The Italian Hedge Fund Market From a Participant’s Perspective

A survey

AIMA and Simmons & Simmons

The following is an abridged version of some of the findings of a report by AIMA and Simmons & Simmons into the current status of the Italian hedge fund industry. For a full copy of the report, please contact AIMA.

General situation of the Italian hedge fund industry

The overall evaluation of the Italian alternative investment market is positive. At the same time, the following negative factors have been identified:

  • the specifics and rigidity of the distribution system;
  • the prevailing development of the funds of funds market and marginal role for single hedge fund managers;
  • the surplus of the offer of low volatility funds of funds with respect to those of high volatility;
  • the high level of commission.

Legal framework: having mainly expressed a positive opinion on the effects of regulation on the Italian hedge funds market, the companies interviewed have not hesitated to point out that the legal subscription limits (€500,000) and 'cultural' aversion by investors to risk are a limiting factor for the diffusion of Speculative funds in the Italian market.

Competitiveness: in terms of competitiveness and development, the absence of specialist onshore knowledge is considered as a hindrance to the use of Italian funds offshore. The respondents note the lack of 'quality' newcomers to the Italian marketplace in terms of expertise. This inevitably limits competition in the market. The increase of onshore ability and skills would, in fact, enable the increase in interest from foreign markets which in turn would promote the entry of new, independent managers.

Putting things in perspective: the anticipated development trend is measurable only in the medium/long term period. Within this time frame the following relative provisions should be noted:

  • Increase in institutional investor appetite;
  • The possibility for managers to guarantee a steady return with a consistent increase of investors' confidence while increasing assets managed;
  • The growth of liquidity and the convergence towards management techniques that are more similar to those of the traditional industry;
  • The 'independent' management of assets that is carried out without any recourse to external advisers.

Structure of Italian law

General picture: the respondents consider that current national legislation provides an adequate level of investor protection. They noted the strain on the market due to current investor perceptions, partly due to terminology; some of the proposed solutions highlight the absolute necessity to amend the name 'speculative funds', so as to highlight, rather, the hedging nature of the funds.

Identification: the perception needs to be changed by differentiating between pure fund (single manager) and funds of funds (multi-manager). Currently, funds of hedge funds are erroneously regarded as highly risky due to their categorisation as speculative funds.

Non-harmonised funds: the opinions are conflicting in regard to the new provisions introduced by the Bank of Italy in relation to non-harmonised open funds, which can invest up to 20% into speculative funds:

  • on the one hand the new provisions are seen as an opportunity for further growth;
  • on the other hand there seems to be an opinion that underlines the lack of development of the non-harmonised funds on the Italian market – they form only a marginal percentage of the total asset management industry – and from the hybrid nature of the management as defined by the new legislation.

Generally the companies consider that it would have been preferable to face the problem of the splitting of quotas of speculative funds, i.e. clearly differentiating between single fund and funds of funds investments.

Types of product offered on the Italian market

Actual picture: the absence of the fast and efficient development of a domestic single manager hedge fund market is due to exogenous and endogenous factors.

Exogenous factors: (i) existence of barriers due to cultural perception, thus acceptance of single manager funds; (ii) lack of requests from institutional investors; (iii) absence of appropriate management ability; (iv) rigid regulation; (v) mechanisms of taxation.

Endogenous factors: (i) difficulty in outlining, from a legislative point of view, the administrator/prime broker relationship; (ii) highest level of diversification guaranteed by the funds of funds; (iii) extremely onerous establishment costs of the speculative SGR; (iv) the benchmark culture that has limited the creativity of managers, and that has not motivated the entrepreneurial profile of this type of investment.

Putting things into perspective, the key factors that can determine future growth of the hedge fund market in Italy are numerous. The companies have, in particular, set out the following:

  • The need for independent initiatives;
  • The flow of expertise and skills from the banks' proprietary trading desks into the asset management industry;
  • Existence of 'incubator companies' that support the start-up of funds providing infrastructure and services (back office, marketing, legal, sales, etc)
  • Exchange of expertise between traditional managers and managers of speculative funds; and
  • Investing in people and technology in order to develop stronger and better quality companies.

Specific limits imposed by the regulation of speculative funds

Limits on the number of participants (200): it is considered, by all respondents, inadequate and easily avoidable. Such constraints actually generate extra costs for SGR, thus reducing returns for investors.

