The proposition of hedge funds of funds to investors, dented by events over the past two years, remains bruised. Assets under management nearly halved and remain stuck around $600 billion amid dismal returns in 2008 and lacklustre performance since then. Virtually a week doesn’t go by without a fund of funds merger or shutdown, while big funds face pressure to change operating practices, slim fees and develop new investment products.
Union Bancaire Privée has been at the eye of this storm. Its peak fund of hedge fund AUM plunged from over $50 billion, but has now bottomed out at $19 billion. With redemptions ceasing, there is evidence of new allocations to existing products and the development of some interesting new ones. As UBP has sought to rebuild, it has revamped its executive team, something that culminated in July with the appointment of ex-Ivy Asset Management CEO Larry Morgenthal as chief investment officer of alternatives and head of UBP’s operations in the US.
Morgenthal’s arrival may prove timely; investing in hedge funds is recovering. Some big funds like the Brevan Howard Master Fund have reached capacity and closed, while third quarter data from Hedge Fund Research (HFR) showed asset gains of $120 billion – the biggest three month rise since 2007. What’s more, anecdotal data confirms that funds of funds are gaining assets even while UCITS funds are providing a new proposition for investors looking to access absolute return products.
It is commonplace to hear hedge fund executives remark that Morgenthal has taken on an enormous challenge to help revitalise UBP. Even Edgar de Picciotto, chairman of the board and patriarch of the family with the controlling shareholding, combines optimism in the most recent annual report with a realisation that “the West’s Golden Age is drawing to a close.” But UBP’s balance sheet cash of CHF6.8 billion ($7.05 billion) has given the private bank both the time and resources to fight back.
Realistic but confident
Morgenthal is realistic about the challenge but confident about making an impact. During a recent interview in Geneva at UBP’s Rue du Rhone base, he discussed UBP’s changes in risk management, operational due diligence, personnel and some new products. Morgenthal began by explaining how his career makes him an agent of change.
“I’ve seen hedge funds from the hedge fund side, I’ve seen the business from the client side and I’ve also seen the business from the fund of funds side,” he says. “And with fund of funds I’ve played most of the roles there are to play. My experience in the industry is pretty deep and I bring a unique blend of investment expertise along with being very cognisant of what clients want. Often in investment management firms, investments and the client side can be in different silos. UBP was looking for someone like me who had experience on both sides: that is, thinking about investment management with the client in mind and thinking about clients with investment management in mind. It is a relatively rare blend and I think having both is critical to succeeding in the industry.”
Before Morgenthal’s appointment, UBP had made asset management, under Richard Wohanka, a key area for growth. To enable this, the main pillars of the business unit’s platform – long-only funds and funds of hedge funds – had resources strengthened in financial analysis, research, risk management and manager selection. For the hedge fund side, expertise in these areas has been centralised in New York while portfolio management and client service remain close to the clients globally. As well, sales teams are being beefed up, new products are launching and joint ventures are being considered.
Morgenthal’s recent experience may be in funds of funds, but he began his career as a pension plan sponsor, first at NCR Corp and then at Asea Brown Boveri. At the latter he got the experience with hedge funds that allowed him to join Weiss, Peck & Greer. Here he rose to head the hedge fund division with oversight of 10 single strategy managers – something that would prove very useful in subsequent moves to Bank of America (running an alternatives business supporting the private bank) and then Ivy where he got invaluable management experience running a big fund of funds.
With Ivy shuttered by parent Bank of New York Mellon earlier this year, Morgenthal is acutely aware of the challenges that face funds of funds. But he believes hedge fund investing is still in its infancy and that the tailwind provided by rising institutional investor allocations will have a big impact.
Funds of funds offer value
“I am constructive on the industry because I think the basic value proposition is still there,” Morgenthal says. “Hedge funds have provided diversification and alpha. I think it is the early innings for the industry, believe it or not. When I was on the pension side, in 1992 we were debating: is non-US equity an accepted asset class? Now there isn’t a pension plan that doesn’t have equities outside their home country and being a big part of their plan. I think ultimately we’ll see the alternatives, including hedge funds, be treated the same. If you look at allocations today they are pretty low. I feel pretty good about the industry despite the rough couple of years and the future is encouraging.”
Indeed, several signs now augur well for hedge funds. One is that positive performance and new allocations are boosting assets under management. HFR data for the third quarter showed that assets under management jumped $120 billion (including $19 billion in new allocations) to $1.77 trillion, the industry’s best quarter in three years. A second positive sign is the investment landscape. Pension funds are getting 2% or less on bond holdings, leaving them appreciably short of the 7%-plus return target they need to match liabilities. Equities, meanwhile, remain prone to volatility. In such an environment, it isn’t surprising that institutional investors with hedge fund investments are keeping up allocations, while others without allocations are looking at it.
