The boom in the fund of hedge funds (FOF) industry in 2003 was a hard act to follow. Although the number of launches was down from the previous year, total asset inflows continued at a record pace. Cynics predicted that the massive inflows of that year and slack regulation would be pursued by a rude awakening in the form of whittled returns, bloated portfolios and whip-cracking regulatory commissions searching to make an example as a warning to speculative, secretive managers, who have been blamed for almost every market shift this year - from oil price increases to fraud allegation-induced collapses in companies' stock prices.
The universe of funds of funds continues to grow, however, both in absolute terms and as a relative component of hedge funds. Funds of funds currently account for well over one third of the hedge fund industry, which is fast-nearing $1 trillion in assets. Funds of hedge funds alone have grown at a compound annual rate of 50% since 2000, when they comprised 18% of the hedge fund industry, to 65% in the first half of 2004, where they comprised 40% of the industry by the second quarter - 2004 saw indications for another boom year early on. Investors' expectations for future performance are in line with this expansion: compound annual growth estimates are as high as 14% through 2008.
Most of this growth has remained in the US and UK where, as in the rest of Europe, funds of funds are the fastest growing investment product, although the US still has more funds and assets under management (by just 1%). Because investing in hedge funds is more tax efficient in Europe than in traditional vehicles such as direct holdings or separate accounts, it is and should remain the largest single market, as opposed to the US, where funds of funds draw larger tax levies. However, asset inflows to European funds have leveled off somewhat since 2003 in such countries as France, Italy, and Germany, as most investors shunned equity markets and related products (global asset inflows will be discussed later in relation to regional performance trends). As can be expected during a year of mediocre returns, private client demand has retreated during more challenging times in the market, but institutional demand has remained steadfast.
Some have pointed to this year, with sub-par returns relative to historical performance and some highly leveraged positions in the face of growing investment, as the precursor to overinvestment and a subsequent hedge fund bubble (where supply dramatically outstrips demand, collapsing the market). True, this year has shown little volatility (where fund managers of all breeds typically flourish) and margins have been suppressed as a result. However, the last decade has witnessed a performance pattern of accelerated to more subdued return trends; this stabilisation indicates, as in any industry life cycle, more sustainable growth as competitors flood the market in search of profit margins. The mature growth phase of hedge funds is approaching, and as we will see, funds of funds are a perfect illustration of how the industry has evolved in the face of changing market needs and client expectations.
In our view, the accelerating growth of asset inflows through 2004 demonstrates strong demand for these products. Given the overall funds of funds returns during the last few years - the Eurekahedge Fund of Funds index is up over 32% since late 1999 versus a loss of 19% for the S&P 500 - the outlook is encouraging for funds of funds. Multi-manager products should continue to benefit from the increased outsourcing from fund distributors to funds of funds and a growing demand for advice in this attractive but still largely misunderstood and often intimidating industry for the uninitiated.
While performance for 2004 was lower than in the past for funds of funds, they still fared better than their more conventional counterparts. Most notably, the low volatility during the year (equities and fixed income profits have been highly correlated) has prevented arbitrage opportunities. Choppiness in the market, a lack of any direction in indices or the financial climate, and unpredictable geopolitical developments (Iraq, terrorism, and more recently the US presidential elections, to name a few) has prevented managers, particularly in macro strategies, from making the directional bets on which they have previously made their biggest returns.
Funds of funds allocating purely to macro strategies were down almost 3% as of September 2004. Funds investing in CTAs, or managed futures, also rely on long-term trending in markets, as their bets are usually centered on broad price movements in currencies or physical commodities and thus are closely tied to large scale exchange rate movements, political developments and supply demand for materials and goods. These funds fared the worst in 2004, down over 6% late in the year.
This decline in performance of funds of funds was not as severe as the rest of the market, however: at the end of August the benchmark Standard & Poor Managed Futures Index was down 8.68% year to date. Convertible arbitrage funds tugged at arbitrage FOF returns -- up only around 1% late in the year. The relative value niche players who specialise in concentrated areas where less capital is invested were able to place their bets assuredly while the market faltered and thus fared better than the funds (merger arbitrage, macro, and CTAs) that are more dependent on the market climate and trading volumes.