Minimum investment threshold: the companies agree that such a threshold is not necessary in regard to funds of funds investment. Moreover, such provisions do not offer sufficient protection to the investors; the threshold does not in fact guarantee that the client is diversifying its investment (and that it is not investing all wealth in a single product).

Splitting prohibition of quotas: the common opinion of the respondents is that the splitting prohibition should be eliminated.

Comparison with other countries where hedge funds are marketed

Solicitation prohibition: those participants that consider that it is appropriate to revise the solicitation prohibition comment that the prohibition limits investor education on such products. Alternatively, an solicitation prohibition could be measured on the characteristics of the investors. The companies propose, moreover, to "replace" the prohibition with the provision of greater informative obligations on the risks of hedge fund investment.

Obstacles for the marketing of Italian speculative hedge funds abroad:

  • the domestic taxation mechanism;
  • the lack of credibility of Italy;
  • the rigidity of the legislation.

The relationship between SGR and third party subjects

  • Entrusting the NAV to the custodian bank is considered the best solution by the majority of participants, even if the specific solutions adopted are different, in practice. The main advantage of entrusting this task to the custodian bank is recognised in the independence of third party status (terziet√†) and the further comfort that this can provide to the investor.
  • The possibility of taking advantage of foreign administrative services is desired by all participants. This could bring further inflow of knowledge and expertise to Italy.
  • The companies highlight that a business model which tends not to outsource management functions guarantees full control of the investment process. Thus, a business model where the selection of hedge fund managers is done independently and not driven through any external advisers is the most efficient.

Development needs for the growth of the Italian market

  • All the speculative SGRs highlight the need to improve the fiscal regime. In particular, they require a changing of the mechanisms employed in order to compete with international players.
  • The companies require a change from the current name "speculative funds" (fondi speculative) into one which highlights the 'hedging characteristics of these products.
  • The name is considered misleading in that it presents the product as being highly aggressive.

Survey Results

From 1999 to date, the Italian hedge funds market has recorded exponential growth, both in terms of the number of speculative funds and dedicated SGR. Nevertheless, this still represents a niche sector with respect to the most traditional forms of collective portfolio management and, if considered on an international level, the relevant dimensions are still of very small significance.

In only a few years since its commencement, one can evaluate the Italian hedge fund industry very positively. The participants have highlighted how the hedge fund market in Italy still offers great opportunities despite certain legislative barriers. The key reason is that, to date, these funds have been of interest to high net worth individuals, and not to the institutional and retail market yet.

The following points were given by participants as an indication of positive market development:

  • growth of assets;
  • positive performance;
  • active management of all risks associated with the business;
  • regulated and progressive growth of the market, partly due to the severity of the authorisation process imposed by the Supervisory Authority;
  • the success of independent players, in a market traditionally dominated by banks and insurance companies.

At the same time the following negative factors were identified:

  • the specifics and rigidity of the distribution system given by the minimum investment (€500,000) required to invest into speculative funds, and the prohibition on marketing these products;
  • the prevailing development of the funds of funds market, resulting in a marginal role for direct managers (also partly due to the natural concentration of hedge fund managers outside Italy);
  • the surplus of low volatility funds of funds; and
  • the high fee levels.

However, despite the market having noted a temporary slowdown phase, the common view is that the market is undergoing a consolidation phase, continuing to provide strong products and strategy innovation.

Development opportunities offered by the Bank of Italy's new provisions (in particular the regulation of non-harmonised domestic funds)

Italy boasts one of the most complete hedge fund regulatory regimes, following the introduction of the note provisions relating to the Bank of Italy's Regulation of 14 April 2005.

Opinions on this topic are conflicting – on the one hand, the new provisions are seen as an opportunity for further growth of speculative funds through the shield of non-harmonised funds (a category of funds that can invest up to 20% of its assets into speculative funds). In particular, significant benefits are identified in terms of opening the retail market: the diversification of retail channels for such investments should increase appetite by the potential market, which will lead to a positive impact on assets under management. Also, participants are keen that retail access to these types of products is provided through the asset management companies.

On the other hand, there seems to be an opinion that underlines:
 

  • the lack of development of the non-harmonised funds within the overall Italian fund marketplace;
  • the hybrid nature of the product which creates a mis-match technique of the liquidity (daily/weekly NAVs required by the non-harmonised fund vs a monthly NAV for speculative funds).

