Round-up: Hedge Funds Returned To Form In 2009

Opportunities remain amid climate of regulatory uncertainty

Originally published in the January 2010 issue

David Harding
Founder, Managing Director and Head of Research
Winton Capital Management

It has been a fairly indifferent year for managed futures funds after a strong performance in 2008. There have been trends, especially in markets like equities and metals, which attracted attention. Other markets like bonds and grains have been quite unprofitable, while currencies have been a mixed bag.

There have been trends in oil but not really profitable ones. Everyone is waiting to see whether the dollar continues its slide and whether bond yields go up given the massive amount of government debt. That could obviously affect stocks. There is substantial potential for further instability.

There is no evidence of mean reversion in what we do [as a managed futures fund]. I wouldn’t say we were more likely to make money after we have done poorly, but also I wouldn’t say we are likely to continue losing money after having done poorly. Our performance in 2009 has been flat. We had a weak first half but have recovered quite strongly in the second half. Like everybody we had redemptions after the crisis, but flows turned net-positive in May and June. We continue to experience a pretty high level of redemptions and a pretty high level of allocations. There is a lot of investment coming in from sovereign wealth funds and pension funds.
We are awaiting regulatory developments. We have taken a lively interest in what is going on in EU political and regulatory circles but so far we are not terribly alarmed. In the USA we are waiting to see whether there will be dual regulation between the Commodity Futures Trading Commission and the SEC, though obviously we would prefer to continue just having one regulator in the CFTC.

Speculative position limits are grinding forward at an unrelenting pace but we expect them to be quite high and not affect our business. This is all being fought out in terms of the height of the limits and who will enforce them.

Registration, speculation limits and a transaction tax are certainly being talked about. I think there could be a global agreement but each country can’t announce it at the same time. If the Brits, the French and the US all do something then everyone else will follow along. If a Tobin tax was put at a low percentage then it wouldn’t hurt our business unduly.

It is always difficult to tell whether CTAs will be profitable in any particular market environment. They thrive on volatility. And there is certainly enough risk around so that CTAs should be a good diversifying investment.

Blaine Tomlinson
Founder and Chairman
Financial Risk Management

What all investors want is capital protection and to maximise risk adjusted returns. They may not all think in terms of Sharpe ratios or volatility but behind their decision making is that for any amount of risk, they want to maximize their returns.

Sophisticated investors are generally able to specify what volatilities, liquidity constraints and beta they prefer. Investing in portfolios of hedge funds allows targeting of specific return streams and I believe they provide a much better solution, even when 2008 is taken into account. If you look at the model, hedge funds are much more able to satisfy the demands of capital preservation because they can actively manage downside risk. The other thing is that hedge funds reduce the beta element of return and have much higher alpha generation than long-only funds.

So looking at the past year could you say hedge funds were blameless? No. Were some hedge funds caught out? Yes, on the liquidity front. Could they do a better job in terms of managing liquidity profiles going forward? Yes, I think they can and will. What I wouldn’t like to see is everyone trying to go for managed accounts as I think that in many cases there are more efficient ways to fix issues around control and liquidity. The more important issue is alignment of interests between hedge funds and investors and proper governance that protects investors.

I am very optimistic about the hedge fund industry and funds of funds. There is a long-term outperformance and lack of correlation relationship with other risk assets that still stands. However, hedge fund strategies offer pretty complex alphas and betas. You have to do enormous amounts of due diligence and you have to be able to connect the dots between a manager’s strategy, its performance and the markets. It is something we all need to do in order to understand what we are investing in, as well as to build portfolios of hedge fund investments that meet investor needs. To do that takes an enormous amount of resources, otherwise you may be buying something that is different from what you expected or going further out on the risk spectrum than you intended. The people that have the resources are some of the larger funds of funds groups, although some of the institutions have them too.

What happened in 2008 made investors very nervous about markets. But now investors are more worried about future economic prospects than systemic risk. They are starting to re-invest and our conversations with them are reflecting this.