Not surprisingly, distressed debt and event driven funds of funds, whose constituents follow a more isolated evaluative model, have seen the best performance year-to-date. Distressed debt funds, which have benefited from tightening credit spreads were up over 6% toward the end of the year, while event driven was up over 3% slim pickings from depressed deal volume. To put these returns in perspective, the Dow lost about 3% over the same period. While these strategies were the highlights for funds of funds this year, they still paled in comparison to their 2003 equivalents: over 10% for distressed debt-based funds and 18% for event driven. Similarly, the losses that the CTA and macro funds suffered were far more subdued in 2003 - 1.52% and 1.21%, respectively - about one third of the damage that was inflicted this year.
|Event Driven/Merger Arbitrage
|*as of 1/10/2004, based on 734 funds
Certain strategy-based funds of funds that would seem to have high correlation, such as those funds allocating to merger arbitrage and convertible arbitrage hedge funds, show drastically different returns. Hedge funds, and the funds of funds that track them, are notoriously unclassifiable; that is, the independence of the managers and their uniquely cultivated skills precipitate widely, varying portfolios and strategies that cannot be adequately captured by a dozen labeled buckets: such is the nature of the industry. Thus, while certain correlations, such as simultaneous losses for macro and CTA-allocated funds, make sense, the success of event driven FOFs and concurrent mediocrity of relative value FOFs is equally unsurprising.
However, the asset inflows into various strategies focuses can assist in elucidating the sometimes foggy relationships between the strategies. Take the twelve months between October 2003 and October 2004 as an example. Inflows followed a definite pattern, as the market neutral funds, such as relative value and arbitrage, received the heaviest inflows. Relative value FOFs saw asset increases of 218%, while event driven increased its volumes by 104%. In contrast, the directional strategy funds invested in CTA, equity long/short, and macro single manager programs received the lowest inflows. In fact, CTA FOF inflows increased by only 7% versus an average of 42%. Managers generally made good bets about market returns, as those neglected strategies did indeed fare the worst for the year.
|12-month asset flow increase*
|*October 03 - October 04, based on 734 funds
Furthermore, this year's dip in volatility - the CBOE Volatility Index is hovering around its lowest point since 1997 - will likely result in a shunning of funds of funds focusing on those strategies, such as convertible arbitrage and fixed income longer term convertibles FOFs, which benefit from stagnant market churning and general investor complacency. We expect funds of funds manager pushing money back into CTAs and managed futures and multi-strategy.
Lastly, one of the areas where the inefficiencies are still generally perceived to exist is in the relatively unexploited fixed income universe, and a correspondingly high number of these strategy FOF mandates have recently opened as a result. We expect asset inflows from FOFs to continue to increase to this strategy. In line with this prediction, we expect the equity long/short strategy, which is becoming viewed as a bit of a return-barren dinosaur in such a dynamic, relentlessly evolving industry, to continue to receive low volumes from FOF managers relative to the industry in line with its 21% 12-month increase. FOF neglect of CTAs will prove to be a more cyclical sentiment, especially considering the fact that general inflows to CTAs - not just in funds of funds -- more than doubled prior to the slowdown. And with good reason: at the time of this writing, it appears that a performance recovery of CTAs has already begun.
Alpha's particular elusiveness this year has demonstrated which managers truly embody absolute return investing: by making a profit in poor market conditions through experience and dexterous portfolio management. That is, the low activity and inconsistency in the markets has forced most managers to chase fewer market inefficiencies and has consequently eroded those opportunities, particularly in equities, as a recent JP Morgan report demonstrated in a case by case analysis. In short, too many dollars have chased too few potential gains in identical capital markets and a fixed universe of vehicles, and has squeezed margins as a result of its sheer weight in those areas.