Participants note that it would have been preferable to face the problem of the splitting of quotas of speculative funds.

The new category of funds defined by the Bank of Italy's provisions, non-harmonised open funds that invest in speculative funds, seem to allow for a more widespread distribution of speculative products. The aggregate maximum limit of investment (20%) in speculative funds imposed by the provision is considered to be limiting. Such a limit reduces the impact that returns of the speculative product could have on the investor's portfolio. This would be particularly noticeable in downward trending markets.

Several participants in the survey pointed out that the operational challenges in connecting the "traditional" nature of the investment with the "speculative" nature of the funds. In particular, they noted the criticisms regarding the frequency of the NAV calculation: speculative funds usually have a monthly frequency, whereas the traditional funds have a daily or weekly frequency.

The Italian market is still characterised as a multi-manager hedge fund industry, waiting for the much hoped-for development of single manager hedge funds. The absence of a fast and efficient development of the domestic funds market is due to exogenous (environmental) and endogenous (investment management) factors.

Amongst the exogenous factors, the speculative funds' environment is influenced by a number, in particular:

  • A lack of financial knowledge and risk-taking culture which creates entry barriers for single manager hedge fund products;
  • Lack of institutional appetite;
  • Absence of appropriate onshore management experience;
  • Inflexible regulation.

Considered as whole, these issues contribute to rendering the Italian market less favourable than foreign markets, such as the UK and Switzerland.

Considering the endogenous factors, the interest is focused:

  1. on the difficulty of outlining from a legislative point of view the administrator/manager/prime broker relationship;
  2. in terms of costs, on the consequences deriving from the complexity of the financial infrastructure of the speculative managers;
  3. on the highest level of diversification guaranteed by the funds of funds;
  4. on the extremely onerous nature of the establishment costs of the managers and on the timing difficulties experienced when required to complete the authorisation process;
  5. on the culture of the benchmark that has limited the creativity of managers and that has not motivated the entrepreneurial profile of the investment.

In relation to sub-paragraph (ii), it is noted that very often the managers of speculative funds need a sophisticated financial infrastructure as well as easy access to financial intermediaries and companies. Moreover, in relation to sub-paragraph (iv), it is noted that the management and structure of an ItalianSGR is more complex than an analogous foreign structure, in that it involves the absorption of greater capital, and a greater number of controls.

Recently, the legislator and the Supervisory Authority have demonstrated that they are prepared to halve the minimum threshold for participation in speculative funds and to double the maximum number of participants. Yet a number of participants want further legislative intervention in relation to this.

Is it appropriate to have a separate regulatory regime for single manager hedge funds and funds of funds in Italy? Where should specific regulation differ?

The participants believe that there should be a separate regulatory regime for single manager funds, and funds of hedge funds. This differentiation should operate, above all, in terms of thresholds and investment limits. There should be a lower threshold for funds of funds.

 

It is generally accepted that a minimum level of investment in a single manager speculative fund should remain higher, and that access to these funds should be confined to those investors that can prove a reasonable understanding of the product and its risks.

Relating to the minimum threshold of the investment, opinions are directed towards the adoption of an autorestriction mechanism by the managers of either single manager funds or funds of funds. They will be responsible for determining the appropriate capacity levels for their strategy/ies (instead of being limited by a minimum threshold) and determining when they close new investments into the fund.

What are the main channels used to research clients? And what steps are clients required to take in order to invest?

The procedures set out by the market participants of the sector make it clear that the channels most in use for the research of their clients are either via the private banking group's structure, or an internal sales network. The private bankers act only upon specific written requests received from potential investors. Subject to production of the above mentioned request, they acquire materials from the SGR to be provided to the client.

Some participants hold one-to-one meetings, if the investors are not institutional investors; others meet exclusively with prospective clients being introduced by the company's shareholders and board directors.

During the preliminary phase of the investment, some companies will deliver to the prospective client explanatory brochures specifically created for this purpose.

In the early years of regulation, the Supervisory Authority excluded the possibility of indirectly investing into speculative funds through structured notes, social security, and insurance products. This continues to be subject to lively discussions, particularly in consideration of the significant evolution of the domestic hedge funds market, and of the ever more sophisticated and elaborate structures created and marketed by foreign 'competitors'.

What do you think of alternative instruments that enable investors to obtain exposure to hedge funds?