Prior to Morgenthal joining the firm, UBP had been active in strengthening and reorganising its operations. After losing $700 million in Madoff-related investments, UBP offered clients a commercial gesture and partial compensation. Hedge funds on UBP’s allocations list were also compelled to use independent administrators to value their portfolios causing some big-name funds such as Millennium Management to comply. In addition, the firm revamped its funds of hedge funds into two ranges: multi-strategy and thematic.
In operational risk management, resources were increased and the risk head got the power of veto over any manager on the platform which currently extends to an approved list of 130 funds. Underlying managers are also required to offer more transparency and this data is being used to improve the analytics for each fund of funds portfolio.
“What we are doing is a lot of work with combining the risk analytics we are getting with individual funds, so as to give us a real insight into the risks in the overall portfolio; this leads us to be able to better manage the portfolios in the future,” says Morgenthal. “It is an area where we will continue to invest significant capital. We are also building some proprietary systems to enable us to do a lot with the data we are collecting. One of the things we are looking at is forward risk factors and taking portfolios and seeing how we expect them to react to different environments. When you can marry the risk factors with expectation of the environment it gives you another way to position and allocate portfolios. We are trying to do a lot of work modelling the portfolios and how different managers trade to give us an idea about how they should perform in different environments. Then we set our portfolios up given the environment that is expected.”
One example of the mandate to innovate that Morgenthal wants to drive further is the Dinvest Focus Recovery fund which launched in the summer of 2008. The five year duration fund raised money to take advantage of the spectacular dislocation in credit markets and has beat the target of a 20% internal rate of return. UBP is also building an increasing number of specialised portfolios for both institutional and private clients with over 80 now running.
The continuing turmoil in credit has UBP considering rolling out a new financials recovery fund in early 2011. “Today’s focus on manager liquidity has created a big illiquidity premium in the industry,” says Morgenthal. “You can be paid for illiquidity with the right managers. The new fund would seek to take advantage of that illiquidity premium. Some ofthe opportunities will be different than in 2008 but believe it or not, some of them are the same.”
A prominent feature of the new fund of funds environment is managed account platforms. Several big funds of funds have embraced managed accounts to reassure investors about asset custody. Notable among them is Man Group, whose former RMF fund of funds (now restructured and rebranded as Man Investments) lost $300 million with Madoff. Man responded with a major ramp-up in managed account capabilities, offering a clear message that it would use the experience gathered as a CTA where managed accounts have long featured to innovate in its fund of funds business.
In contrast, UBP has taken a more measured approach. UBP continues to use four external platforms for its managed account business. It has been careful to embrace managed accounts for liquid strategies but not at the expense of limiting the investment products it can offer and the returns that can be provided. To provide investors with a managed account option UBP launched Dinvest Access 30 in April. It has monthly liquidity and only invests in funds via managed accounts.
“We took the view that we want to be upfront with clients about what they are getting,” says Morgenthal. “Part of our solution was to use the managed account platforms and create a fund of funds just of managed accounts. It keeps everything clear and transparent. I think we will use managed accounts in the core funds over time but for now we have largely restricted it to the specific managed account fund of funds.”
UBP’s core co-mingled funds may not yet use managed accounts, but portfolio managers have put more focus on liquidity management. Liquidity terms range from monthly to quarterly with the longer lock-in products being evaluated. The aim is to make liquidity terms a key reference point for investors in choosing one product over another.
“We have a robust business with the quarterly liquid funds, but there is still not a lot of demand for longer duration lock-up funds,” says Morgenthal. “Earlier this year there was a lot of demand for better liquidity. But as markets have stabilised over the last three or four months we have seen investors become less focused on liquidity than they were at the beginning of the year. It goes in cycles. How markets are for the next few years will drive how important liquidity will be for investors.”
Competition from UCITS
Another area of innovation and a growing source of competition to funds of funds are UCITS funds. Though the HFR third quarter data showed funds of funds adding about $250 million in new allocations, this is dwarfed by the billions flowing into UCITS products, whether following hedge fund-like strategies or absolute return mandates. The robust growth in UCITS funds and a fat pipeline of upcoming launches is having UBP consider its options.
“As the universe gets big enough we are looking at the idea of doing a UCITS fund of funds,” says Morgenthal. “Eventually it will depend on whether it is something our clients are looking for and whether we can do a good job with the managers that are available in UCITS format. It is a good development for clients who need the transparency and the liquidity. The question is whether you give something up in terms of performance or the types of managers you can get access to.”
Morgenthal is comfortable with UCITS managers’ use of swaps to construct short exposure but is mindful of the extra level of risk with the attendant counterparty. UBP’s renewed focus on operational risk management means that counterparty risk assessment would be a key thing to evaluate in any future UCITS product. In the meantime, UBP is looking at the UCITS universe and considering the criteria they might employ to pick funds for a compliant fund of funds.
“If you are doing something in UCITS you need to be clear to clients that there are some differences from what a traditional fund of hedge funds would be,” he says. “As long as the client understands the risk and return, it is fine. Then it is for the client to decide whether a UCITS fund of funds or a traditional hedge fund of funds is better for them. There is nothing inherently good or bad about UCITS. It is a question of what is right for an investor.”