The need to find new profitable avenues has seen many managers diversify their approaches, with distressed debt expanding into private equity, convertible arbitrage moving into derivative products and swaps, and sector funds creeping away from their areas of specialisation into the businesses that are providing returns. These trends have interesting implications for funds of funds, which often pick managers that can boast a steadfast, knowledgeable and patient approach to a specific discipline. Indeed, this style shift deters fund of fund managers, who essentially invest in managerial talent and were surely disappointed in some ill-advised directional bets that did not pay off for the single managers. As such, the beginning of 2005 should see a re-weighting of investments. Again, this shuffling of assets will mean higher costs and lower margins for hedge funds, which will in turn favour larger fund of funds managers with economies of scale and the more sticky money from family offices, endowments, and pension funds.
An important disclaimer must be noted when inspecting these performance figures. One of the reasons to invest in FOFs as opposed to single managers hedge funds is to diversify. Hence single strategy focused FOFs are removing this opportunity for investors and limiting their own appeal. This pattern is evident in the numbers. 64% of funds of funds contribute to a multi strategy approach, followed by 21% that allocated primarily to equity long/short, the next most popular target. This overweighting of the industry is even more prevalent with respect to asset volumes: multi strategy claims 78% of managed assets among funds of funds, versus only 11% for equity long/short. The remainder of the allocation is divided among the other strategies, ranging from 1 to 3 %. Simply looking at the visual presents a striking example of how much more appealing diversified funds of funds are to investors.
The implications for this weighting imbalance are self-evident: as the multi-strategy funds fare, so fares the index. This deduction leads to two further conclusions. Firstly, investors clearly utilise funds of funds for their diversification benefits. Secondly, while it is possible to assess fund of funds performance based on average return, the vast differentiation between strategies, as with any diversified investment universe, allows for equally different return potentials. This differential is illustrated by the gap between the CTA and macro funds of funds returns on one hand and the event driven, distressed debt fund returns on the other.
Breakdown of Funds by Strategy
Assets under Management of Funds by Strategy
As should be the case, FOF performance remains more volatile by geography, where the returns tend to be more stable when analyzed by region rather than by strategy. Nevertheless, certain stories have surfaced among regions, particularly when one looks at inflows on a country-by-country basis. The most notable regional mandate is in the US$26 billion emerging markets sector, which sees FOFs allocating to hedge funds that invest in foreign securities or the sovereign debt of developing countries. Largely due to China's brazen growth and Latin America's - particularly Brazil's - renewed stability, the sector gained around 4% as of late 2004. While this was certainly the best performing sector, the true discrepancy is more evident in examining 2003 figures, where emerging markets FOFs gained 14%, compared to a 5.28% average gain. Clearly, one would expect asset inflows for the following year to chase the performance of the preceding year, and this was generally the case. Asset inflows over the 12-month period between October 2003 and October 2004 were up 80% for emerging markets, versus 42% for all geographic mandates.
The focus of investors is clearly driven towards less developed arenas, as inflows to US hedge fund-focused fund of funds trailed the pack with a 13% increase; European FOF managers received a 22% increase of investors' money. Still, the inflows to these regions are enormous compared to the rest of the world; that is, one cannot neglect the huge base that the US and Europe have already established with these managers. In fact, the high levels of these comparatively low numbers vouch for the tremendous overall growth of the industry. Despite what these inflows might indicate about investor sentiment, Europe-focused FOFs nevertheless had a great 2004, almost on par with emerging markets with a 3.76% increase. Again, these figures are admittedly from a high base - 28% of all fund of funds are in the UK, and 26% are in the US - but the data shows where managers believe new opportunity lies. Sure enough, the returns in 2004 were low for the US FOFs, which affected global performance with a 1.87% return for the year.
With regard to the domicile of FOFs in specific countries, the returns to tax havens such as the Bahamas, which saw a 177% increase in number of FOF registered, and the Cayman Islands, with an 205% increase, show less about regional trends as they do about overall inflows to funds of funds (although the Cayman Islands is emerging as the offshore domicile of choice for most managers).
|12-month asset flow increase*
Asia Pacific-focused FOFs have had a good year, up 2.35%; 2003 was even better, bolstering the Asia Pacific region by 8.21%, second only to emerging markets. Indeed, the Eurekahedge Fund of Funds index is up 1.6% for the year at this writing, and the ABN EH Asia ex Japan Index has gained 2.1%. However, the asset flows during the same 12-month period (October 2003 to October 2004) were up 113% for Asia Pacific. Hong Kong, and to a lesser extent Japan, have played key roles in this continued interest, with asset inflows up 168% and 52% for the year, respectively. Singapore has yet to become a major global player (although it has been the start-up hedge fund location of choice in the Asia Pacific in 2004) but inflows will play an increasingly important role, partly because of and partly as a contributor to, the growing popularity of the Asia Pacific as an area of huge investment potential, much of which has already been realised by those who blazed an early trail.
