November 2012 Executive Summary

Markets prime finance: monthly hedge fund trends

DEUTSCHE BANK

Hedge fund assets under management reached an all-time high in Q3 2012 of $2.2 trillion. In order to assess hedge fund asset flows in more detail, Deutsche Bank’s Hedge Fund Capital Group (HFCG) undertook a study to investigate the underlying trends behind the industry net inflows of $31 billion YTD.

We interviewed global hedge fund managers representing over $192 billion in assets under management. A high-level analysis has shown that 60% of the asset flows have come from US investors, 28% from Europe and 6% from Asia. The majority of the remaining 6% of inflows were raised from the Middle East.

In terms of investor type, our study has provided quantitative evidence for a well reported trend that we have been observing for some time – the institutionalisation of the hedge fund industry. Of total assets raised thus far in 2012, 46% were from institutional investors. When a spotlight is put on US-based managers, this figure increases to an average of 61% of inflows from largely US institutional investors. The majority of inflows to US managers came from the domestic market, with 66% from US investors. 23% of new assets came from Europe.

Asset flows into European-based hedge funds have come from a more diverse range of investors. These have included the institutional investors, such as pension funds, who continue to foray into the industry despite the challenging environment and made up 48% of new assets into European funds. Funds of funds represent an ever decreasing portion of new asset flows – contributing 16% YTD. However, a significant portion of assets (36%) have come from other sources, including banks, ultra high net worth individuals and family offices. The US investors were once again the largest contributor to flows, representing 50% of assets. The domestic market did not fall far behind, with European investors contributing 42% of flows into European hedge funds.

New flows into Asian-based managers have been dominated by the funds of funds, representing 48% of all assets. We were also informed of some notable flow from the family offices. New institutional allocation remained low, at 16% of new assets. 64% of the flows came from the US, with Europe and Asia representing 19% and 5% respectively. The reason for lower institutional participation in Asia can be attributed to manager asset size as well as length of track record. Additionally the numerous fund of funds emerging manager programmes that we have seen emerge have been an attributing factor to their large representation of inflows to the region.

US family offices show a renewed interest in smaller, under the radar managers
Our recent conversations with US-based family offices have revealed a renewed interest in real assets. Many are currently undertaking research within the space and are reviewing asset allocation plans as they enter the last quarter. There appears to be a good deal of discussion around what the most efficient structure for these investments would be – i.e. the relative merits of a hedge fund, private equity, or a hybrid structure.

Several family offices have shared with us that they are looking for smaller, under the radar managers that have a clear edge over their competitors. They need to offer a low level of correlation to other hedge fund managers, as well as the broader portfolio. This is a trend that we have continued to observe throughout the year. In line with our conversations, managers in the sub $500 million range have received 9.35% ($2.9 billion) of the net inflows YTD. Not surprisingly the HFR Q3 report indicates that managers with over $5 billion in assets under management continue to receive the vast majority of the industry’s net inflows, having received $43 billion of new capital YTD while managers in the $500 million–$5 billion range experienced $15 billion of outflows YTD.

Florida: investors seek both equity l/s and niche hedge fund strategies
During a recent trip to Florida, we noticed that investors were interested in a variety of different themes, particularly within the family office community. There is interest in equity l/s strategies. However, this is primarily driven by investors seeking to upgrade existing managers in their respective portfolios. That said we also had conversations with a number of investors who are interested in looking at the long-only equity space, with the aim of rounding out their overall portfolio exposure.

Several investors – mostly family offices – expressed an interest in niche strategies. Whilst seeking these strategies, they are considering both smaller funds that are run by larger established managers as well as emerging managers. That being said, the assets under management sweet spot for investors in Florida tends to be between the $500 million and $5 billion range.

Several European investors are taking a bottom-up approach to hedge fund investing, seeking funds with strong performance
In conversations with a number of European investors, we have noticed that they are interested in looking at managers with more aggressive return targets. We have certainly noted that there has been a significant dispersion of performance within strategies this year. As such, it is perhaps unsurprising that more investors are taking a bottom-up approach to their hedge fund allocation process, seeking the best managers, irrespective of strategy. However, a few have indicated that they are always seeking to add macro managers to the portfolio, but have found this one of the more difficult strategies to source. This might help explain why alternatives portfolios still tend to be underweight the strategy.   

Middle East: sovereign wealth funds continue to dominate hedge fund investments in the region
The hedge fund investor landscape in the Middle East has traditionally been dominated by the sovereign wealth funds. Indeed a number of the key sovereign wealth players in the Middle East have indicated to us that they are actively allocating across all strategies and looking to increase their overall hedge fund exposure. Further, they are broadening out their mandates to include allocations to smaller and more niche managers, as well as looking to increase exposure to the European and Asian manager space.