Evolving the offering
As UBP has rethought its fund products, organisation and processes it has looked to provide clients with a number of potential ways to use hedge funds. With the core multi-strategy funds, for example, it has aimed to link returns with different liquidity structures. It has also developed thematic funds to tap into a growing trend of institutional investors using sector hedge funds as part of their long only allocation.
UBP has just launched its first foray outside of developed markets with Dinvest Access – Emerging Markets Fund. It will aim to match the blended returns of the MSCI Emerging Markets Index and the JP Morgan Emerging Local Markets Index by investing in long/short equity, event credit and global macro funds.
“Emerging markets have all the characteristics to suggest that hedge funds are the best way to play it,” ways Morgenthal. “The emerging markets are inefficient and that is where active management should perform best. These markets are very volatile so having the ability to hedge and short is particularly useful. It gives clients a way of being exposed to emerging markets through hedge funds, which we think are a more efficient way to get exposure to that asset class. That’s an example of something client need has driven and of a new theme of using a hedge fund as a substitute for long only allocation.”
UBP has found that the most developed emerging market in terms of managers is Asia where it has opened a Hong Kong office to do manager research. It is considering adding a similar function over time in Latin America. The emerging markets fund will mix local managers with managers in centres like London and New York. The fund may, for example, use regional managers to focus on equity long/short and blend that with global macro managers to provide exposure to currencies, commodities and rates. If the emerging markets fund succeeds, UBP hopes to tap into allocations from outside the bucket that pension funds earmark for alternative investments.
Besides the emerging markets push, Morgenthal is bullish on credit, but is unlikely to add much additional exposure. Long/short equity manager exposure is likely to rise but not quite yet. He also notes that the development of thematic funds has helped UBP come across many managers that may be applicable to some of its multi-strategy vehicles.
Funds of funds, in their early manifestation during the late 1960s, provided access, connecting high net worth investors with emerging hedge fund managers. Now, of course, many single strategy managers don’t need a fund of funds to get to the bargaining table with investors. When these investors are pension funds, with their own specialists and skilled portfolio managers, they are perfectly capable of investing directly.
Morgenthal realises that investors are going direct, but argues that such allocations go mainly to the very big funds. He thinks the way that capital has flowed away from most managers to the very biggest names offers UBP and others a better way to serve investors.
“I think more than ever before funds of funds have an opportunity to focus on the mid-sized and emerging managers because that is an area where there has been less and less investor attention,” Morgenthal says. “There has been such gravitation to the big funds that everyone else is being ignored. In my mind, that creates an opportunity to look at the middle market segment. Funds of funds have the resources to be able to do it and in certain areas that is where the best returns are going to be.”
Morgenthal is joining UBP at a time when investor fear about markets is giving way to cautious optimism. Joining UBP is also an expression of optimism that the many changes that have occurred across the firm will have time to settle. Clearly, a period of organisational stability with encouraging investment returns is what’s needed.
“My business model is pretty simple,” says Morgenthal. “It is driven by performance and customer service. What is important is that we have top talent in every seat. Part of the attraction of joining UBP is that when I looked at the senior staff we had a team with an average of over 20 years’ experience. Many of them had been CIOs at other firms. There is strong depth in the team on the investment side.”
With that level of experience and the bank’s healthy balance sheet – Tier 1 capital is above 25% – UBP is well placed to be a consolidator. Clearly with the number of funds of funds still above 2,000 (compared with some 3,300 in 2007) there are more mergers to come. The question, however, is whether the right deals are out there and, indeed, whether acquisitions can really work in such a people-driven business.
Morgenthal is convinced that scale is more relevant than ever post-2008. Moreover, he sees a bleak future for many of the small funds of funds that lack the resources to grow and consequently find it difficult to properly service investors. But he is sceptical that consolidation will provide a neat solution for many funds of funds.
“Consolidating is difficult because the assets are very often tied to the portfolio team and the sales and marketing people,” he says. “If you are looking to acquire capabilities, that’s possible. But if you are just looking to acquire assets, it’s very difficult. We’d more likely be a buyer than a seller but we are very cautious on the buying front. An acquisition would have to fit in well, perhaps offer a strategy we don’t yet offer or something complementary in terms of a client base we didn’t have with an investment team that could fit in. You haven’t seen very many funds of funds mergers because it is very difficult to do.”
If consolidation is one feature of the downturn, another is new product development. Volatility arbitrage funds designed to give tail protection are one innovation Morgenthal likes. Another is the development of CTAs with different time frames that give fund of funds portfolio managers the ability to protect against downturns of different lengths.
The downturn has also forced portfolio managers to communicate better with investors. That requirement combined with demands for better risk reporting and transparency has raised barriers to entry for fund managers.
“It has kept some of the marginal players from coming into the industry and it has often been the marginal players who have caused trouble,” he says. “Those are good things that have come out of the most recent turmoil.”