There is a disconnect that is important to identify, as it isolates the emerging importance of Asia Pacific within the investment community. That is, despite the emerging markets' stellar performance, they still could not achieve the same inflows as Asia Pacific: this continued surge in Asia-Pacific investments presents a lucid illustration of the continued attractiveness of the region, and underlies one of the reasons why we believe the entire area still maintains substantial room for growth. When supplemented by the high returns but decelerated inflows into Europe, the data indicates that money is chasing more long-term opportunity than short-term gain, and is a clear case for Asia Pacific's long-term sustained growth. Incredibly, Asia ex-Japan funds of funds comprise only 3% of the universe, while their assets boast an even tinier sliver - merely 1%. Japan holds 2% of funds and 1% of assets. These numbers stand as irrefutable evidence that the Asia Pacific has plenty of space to move forward and will, in fact, likely blaze the trail of growth for the rest of the industry.
Breakdown of Funds by Geographical Mandate
Assets under Management of Funds by Geographical Mandate
Strategy, Structure, and Rivalry
2004 witnessed increased consolidation among funds of funds, as the larger players looked for viable takeover targets in addition to compressing their own products. As one of many instances, GAM, the world's second largest hedge fund manager, this year consolidated four of its single strategy funds into one multi-strategy fund, in an effort to diversify its product. Man Group, the world's largest publicly traded hedge fund company, has raised about US$6 billion in 2004 and boasts US$39.5 billion under management. Furthermore, many launches in 2004, as can be expected in the future, are from established fund of funds that utilise their own talented managers and simply market new products, thereby further augmenting their balance sheets.
An increasingly fascinating story is the dynamic in the market between funds of varying sizes. As in most highly competitive markets, funds of funds with less capital have found it difficult to compete with larger players, some of which hold more than a billion dollars in assets. Primary among the reasons for this elimination of smaller players is the difficulty of sustaining in-house research programs in the smaller firms, which have a harder time performing industry-wide analysis as thoroughly as larger managers. The difficulties of running a smaller operation will prove harsher to those managers with less than US$50 million: these FOFs comprise almost half of the industry. Most of these funds are young and have yet to reach even close to their capacity; moreover, the hardest stretch of a fund's life is during the initial stages, when capital generation can prove to be the most difficult.
In addition, FOFs with fewer assets may be too small to survive because the competition is squeezing fees, which makes it difficult to compete with their larger counterparts. While fee levels for single managers will continue to rise as 2% flat and 20% incentive fees become the norm, the funds of funds' competition should drive down the extra layer that repels so many institutional clients, such as principal protection-wary pension funds. Some analysts have predicted that funds of funds with less than US$400 million assets under management will face certain closure simply from lack of research capability, although we feel that number should be revised considerably downward to $250 million. For example, we estimate that an Asian-based hedge fund that has not raised more than US$20-25 million over two years is unlikely to be able to afford to cover its operating costs and hence will fold.
A final consideration bodes especially well for the largest fund of funds: getting a foot in the most desirable doors before they slam shut. The best single manager giants are well aware that with asset accumulation follows the law of diminishing returns, and that beyond a certain size the ability to pull in and out of positions quickly may become impaired. This has resulted in the closing off of the largest, most successful funds, which in turn provides another lucrative selling point for these funds of funds, whose owners can often use networks or industry leverage to find their way onto a popular manager's short client list.