There are also a number of sovereign wealth funds that continue to favour the fund of funds route. However, a number of these institutions are taking an increasingly proactive role in fund selection and portfolio construction and will often have the flexibility to allocate to single managers as satellite positions where appropriate. Family offices and banks in the region do continue to allocate capital to the hedge fund space, albeit at a far lower asset level. They continue to show a stronger appetite for private equity and real assets.

Private bank clients in Asia have less appetite for hedge funds
Many of the private banks based in the region have informed us that their clients do not currently have huge appetite for hedge funds. The Asian HNWs are primarily seeking yield-enhancing products and not hedge products. Even private equity, which has traditionally been a popular investment for HNWs in the region, has slowed in its asset raising through the private banking channels. Private banks are still selectively adding managers to their approved list. However, most of them are choosing to go for relatively established names with a long steady performance track record.

China: continued interest in hedge funds
The Shanghai Municipal Government Financial Services Office (FSO) is preparing to launch the Qualified Domestic Limited Partner Programme (QDLP) that will allow qualifying hedge funds to raise onshore money in mainland China. The requirement being that the capital raised in and from China must be invested in foreign markets. Recent media reports suggest that the initial quota for the trial will be $5 billion and that this should see a stable expansion over the next five years to at least $60 billion by 2017.

Another important development is the Wenzhou Pilot Initiative, under which the residents of Wenzhou in China will be allowed to invest funds abroad; with no restriction on the markets or asset classes. This is currently pending formal approval by the State Council and media reports speculate that approximately $56 billion may be available to be deployed through this programme.

Regulatory
The delegated acts for the AIFMD (which were expected by the end of September) have still not been published and are now expected during November. The Short Selling Regulation (SSR) entered into force on 1 November.

ESMA provides colour on exemptions and reporting thresholds relating to Short Selling Regulation and Certain Aspects of CDS (SSR)
The Regulation entered into force on 1 November 2012. The technical standards and delegated acts have now been adopted by the European Commission based on those submitted by ESMA in April. In addition, ESMA published a list of exempted shares that have their principal trading venue in a third country, a list of sovereign issuer thresholds for the purposes of notification and the websites of the competent authorities for notification and disclosure to regulators. ESMA also published an updated list of Q&As that provide further guidance on the duration adjustment for calculating net short positions in sovereign debt and the calculation and reporting for the specific situation of group and fund management activities.

ESMA intends to publish the guidelines on the operation of the market making exemption in November.

Market participants await guidance on the treatment of non-centrally cleared derivatives under the European Market Infrastructure Regulation (EMIR)
On 27 September, the European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) published the first package of technical standards covering certain aspects of the regulation including details of how the clearing thresholds will operate for centrally cleared derivatives, organizational, conduct of business and prudential capital requirements for CCPs, and standards for the authorization and supervision of trade repositories.

The European Commission has three months from the end of September to decide whether to adopt the ESMA and EBA technical and implementing standards. Following this period and assuming no changes, Member States and the European Parliament will have one month to decide whether to object to the regulatory technical standards. If no objection is forthcoming, the standards will enter into force soon after.

ESMA is also required to produce guidelines or recommendations on interoperability between CCPs by 31 December 2012. A deadline is still tobe set for the publication of standards for contracts that are considered to have a direct, substantial and foreseeable effect in the EU or cases where it is necessary or appropriate to prevent the evasion of any provision of EMIR and rules on margin requirements for OTC derivatives that are not cleared by a CCP. This latter set of standards has been delayed in order to incorporate the work of the Basel Committee on Banking Supervision (BCBS) and International Organization of Securities Commission (IOSCO) which finished consulting on a set of principles for margin requirements for non-centrally cleared derivatives at the end of September. Capital requirements for non-cleared derivatives are expected to take effect from the end of 2012, and by the end of H1 2013 the clearing and reporting requirement of certain classes of OTC derivatives is likely to come into effect.

European Parliament endorses the position of the ECON, with some notable changes –Markets in Financial Instruments Directive (MiFID 2)
MIFID 2 continues to be discussed in the European Parliament and Council. On Friday 26 October, the plenary session of the European Parliament voted to ratify the position of the Economic and Monetary Affairs Committee (ECON). The plenary vote largely endorsed the position taken by ECON, but made some notable amendments.

