedge funds posted the worst annual loss in history brought about by the falls in equity markets, a ban on short-selling and pressure to liquidate positions to meet margin and redemption calls. As market conditions improved in 2009 and equity markets recovered, hedge funds saw positive performance across most strategies. The 2009 return was lower than the 27% return on the MSCI World Index but much higher than the 6.9% of the Barclays Capital Global Aggregate Bond Index.

Hedge funds investment strategies vary enormously. Strategies may be designed to be directional (which try to anticipate market movements) or market-neutral (which have low correlation to the market movements). Equity long/short strategies typically account for the leading share of strategies. While nine out of ten of the most common investments strategies saw a net outflow of funds in the first half of 2009, only four experienced outflows in the second half of the year. Long/short equity, event driven, managed futures saw the biggest inflows in the second half of the year (see Fig. 4).

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Sources of Funds
Institutional investors are the biggest source of capital for hedge funds, having overtaken high net worth individuals in 2008. Funds with a higher proportion of institutional investors fared better in market conditions of falling liquidity in 2008 and the early part of 2009. A breakdown of institutional investors by type of investor shows that fund of hedge funds accounted for 24% of assets, followed by public pension funds 17%, endowment plans 14% and private pension funds 14%. The geographical breakdown of institutional investors shows that more than a half originate in the US, followed by the UK 14% and Switzerland 5%.

Fund of hedge funds’ assets totalled around $500 billion or some 30% of global hedge fund assets. This was down 17% from the previous year and nearly a half below the peak seen two years earlier. The value of the industry’s assets began to fall in mid-2008 as investors began converting their investments into cash due to widespread losses in the hedge funds industry. The fall in reputation of the industry following the revealing of the Bernard Madoff fraud in 2008 also contributed to the decline. Adding to this, fund of hedge funds significantly underperformed hedge funds in 2009 with around 10% in returns in 2009, much less than the 19% made by the hedge funds industry.

The breakdown of hedge fund of funds by manager location shows that around a quarter of assets were managed from the UK. The US was the most popular location with around 30% of the market. Switzerland, France and Hong Kong were also important centres. To deal with the decline in assets many fund of funds were forced to reduce management and performance fees in order to attract new investments and retain existing customers. The number of publicly quoted hedge fund of funds has increased over the past decade. Most of these listings are on the London and Zurich exchanges. The London Stock Exchange overtook Zurich in 2006 to become the location of choice for funds of hedge funds listings.

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Secondary market for hedge funds is a market where investors can buy into some hedge funds at a discount to net asset value. This is an OTC market where each deal is individually priced and structured. The secondary hedge funds market allows investors to sell stakes in funds that have lockups or have limited redemptions. It also lets others into funds that aren’t accepting new investors. As record investor redemptions swept over the industry in late 2008 and restrictions on redemptions imposed by some hedge funds increased, many investors turned to the secondary market to try to sell their stakes. In December 2009, Hedgebay, one of the leading players in secondary market-making for hedge funds, saw its global hedge funds secondary market index drop to a record low, to just under 80% of the average net asset value.

Largest funds
The hedge fund industry has become more concentrated at the top end over the past decade. With fund closures on the rise and new launches on the decline for much of 2008 and 2009 consolidation intensified. The industry will probably be characterised by a greater concentration of assets in the large funds in the next few years. The top 100 hedge funds accounted for around 70% of total industry assets in 2009, up from 54% in 2003. JP Morgan was the largest hedge fund with $50 billion under management in January 2010. It was followed by Bridgewater Associates $44 billion and Paulson & Co $32 billion. The 8% hedge fund attrition rate in 2009 was down from 13% the previous year but much higher than the 3% to 5% range seen over the previous 10 years.

Service providers
Prime brokers offer brokerage and other professional services to hedge funds and other large institutional customers. Rather than providing particular niche services, prime brokers offer a diverse range of services including: financing, clearing and settlement of trades, custodial services, risk management and operational support facilities (see Fig. 5). The bulk of prime brokers’ income comes from cash lending to support leverage and stock lending to facilitate short selling, both areas that have been affected to a large extent in 2008 and early part of 2009 by redemptions and a general decline in hedge funds’ leverage levels. London is Europe’s leading centre for prime brokerage services and accounts for more than 90% of its activity, as the largest investment banks that provide these services are either headquartered or have a major office there.

IFSL6Major restructuring occurred amongst prime brokers in 2008 and 2009 such as the acquisition of Bear Stearns by JP Morgan, the takeover of Lehman Brothers by Barclays Capital and the acquisition of Merrill Lynch by Bank of America. This resulted in a shift in market share from some former investment banks to commercial banks. Goldman Sachs and JP Morgan were the largest prime brokers in 2009 each with around a fifth of the market. Morgan Stanley saw the biggest decline in its market share, dropping to 13.5% in 2009 from 20% in 2008.

