Outlook 2006

Comments from our panel

Stuart Fieldhouse

Thomas Della Casa, Investment Strategist, RMF: The trends initiated in Q3 2005 will likely have a positive effect on hedge funds in 2006. The continuing economic boom in Asia will help maintain momentum, with the Asian economy expected to outpace European growth in 2006 by two or threefold. The likelihood of a dramatic economic crisis similar to the ones that occurred at the end of the 1980s or in 1997 has decreased as most Asian countries now have more stable fundamental data, higher credit standing and more competitive currencies, and are more integrated into the world economy. In addition, large countries like China and India are less dependent on exports than they were before, with a burgeoning middle class generating greater domestic consumption.

As a rule, hedge funds can assess investment opportunities in developing markets in Asia better than traditional long-only funds. Alternative strategies are more effective in an environment with some inefficiencies and high volatility; second, strong economic growth is not a foregone conclusion in consistently bullish equity markets. Various tensions must also be taken into account, which experienced non-traditional managers can exploit better than traditional managers.

The boom in Asia is helping Japan to awaken from a 15-year slumber. Japan is best positioned to take on the role of Asia's economic engine. It has opened its economy, loosened the stranglehold once held by the cartels, strengthened its domestic market thanks to rising consumer demand, and is producing top-quality products that are in demand not only in Asia, but around the world.

Another major theme will be the developments in the commodities markets. Energy prices are unlikely to return to their previous levels, as many hope they will. Thus inflationary pressure is likely to continue, which will have feedback into the commodities sector. This will likely mean price fluctuations, particularly for precious and industrial metals, and soft commodities.

 

Paul Smith, Head of Alternative Fund Services, HSBC: Whilst asset inflows into hedge funds were negative for the final quarter of 2005, we believe this owes more to the current attractiveness of equities and, to some extent, a rebalancing of portfolios by larger investors rather than any wider dissatisfaction with the hedge fund industry as a whole. As such, inflows will strengthen once again during 2006 as traditional managers continue to enter the hedge fund arena as part of a wider trend that is seeing larger global managers extending their product ranges in an effort to capitalise on increasing investor demand for absolute returns. However, this will not necessarily lead to a frenzy of M&A activity in the market place, as many managers will choose to build platforms internally due to the inherent difficulties involved in what is essentially a transaction in human capital.

The coming year will also see a correction in the balance of power that has, until now, favoured the manager at the expense of the investor. Indeed, we are already seeing this trend emerge with a reduction in risk profiles and a corresponding increase in liquidity and transparency as managers court the institutional dollar. Transparency, as it is currently focused on underlying investments, will be brought to bear on performance as investors begin to question what percentage of their returns are alpha as opposed to alternative beta. This trend will be further expedited by the desire of new market entrants to attract their existing, traditional client base into higher margin products. Those managers who are able to find pure alpha will find it easier to justify, and thus retain, higher performance fees.

Downward pressure on fees will see an increasing variety of delivery mechanisms being deployed by large global players in an effort to add value and enhance, or favourably distort, product attributes according to the wishes of their clients.

Much is made of the imminent demise of funds of funds. However, as 2006 witnesses an increase in tactical reallocation between specific strategies or regions as a means to optimise performance, the liquidity provided by the fund of fund sector may prove this view to be premature. Elsewhere, blue chip fund of fund managers providing risk adjusted returns and niche fund of funds offering targeted access to specific markets or regions will continue to thrive. As such, whilst multi strategy funds are no doubt encroaching on their territory, there remains a need for the mediator function provided by the fund of fund manager. Indeed, those institutions currently providing the marginal dollar will choose to sample the sector through fund of funds as those before them have done.

On a regional basis, Asia proved to be the sweet spot for many investors during 2005 and, together with the emerging markets, we expect this to continue during 2006. As such, multi-regional asset managers and service providers with global operating platforms will be best placed to capitalise on this trend: it will become increasingly fashionable for US and European managers to establish a physical presence in Asia as a means to boost credibility.

As hedge fund activism becomes ever more prevalent, another key trend going forward will be the convergence of hedge funds and private equity. As hedge fund strategies become crowded, managers will move down the liquidity spectrum in search of higher returns. Liquidity will be sacrificed as those investors chasing double digit performance are forced to accept longer lockup periods. This trend will provide its own set of challenges for those service providers hoping to operate in this sector of the market. Theanswer rests with a long term investment in technology, rather than a reliance on short term tactical fixes.