Antonio Borges
Hedge Fund Standards Board

First, 2009 has clearly been a year of recovery. It has also seen change in the industry and the return of professional investors. These investors are more and more committed to the regulatory process and standards. They realise they have to stand up for their interests and that they have a role to play in the evolution of the regulatory framework and hedge fund standards. The HFSB added three investors to our board and they will have a significant presence. Many managers are taking the Standards process very seriously. We now have about 2/3rds of global AUM outside the US – a total of 60 managers – committed to our Standards.

The year has been dominated by the proposed Alternative Investment Fund Managers Directive. We believe that the industry and its key players – meaning both managers and investors – are best positioned to define what is best for the industry. Together with AIMA we have been working with the European Commission, national governments and regulators and the EU Parliament to improve the draft Directive. We are now convinced that what will be approved will be substantially better than the initial proposal.

For 2010, I think the industry will recover and gain significant market share as investors realise the value it provides. It is likely that in 2009 many long-only funds will do better than hedge funds, but investors will recognize that hedge funds will have much less volatility in the long run. As we move to a phase of the cycle where alpha is more important than in 2009, hedge funds will gain market share. I also hope in 2010, as the US moves in the direction of some regulation of hedge funds, that Americans will realise how much experience we have gathered in Britain in this area, thus allowing some convergence of regulation and standards.

I think investors may find that the problems of 2008 will segment the market; hedge fund managers will give preference to long term investors who understand market cycles and have a longer term time horizon. We will see some return of bargaining power to managers such that short terms investors, notably high net worths through funds of funds, will find managers not so keen to have them in their investor base. Managers who are in strong positions don’t want investors that panic easily.

Finally, I very much hope we go back to a dynamic phase with many new funds opening. This is where a lot of the innovation and sophistication is brought to the market.

Alexandre Col
Head of Investment
Banque Privee Edmond De Rothschild

Regulation will be the most important issue of 2010. Regulatory changes may be implemented in 2011 or 2012, but the discussion of the rules will be finalised in 2010. Thus it is a crucial year. The important thing to realise is that regulation will be by EU-wide rules and will be done by EU regulators. When I say the Alternative Investment Fund Managers Directive will impact the hedge fund industry, I mean that it will impact European and non-European managers as well as investors, custodians, administrators and auditors of the funds inside and outside the EU. The Directive is a very important development but is shrouded in uncertainty and that is always bad for business.

The Directive has things set up backwards in one profoundly important way: it is built on the proposal to regulate hedge fund managers rather than the funds. Regulating the fund through the manager is a big mistake. The fund is a legal entity and everyone – investor, prime broker or custodian – has a legal relationship with it. Paradoxically, the Directive as currently outlined would give much more power to the manger and make the fund weaker.

What’s more, regulating through the manager means that an EU regulator will need to deal with managers not based in Europe. But regulating non-EU managers will make the Directive overly complicated. In contrast, if you regulate through funds the vast majority of US managers would set up on-shore vehicles to market in the EU to replace the Cayman funds that European investors now use. Managers are ready to have EU funds and this shows that regulating the fund is a better way to proceed.

From the standpoint of asset allocation 2010 will not be too different from 2009. Range bound trading is the greatest likelihood since to exit the current trading range would require strong economic growth. There are several strategies that are well placed to exploit the current economic juncture.

Sovereign fixed income should see plenty of exploitable opportunities given the massive issuance of government bonds and the unprecedented intervention by central banks around the world. Restructuring corporate debt is another area with lots of potential as recapitalisation and balance sheet restructuring continues. Strategies in this area won’t produce the 30-40% returns recorded in some instances in 2009, but should still produce performance in the mid-to-high teens in terms of annual percentage gains. Macro should also do well again given the divergent trends in different global markets and the strategy’s high liquidity means it will remain popular with investors.