According to the Financial Services Authority (FSA), the average margin requirement of prime brokers increased from around 25% in 2007 to nearly 40% in October 2009. This is likely to drop in 2010 as liquidity continues to return to the industry. Hedge funds leverage increased to an average of around 1.50 in 2009 from 1.10 in 2008, almost back to levels in the years preceding the credit crisis.

The extent to which hedge fund managers outsource administrative functions such as accounting, investor services or risk analysis varies widely. Assets under administration by third-party hedge fund administrators fell by around 2% in the first half of 2009 following a 30% fall in 2008. Citco Fund Services retained its position as the largest hedge fund administrator despite a 9% fall in assets under management in the second half of 2009 to $340 billion. It was followed by State Street Alternative Investment Solutions and The Bank of New York Mellon. There may be an increase in the outsourcing of administrative functions in the coming years as hedge funds will be looking to reassure their clients due to the fall in reputation of the industry following the Madoff fraud and the suspension of redemptions by a number of funds in the latter part of 2008.

Managers of offshore hedge funds typically rely on offshore administrators for various types of services and operational support. In addition to helping set up the offshore fund, offshore administrators may also provide accounting and reporting services; offer advice on an ongoing basis with reference to complying with applicable laws; or offer independent pricing of a fund’s portfolio of securities. Some offshore locations may subject the administrators to licensing and auditing requirements.

Hedge fund assets are generally held with a custodian, including cash in the fund as well as the actual securities. The flow of capital to meet margin calls may also be controlled by custodians.

Most hedge funds are set up in a way that does not require them to have their financial statements audited. Some hedge funds however, may undergo annual audits if this is a part of the contract between the hedge fund and its investors. This may however change if regulation of hedge funds is tightened. Some offshore locations require hedge funds to have their accounts audited.

Regulation
The hedge fund industry has faced calls for stricter regulation in recent years. Although hedge funds did not play a major role in the emergence of the credit crisis it is alleged that they contributed to volatility through short-selling transactions and selling shares as a result of deleveraging and redemptions. The Financial Stability Board, successor to the Financial Stability Forum, was established in April 2009 following the G-20 London summit. The oversight of the new body was extended to all financial institutions important to global financial stability including for the first time large hedge funds.

In the US, hedge fund managers have not been subject to regular SEC (Securities and Exchange Commission) oversight. Rule changes introduced by the SEC in February 2006 that required hedge fund managers to register under the Investment Advisers Act were overturned by the federal court in the same year. Since then US hedge fund managers who registered with the SEC have done so voluntarily. The Private Fund Investment Advisers Registration Act 2009 will make the registration of hedge fund managers in the US mandatory. It will also subject hedge funds to new reporting and record keeping requirements. In October 2009 the House Financial Services Committee voted in favour of the Bill. The Bill will be presented to the House of Representatives in 2010 and if it passes it will move onto the Senate and eventually to the President to sign into law.

Although domestic regulation varies across Europe, fund managers are generally allowed to manage hedge fund products, and both hedge fund and conventional fund managers operate under the same regulatory regime. In April 2009, the European Commission published its proposal for a Directive on Alternative Investment Fund Managers (AIFMD). The draft directive proposes to regulate managers rather than funds, although it will have an impact on both. Under the initial proposal only AIFMs established in the EU will be able to provide their services and sell their funds to investors in the EU. The proposal has since been subject to various amendments and further amendments are likely. EU finance ministers are due to renew discussions about the hedge fund directive in the coming months. If the rules are agreed, they could be in place for EU funds by 2011 at the soonest and for funds outside Europe from at least 2014.

The hedge fund industry is concerned that the directive in its current format potentially creates major difficulties for non-EU funds and non-EU managers in accessing the EU market. It would also have a significant impact on European investors in only being able to allocate funds to EU asset managers of EU domiciled funds investing assets under an EU custodian.

UK hedge fund managers and advisors are typically required to seek authorisation from the FSA. The regime for hedge fund managers in the UK is similar to that which applies to other investment managers. They are able to take advantage of the Investment Services Directive which allows them to offer their investment services to clients in other countries within the EEA. The FSA oversees a group of the largest hedge fund managers from within a specialist supervisory team. The FSA also specifies restrictions on sales and marketing of hedge fund products. Hedge fund products for example, cannot be marketed to the general public but UK investors can deal directly with offshore funds.

Offshore hedge funds are registered in tax neutral jurisdictions allowing investors to minimise their tax liabilities. Offshore hedge funds are usually structured as corporations although may sometimes be limited partnerships. Generally the number of investors is not restricted. Onshore hedge funds often set up a complementary offshore fund to attract additional capital without exceeding limits on the number of investors. The vast majority of offshore funds are registered in the Cayman Islands followed by the British Virgin Islands and Bermuda.