In particular, the Parliament text now bans the receipt of inducements for investment advice and portfolio management when they are provided on an independent basis. Where fees and commissions are permitted (i.e. for non-independent advice) they will have to be clearly disclosed to clients. The text also requires further delegated acts to specify how independent investment advisors should evaluate a sufficiently wide range of products and the details of information that must be provided to clients. The EU Commission is mandated to report on the impact of the inducements transparency regime for the internal market in cross-border investment advice. To enable more effective monitoring of markets and for a more accurate consolidated tape, a requirement for trading venues and their participants to synchronize their business clocks is also introduced.

The European Council are in tandem finalizing their position on MiFID 2 and are aiming to reach a general approach by the end of the year. The key outstanding issues for the Council are market structure and transparency, including the proposed new Organized Trading Facility category of trading venue and the trading that may take place over the counter. Once the Council has reached a position, a trilogue negotiation will take place with the Parliament and the Commission to agree a final text. Final agreement is expected during the first half of 2013, with implementation likely to be at the end of 2014.

Market Abuse Directive and Regulation – Scope widened to include the manipulation of benchmarks
The European Council and Parliament are continuing to debate the update to the Market Abuse Directive. The ECON Committee of the European Parliament voted to agree its position in October. The agreed text widens the scope to include the manipulation of benchmarks and obliges all Member States to ensure that maximum jail sentences apply throughout the EU. MEPs also voted for sanctions to be made public and the fraudsters named unless this would jeopardize ongoing official investigations.

The European Council is simultaneously considering its position and the key issues still to be agreed include the definition of inside information, particularly where it applies to commodity derivatives, and the circumstances under which public disclosure should be required. The Presidency is also querying the applicability of the “ne bis in idem” principle, that if a person has already been subject to criminal proceedings for a particular offence, that person cannot be subject to new criminal proceedings for the same act within the EU.

The European Council and Parliament are expected to finalise their position in early 2013. The regulation will apply 24 months later, in early 2015.

Undertakings for Collective Investment in Transferable Securities (UCITS) – Commission in the process of reviewing responses from the consultation period
The European Council and Parliament are continuing to debate the update to the UCITS Directive (UCITS 5) which will include new rules on tasks and liability of depositaries and introduce a new sanctioning regime and requirements for the remuneration of fund managers.

An initial debate between MEPs took place on 20th September which largely endorsed the Commission’s  proposal to clarify the scope of the depositary’s liability, in particular its obligations to provide replacement assets to investors in the case of loss where depository duties were delegated to a third party. The Parliament is aiming to agree its general approach on the directive by 21 January 2013.

The Commission’s consultation on broader aspects of the UCITS regime (including eligible assets, use of derivatives and EPM techniques) closed on 18th October. The Commission is now in the process of reviewing responses and is expected to issue proposals for a revision of the directive in 2013.

Separately, The European Securities and Markets Authority (ESMA) has published a set of questions and answers (Q&As) on “Key Investor Information Document (KIID) for UCITS” which are designed to promote common supervisory approaches and practices in the application of the revised UCITS Directive and the related technical implementing measures.

Capital Requirements Directive (CRD IV)
The implementation of the Basel III standards in CRD IV, which cover among other things increased quality and quantity of capital, short- and long-term liquidity buffers and the introduction of a 3% leverage ratio, is still in the final stages of discussion in the European Commission, Parliament and Council.

Firms are still expected to prepare for a 1 January 2013 implementation date. However, reflecting the delay in the negotiation process, the European Banking Authority (EBA) issued a press release on 31 July setting out the potential need to phase-in or flexibly apply certain technical standards to ensure a practical approach to implementation.

The European Commission has proposed a series of compromises on the remaining major areas of disagreement: liquidity requirements, systemic risk buffers and caps on bonuses. Political agreement on the final text is expected in November 2012.

European Parliament and Council continue to evaluate the Commission’s proposal to create a single supervisory mechanism (SSM)
The proposal from the European Commission to create a single supervisory mechanism (SSM) as the first step towards a European banking union is currently under consideration by the European Parliament and European Council.

The proposal, issued on 12 September, would make the European Central Bank (ECB) responsible for prudential supervision of all Eurozone banks. It envisaged a phased transition, with the ECB regime coming into force for systemically important banks from 1 July 2013 and for all other banks by 1 January 2014. In parallel, the Commission proposed separate amendments to the regulation creating the European Banking Authority (EBA) to reflect the new structure.