Emmanuel Roman
GLG Partners

Everyone was very, very surprised by how hard the market bounced in equity and credit. Where we are now is a much better place than anyone expected ten months ago. GLG had a really strong year and I am happy with the performance we delivered to clients: 25.2 % returns through the end of October with low risk and low leverage. The returns are very broad-based across equities, credit and convertibles and macro strategies.

It has been a bellwether year for the industry, especially after 2008, and absolute return investing has been validated. The fourth quarter of 2008 saw a lot of redemptions; those investors got out at the worst possible time and didn’t come back. Now there is a lot of pent up demand. There are pension funds in the UK with cash that want to invest and there are high net worth clients who want to allocate. Here and there are insurers, though they are less in evidence than other types of investors, and sovereign wealth funds have also kept their powder dry.

In 2010, the incredibly low short term interest rates are unlikely to go up whereas long term rates will probably rise due to the end of quantitative easing. This makes bonds unattractive and a sell. Conversely, hedge funds as an asset class look attractive. More money will go to liquid strategies, especially equity long/short. Also, more money will go into UCITS III funds as investors use them to get hedge fund exposure.

Our mission in life is performance. GLG is geared to deliver the best risk adjusted returns. We’ve seen a big stabilisation of the business over 2009 and there will be further institutionalisation. It is the classical life cycle of a product. With more institutional investors there is increasing demand for compliance, documentation and legal structure. Obviously I don’t know what is going to happen to markets, but these trends will deepen. With all the regulatory changes, one likely outcome is that firms will become bigger and more institutionalised. Institutions will choose large money managers to whom they will allocate large portions of capital.

Coming into 2009 investors wanted macro and CTA exposure. Macro performed fine but CTAs didn’t. The biggest question for investors is what to do with their CTA allocation and whether they have an appetite to take more risk with illiquid assets. An interesting conundrum is that there remain amazing opportunities in illiquid investments, but investors are still skittish. For people brave enough to invest in distressed, structured loans or special situations in emerging markets, there will be very high returns.

Ferenc Sanderson
Chief Operating Officer
Cranwood Capital Management

Big institutional investors like corporate or state pension plans and insurers will make bigger relative allocations going direct. They will replace fund of funds and high net worth as the high growth allocators. Managed accounts will be a favoured allocation vehicle. If the industry is $1.4 trillion, expect an additional $300 billion to move into hedge funds in managed accounts. This suggests that the bigger funds ($1 billion-plus) will experience a surge of investor interest through the managed account format. In this new landscape, expect a revival in the multi-strategy fund as the favoured vehicle for growth, although the offerings will be more varied. Big institutional allocators prefer big buckets. This may drive another wave of M&A activity in the asset management industry as long-only shops hook up with hedge funds. Even without overt M&A expect more funds to move into the long-only world with their own offerings (e.g. AQR), with blended offerings or so-called hybrids that may be multi-manager in structure (e.g. Permal). The goal will be to offer up low-cost beta on the upside but with a capital preservation play on the downside.

The rational of portfolio diversification blew up quite literally on September 14, 2008. Investors now question the academic rationale that raising the number of additional managers increases portfolio protection. There appears to be growing emphasis on the correlation of a smaller number of strategies and managers within fund of funds: gone maybe the day of 30-plus managers and 10-plus strategies.

In my view, the strategy is more important than the manager in the new world of portfolio construction. Work on the persistence of performance among the world’s biggest and best multi-strategy funds points to several takeaways: multi-strategy managers did not have necessarily the “best” managers, but achieved performance from a blend of returns across a limited number of strategies. This was enhanced with leverage and a favourable funding advantage over average hedge fund managers. “Bets” also tended to be concentrated on fewer strategies. Arguably this pertains to Paulson.

On fees, a two-way street is developing. Fund of funds probably get away with 30-60 basis points management fee and no performance. For single managers, the 2-and-20 model is under attack (especially in the realm of managed accounts), while for big and/or sticky allocations fees get negotiated lower. On investment trends, expect more serious exploration of Africa strategies focusing on its land, commodities and infrastructure. Africa is one of the last great undeveloped markets that is still ripe for opportunities and returns if property rights and liquidity are developed.