 

Oliver Kamm, Portfolio Adviser, WMG Advisors: Europe is experiencing tentative signs of recovery. The outlook for 2006 is dominated by the question of asset price bubbles. Over the past decade and a half, the biggest single shift in economic management in the advanced industrial economies has been the widespread adoption of inflation targeting. It has been an almost unalloyed success in securing greater economic stability, and the resulting diminution of inflationary expectations has contributed to a significant rerating of equity valuations.

Both monetary policy and equity prospects now look to be moving to a new focus, and one that implies a degree of caution about market prospects. Early this year, the Governor of the Bank of England, Mervyn King, delivered a speech that may in retrospect prove as prescient as Alan Greenspan's worries about the "irrational exuberance" of the bull market of the late 1990s. King raised the question also recently invoked by Greenspan: the "bond market conundrum" whereby bond yields have stayed at historically low levels. He suggested two possible explanations: a greater propensity to save and reduced willingness to invest; and a continuing "search for yield", which has driven asset prices higher.

Were those conditions to persist, then in principle the markets could sustain historically low levels of real rates, and there need be no precipitate tightening of monetary policy. This would clearly be good for equity and bond markets, and the opening weeks of 2006 have seen further gains in equity markets that seem to be premised on the notion that we are near the peak of the interest rate cycle.

Alternatively we may be in a period comparable to pre-1998 in the high-yield bond market or pre-2001 in the stock market, where markets are pricing an unusual and temporary appetite for risk. If so, the ratio of asset prices to prices in the real economy might adjust quite sharply. This would take the form of either higher inflation or a rise in yields. At the moment, market expectations seem to be heavily tilted towards the first scenario – an enduringly low level of real interest rates – rather than the second, a fall in asset prices.

It is not difficult to think of exogenous shocks – instability in the Middle East; another currency crisis for emerging markets – that would cause investors to reassess the risk premium adequate to compensate them for holding financial assets. As central bankers are explicitly concerned about asset price inflation, investors may also quickly reassess their expectations for the stance of policy. For these reasons, the course of financial markets in 2006 may prove far from smooth. Valuations of financial markets do undergo enduring shifts from time to time; but always for an economically sound reason, and never capriciously.

 

Florence Lombard, Executive Director, AIMA: The continuing globalisation of our industry has resulted in increased scrutiny by regulators, not only at national but also at supra-national levels.

To give some flavour to this statement and to quote but a few examples, one may wish to consider the implications for our members from the following current regulatory initiatives:
 

  • the newly created EC Hedge Fund Expert group
  • the IOSCO work on valuation and asset pricing and the FSA's working group on this topic
  • MiFID
  • BASEL II and its impact on Japanese institutional investors
  • the SEC dual registration requirements (for all non-US managers)

Recent employment surveys have shown the increased difficulties and costs of finding experienced professionals to deal with the intricacies that all these developments bring. AIMA is at the heart of these initiatives, working closely with members and regulators to navigate this maze, informing all on developments and aiming to minimise any negative impact on our members. We will continue to strive towards greater coordination and cohesion, especially between the different regulatory authorities (and their regimes) that impact our sector.

Related to this is the need for the industry to continue its focus on greater transparency and disclosure. We will be working on the creation of sensible industry-driven solutions towards greater efficiency and effectiveness, which will benefit all – while at the same time allaying ongoing fears and misconceptions still haunting the hedge fund industry. The work in hand in this area will lead to the publication of enhanced guides to sound practices for managers, administrators and other players in the hedge fund value chain.

This leads us to another of the key challenges for the industry: the need to take a close, hard look at the way it communicates with its various stakeholders. In Europe, Canada and the Asia-Pacific, we all benefit from a more unified and united approach and it is important to continue to build on those foundations. In the United States, the landscape is becoming increasingly fragmented – with new hedge fund bodies being created and all professing to speak on behalf of the hedge fund industry. This could lead to further confusion, especially from the regulatory and government authorities. They prefer a more consistent message and are seeking clarity and cohesion in the industry's approach to their various consultations and requests.

Last but not least the need for on-going education is still paramount. The markets will undoubtedly continue to challenge managers. Investors need to be kept appraised of markets' impact on performance and strategies – as well as the perceived weakening of performance in general. Although there is information available via the various databases and indices, the on-going debate about the validity of all those available and the often diverging messages released by their providers is not helpful.

Globalisation, transparency, communication and education. All of these will require greater cohesion throughout the industry and unity in the delivery of its messages. Only with this approach will we achieve our aims.