Both the European Parliament and Council have sought to reduce the scope of banks that would be subject to prudential supervision by the ECB. The draft report from the Economic and Monetary Affairs Committee (ECON), proposes that only banks which have received public financial assistance, cross border banks, and domestic systemically important financial institutions should be subject to supervisory oversight by the ECB. As a result of this change, the requirement for phased implementation falls away, with the new supervisory regime entering into force on 1 July 2013.

In the Council, the scope is proposed to cover only credit institutions that are i) in receipt of financial assistance from euro-zone rescue funds and ii) those considered of national or European systemic importance. For all others, while the ECB would retain formal decision-making powers on prudential supervision, national supervisors would carry out all “regular operational tasks”. The Council foresees the regime entering into force during the course of 2013

Additional changes are also proposed by Member States to ensure separation between the supervision and monetary policy functions of the ECB and to balance the rights of euro-zone and non-euro-zone Member States on the SSM’s proposed Supervisory Board and the European Banking Authority. Member States committed in October to approve the legislation by the end of the year.

Commission publishes a formal proposal for the adoption of a FTT by Member States
On 23 October, the European Commission published a formal proposal which would allow the European Council to authorize 10 Member States to pursue a Financial Transaction Tax (FTT) under the enhanced cooperation procedure.

The proposal to commence the procedure will have to be voted on by all 27 Member States and approved by the EU Parliament before the Commission can issue a new legislative proposal which will include details of the design and scope of the FTT. The Commission said it expected to do this before the end of the year and that, while this will be “very much along the lines” of the FTT it originally proposed for all 27 EU Member States last September, it will “carefully examine whether some adjustments are required to reflect the smaller number of Member States that would be applying it”. EU Finance Ministers will consider the proposal on 13 November. A qualified majority (14 or more Member States and more than 74% of votes weighted by population) will be required for enhanced cooperation to proceed.

The 10 member states that have committed to implement the FTT are Austria, Belgium, France, Germany Greece, Italy, Portugal, Slovakia, Slovenia and Spain.

SEC & CFTC continue to finalise rules relating to swap dealers and major swap participants
US regulators continue to make progress advancing the implementation of Title VII requirements under Dodd-Frank. On 17 October the US Securities and Exchange Commission (SEC) approved proposed rules on capital, margin and segregation requirements for security-based swap dealers (SDs) and major security-based swap participants (MSPs). The SEC’s proposal sets minimum capital requirements for SDs and MSPs, including establishing a fixed dollar minimum for SDs as well as a ratio requirement equal to 8% of the margin required for cleared and non-cleared security-based swaps. MSPs would be required to maintain a positive tangible net worth and comply with specific risk management standards. The proposal also establishes margin requirements for SDs and MSPs with respect to non-cleared security-based swaps and determines segregation and risk management requirements for SDs and notification requirements with respect to segregation for SDs and MSPs.

The Commodity Futures Trading Commission (CFTC) and other federal agencies also responsible for writing rules on margin for uncleared swaps recently reopened the comment periods for their proposals released in 2011, following the consultation by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions on margin requirements for non-centrally cleared derivatives that closed 28 September. US regulators are expected to issue final rules on margin requirements for uncleared swaps in early 2013.

As various Dodd-Frank requirements regarding swap dealer and major swap participation registration became effective on 12 October, the CFTC issued a series of no-action letters and interpretive guidance providing limited relief to market participants. The CFTC’s guidance discussed the definition of “US person,” the treatment of foreign exchange (FX) swaps and forwards, and the treatment of various swap intermediaries, among other topics. The CFTC also issued two Q&A documents to help market participants better understand the swap data reporting rule and requirements for the reporting of cleared swaps. With regards to recordkeeping requirements, on 26 October the CFTC issued time-limited, no-action relief to swap dealers and major swap participants, delaying until 31 March 2013 the compliance date for certain recordkeeping obligations.

CFTC to finalise the first classes of derivatives to be subject to mandatory central clearing
Following the 6 November political elections, the CFTC is expected to finalize the first classes of derivatives to be subject to mandatory central clearing. Once these clearing determinations are finalised, central clearing will be phased-in by entity type, with swap dealers and major swap participants making up the first group and having 90 days to comply. This means the first clearing requirements could therefore be in force by mid February 2013.

CFTC proposes rules aimed at enhancing customer protection
Outside of Title VII, the CFTC proposed rules on enhancing customer protections on October 22nd which would strengthen the safeguards surrounding the holdings deposited by customers with futures commission merchants and derivatives clearing organizations.  The CFTC’s Technology Advisory Committee held a meeting on October 30th to discuss defining high frequency trading, developing  new surveillance capabilities and addressing market microstructure impacts.