Richard Perry
Simmons & Simmons

Until the third quarter of 2009 and the pick-up in new investment allocations, fund launches were inevitably down. Earlier in the year, the new funds that got away tended to be highly liquid strategies. As the year went on we saw the launch of new distressed debt strategies often with structures using private equity fund technology.

A time consuming item has been the AIFM Directive. In the spring, regulatory and government reports about the need to reform the financial systems largely seemed to exonerate hedge funds. The earliest drafts of the AIFM Directive therefore came as a surprise – seemingly contradicting G20 announcements made around the same time. Since then the developments under the Swedish Presidency of the EU Council have been largely positive from the industry’s perspective but there is more work to be done on the Council’s version of the Directive and the Parliament will have its own views on many items.

We have spent a lot of time with our UK based fund manager clients focusing on making sure we can get capital gains tax treatment rather than income tax treatment for UK investors’ investment in funds. Often a catalyst for seeking this treatment is the principals’ own investment in the fund and obviously the significant difference in tax rates. There is more opportunity to convince HMRC that some investment strategies carried on by hedge funds represent investing rather than trading and this is critical in the analysis of whether capital gains tax treatment can be achieved.

Regarding other regulatory developments, we are beginning to see a more intrusive style of regulation. The most obvious impact has been greater regulatory attention to investigating market abuse. Also, the FSA application process for new fund managers became a lot more time consuming in 2009. This is due to a number of factors, one of which has been a more detailed level of review.

In 2010, I expect to see more of that intrusive regulation around the world. We can expect non-US managers to register (or re-register) in the US as investment advisors. I think we will also see a rise in tax planning at every level. This will affect where managers basetheir operations. At portfolio level it will affect how transactions are structured. For 2010 and beyond we will see more proprietary traders from banks moving to hedge funds as they grow tired of being in a more cautious banking environment and one that is more restrictive on remuneration. The new tax on banker’s bonuses can only make that migration more likely.

Robin Bowie
Dexion Capital

During 2009 we have seen one of the biggest opportunity sets ever presented. That’s shown by Dexion Absolute rising 23% and hedge funds in general up 15%. The situation at the end of 2008 was a flight to cash. As things normalised cash came off the sidelines and went into value assets. And this spurred an improvement in the whole economic picture. Normalisation is the story. At the end of 2009 we find ourselves in a position where many equities are at fair value, however there are still some very cheap assets out there, particularly illiquid assets.

During 2009 the closed ended sector saw an enormous amount of capital – some £1.8 billion – returned to shareholders (via buy backs, reverse auctions and other corporate actions) and cutting discounts to fund net asset values. Dexion Capital, mainly through Dexion Absolute, gave back £360 million. On the fund of funds side clear winners included Dexion Absolute, Absolute Return Trust and Dexion Trading. It also means that some companies have gone out of existence and others have been restructured such as Dexion Commodities which was formed out of Dexion Alpha Strategies.

The investor base has become more institutional. Big institutions are coming into the closed ended area as they have seen the value in it. I think the government leaving capital gains tax at 18% means that it still remains an attractive area for HNW investors. I see further recovery in 2010 and then normalisation of the markets and a return of trading-to-NAV premiums. Bluecrest has just issued the first new C class shares of the listed fund sector in 2009.

For 2010, there are three main strategies where a lot of money will be made. Equity long/short is the way to play the many opportunities in equities, which are not necessarily directional. Since governments have to auction a lot of stock, fixed income arbitrage will be a very profitable strategy owing to the many trading opportunities that are likely to arise. Event driven, with merger arbitrage and distressed plays as well as refinancing and restructuring will all continue to offer a rich seam of opportunities for hedge fund managers to exploit.

Returns for hedge funds will still be very good with funds of funds performing at 12-18% on the year. With returns of 1200-1500 basis points over Libor, given the limited amount of risk being taken, these are exceptional times for hedge funds. Indeed, it could be described as a golden age for managers using alternative portfolio techniques to manage traditional assets.