With regard to structured product investment as an alternative to the direct subscription into speculative funds, some of the participants agree that such instruments provide an investment opportunity, useful for certain investors with particular needs. The characteristics of such products include: a principal guarantee, a possibility to invest in more alternative instruments, a possibility to employ leverage to increase investment returns, and the possible access to fiscal benefits.

In order to reach an objective evaluation of such products, it would be necessary to measure whether the value is in proportion to the costs. Some participants consider that the 'structuring' of such products could be helpful to carve out a more appropriate risk-yield profile for investors. Others consider, however, that the guaranteed principalstructure does not adapt well to speculative funds. This is due to the lower risk profile that speculative funds (specifically the funds of funds) already employ.

Attention must also be paid to the level of additional product fees for such a guarantee, when fees are already high for speculative funds, thus impacting returns.

It seems that no consistent reasons for prohibiting the distribution of such products exists. Even any potential methods of avoiding the restrictions to the splitting of speculative funds' quotas in order to distribute funds to retail clients could make sense. In fact, eventually such products will be totally different from any speculative funds, given the fact that they employ a much lower amount of risk.

Moreover, with particular reference to insurance products that have underlying foreign hedge funds, the participants expressed a negative opinion, noting that often these underlying funds are less regulated than Italian speculative funds. In particular, the main concerns surround 'non European' target funds, where it is impossible to rely on a uniform level of regulation.

There is a great deal of different of opinion in relation to the fact that structured products could provide a valid alternative to the subscription quotas of speculative funds. It is also noted that while a structured product could be an appropriate non-traditional financial vehicle, it is burdened by costs. Additionally, the underlying speculative fund should have liquid characteristics. In terms of perception, certainly, prospective investors seem to consider that such products are less of a risk.

The structure of alternative CPPI products (Constant Proportion Portfolio Insurance) or zero coupon with options, is more preferable to participants. These products deal with construction financing that guarantees principal protection. Nevertheless, some of the respondents have indicated that the kind of structure for such products depends on the risk-return objectives. Therefore, the specific structure should meet the range of client needs and should not be assumed beforehand.

Some of the participants have expressed the need to amend the provisions on structured products so as to permit the 'construction' of structured products indexed to speculative Italian funds and which can be subscribed to by retail clients. The need to strengthen the transparency obligations in regard to the risks and costs has been recognised, enabling the client or his advisor to evaluate the additional value of the product.

A further requirement which was strongly voiced was the need to avoid 'legal arbitrage'. This means removing the prohibition on distributing structured products; today, such products can be sold from a number of foreign markets, thus creating a competitive disadvantage for Italian managers.

The relationship between SGR and other entities involved in the management of speculative funds remains a delicate factor in the regulatory equation, with there being a strong need to leave ample space to manager autonomy.
 

 

What are the main advantages and disadvantages for investors entrusting the custodian bank with the task of calculating the NAV?

Entrusting the NAV calculation to the custodian bank is considered to be the best solution by the majority of speculative fund market participants, even if these participants adopt different solutions. The main advantage of entrusting such tasks to the custodian bank is the existence of an independent third party required to carry out the calculation. In compliance with international market practice, such a mechanism would guarantee greater transparency and fewer conflicts of interest as security for investors.

Some consider that there are not enough advantages to the investors for this to be the preferred solution, though it does bring more organisationalflexibility for the managers.

The negative aspects of this arrangement are:

  • the banks' lack of competence, with possible consequences in regard to the quality of pricing and the timeliness of calculations;
  • increase in costs.

The participants have described different solutions adopted in order to calculate the Net Asset Value (NAV):

  • the calculation of the NAV is carried out in accordance with an internal dealer's structure and is subject to checks by the custodian bank;
  • the calculation is entrusted to the administrator that processes the data received from the SGR;
  • the NAV is calculated on a monthly basis by the managers' accounting department;
  • the calculation of the NAV is outsourced;
  • the calculation of the NAV is outsourced though subject to checks by the manager's administrative personnel or back office;
  • the NAV [of the fund of funds] is calculated on the basis of the total NAVs of the target funds in which it is invested: the target funds' NAVs are transmitted by each fund's administrator to the fund of fund's administrator, to the fund of fund's manager, and to the custodian of the bank at the same time.

Some feel that outsourcing the calculation of the NAV could bring a slight increase in the cost structure of the fund; such increase could be avoided only through reduction of the management fees.