Ian Plenderleith
BH Macro Ltd

It has been a very challenging year. The underlying performance of BH Macro’s NAV was very encouraging, up 18% (to mid-December). It reflects Brevan Howard’s research process, risk management and investment strategy to trade macro and macro-influenced elements in the market – focusing on exchange rates, interest rates and yield curves.

The uncertainty and lower risk appetite among many other players meant there were many opportunities for Brevan Howard traders at wider margins. Markets in the first three months of 2009 were dysfunctional – panic and the need for liquidity drove people to sell and nobody wanted to hold any risk instrument. That calmed down in the spring and summer, and markets began to function in a sensible but still subdued way.

January saw the best monthly performance with an average gain of 5.2% across the three share classes. The majority of the gains came from fixed income directional trades, notably in positions atthe short end of the euro yield curve which rallied early in the year. February provided a 2%-plus rise with smaller but steady gains accruing to the fund over the rest of 2009. Brevan Howard took the view that the world economy was going into a steep dive and that interest rates would be dramatically lowered.
If the Brevan Howard Macro Fund closes (it now has a minimum allocation of $20 million) then BH Macro becomes the only way to access the strategy. Until September 2008 the shares traded at a small premium, but since then until the spring of 2009 we got sold down like everybody else in the rush to liquidity. This has recovered so the discount now is at about 5%. After markets calmed down in March, share buybacks began. A subsequent tender offer to take out about 7.5% of the shares (across the sterling, dollar and euro share classes) saw about 7% of the shares taken out. That helped to stabilise the NAV discount.

Now the influences on the market are changing again. Earlier, the question was how deep the recession would be and whether more financial institutions would get into distress and need government support. The question now is how solid and rapid the recovery will be. There is also the matter of how governments will withdraw the fiscal boost that led to larger deficits and the monetary boost provided by low interest rates and quantitative easing.

The great uncertainty is how rapidly the stimuli will be withdrawn. There are different sorts of uncertainty hanging over markets but that should continue to provide opportunities.

Peter Turecek
Senior Managing Director

Both the Mark Dreier and Bernard Madoff cases – and other incidents including the fake plane crash engineered by Marc Schrenker – generated a lot of inquiries from funds of funds and high net worth clients. A lot of people stepped back to look at how they were doing due diligence and were concerned that they didn’t know who they were investing with. Since the reputations of people couldn’t be taken at face value, they had to do their homework with background checks.

That said, the collapse of a number of hedge funds due to poor performance in 2008-early 2009 meant that there were less people moving into hedge funds and we didn’t have the demand for the service like we did in 2007.

People fell victim to Madoff because he had a decades’ long reputation and had held senior regulatory and industry positions. He had been the New York region chairman of NASD and had a sterling reputation. It was a classic affinity fraud. Madoff was part of the New York and Palm Beach social scenes. His investments were exclusive and often by invitation only. If you look at some of the other frauds, it was the same sort of thing. Arthur Nadel had well-to-do people in Naples, Florida investing with him. These men preyed on people with similar backgrounds. The final reason well- known investors fell for it was that they got recommended by people they trusted.

Due diligence isn’t always what people want to spend money on, but it needs to be done and has to be robust. People don’t buy a car or house or invest in a stock without doing some homework. But when it comes to making a large investment with somebody based on their investment and business skills, people will often turn a blind eye.

Managed accounts make things a little bit more transparent. But a Madoff-type fraud can still happen unless those accounts are being audited independently each month to show the money is really there.Otherwise it is no different than Madoff sending falsified balance statements out each month. You still need to go with reputable fund managers on whom you have properly done your homework.

We are starting to see an increase in start-up funds and people are coming back to the industry. We also see a trend in redemption policies that will offer more frequent withdrawals and more transparency. But I think that with more money flowing into this industry there will always be an opportunity for fraud.