However, the returns for the last couple of years highlight that these large FOFs are not necessarily the wisest investment choice, as small funds of funds (less than US$200 million AUM) returned 1.64% this year-to-date as of September, followed by 1.57% for medium-sized funds (US$200-500 million) and only 0.36% for large funds (over US$500 million). The 2003 returns for small, medium, and large funds were 5.42%, 5.25%, and 3.93%, respectively, demonstrating a similar pattern in correspondence with that year's generally superior returns. This contrarian evidence might indicate that streamlined portfolios allows these smaller funds to perform more detailed, thorough research (not to mention more nimble portfolio management and adjustments based on client needs) on a smaller collection of potential investments without tossing disproportionate funds at massive research undertakings. Regardless, if those small funds of funds that cannot compete, there are plenty of larger US and medium-sized UK based multi-manager funds looking to swallow them up to further increase asset volumes.
|Fund Size (US$m)
|200 - 500
In addition, 2004 saw what will become far more common in future: the institutionalization of funds of hedge funds. The two most notable examples this year were Lehman Holdings' purchase of US$11 billion London-based GLG partners and JP Morgan's acquisition of a majority stake in US$7 billion New York-based Highbridge Capital Management. In addition, at the point of this writing, JP Morgan is looking at a willing Permal in a continued effort to expand its array of hedge funds offered. The funds of funds are particularly attractive to these banks because they offer higher fees on which the front offices of those banks thrive. Funds of funds charge an extra layer of administrative fees beyond single manager funds (mostly for the leg work and due diligence required on the individual managers and the implicit diversification benefits) and offer far more commission than mutual funds, which only offer around 5% for an investment bank's bottom line.
It will be interesting to see how this tension plays out in 2005 as managers, most of whom escaped to hedge funds from an institutional setting, are successfully courted by the big dollars, security and infrastructure (particularly in compliance issues) that those very banks can provide. In conclusion, while these banks are honing their own fund of funds managerial talent through in-house programs, they will continue to shell out cash for the profitable, ready-made packages that independent funds of funds houses offer.
The regulatory environment for hedge funds has changed somewhat with the controversial but widely anticipated SEC ruling on 26 October to increase oversight of hedge fund managers with US$30 million or more in assets, including required registration, appointment of a chief compliance officer, adoption of a written code of ethics and audited financial reports to the SEC and investors. While the ruling will not take effect until 2006, its impact largely lies, like most court rulings, as a watershed precedent that will undoubtedly usher in further regulation, as advocated by the IFA and worldwide retail banks. The alternative investment community was generally perturbed by this legal development (three quarters of statements offered on the issue discouraged a positive ruling) and some of the financial communities most respected members, such as US Federal Reserve Chairman Alan Greenspan, were strong adversaries, claiming that regulation of hedge funds would reduce liquidity and stifle important innovation in financial vehicles.
Nevertheless, the legislation substantiates the aforementioned benefits to larger managers, as those bigger companies that already have legal, compliance and transparency structures in place will find it easier to comply with the new regulations. The smaller firms will find that an environment in which their opacity is met with skepticism will become even more inhospitable. While manager with less than US$30 million under management are exempt from these rules, most funds of funds will have to comply by virtue of their inherently large size. Indeed, the buzz word for 2005 will be transparency. Those funds that provide enough resources to make due diligence easy for institutional investors and oversight easy for regulators will find the fund of funds setting more forgiving during the continued flood into mainstream investments. Moreover, investors will continue to flock to those names and numbers they can trust: the benefits of investing in hedge funds have become apparent, but the potential downsides are still not fully understood by most investors.
Yet this transfer of focus into hedge funds on the whole, in combination with the consolidation of funds of funds and more purchases by banks of funds of funds, will continue to institutionalise the alternative investment arena. Moreover, it is the fund of funds, which offers lower minimum investments, greater liquidity and broader diversification (and therefore appears less risky) than its single manager counterpart and therefore appeals more to the average investor, that will profit most from these changes in the form of increased asset flows. In Europe, funds of funds have begun to benefit from UCITS III, which essentially allows funds to be sold from one country into a number of other European Union countries. While the incorporation process into local law still has rough edges, the categorisation of funds of funds under collective investments bodes well for their liberalised distribution.
While the United States and European Union grapple with efforts to harness their monstrous fund of funds industries, the rest of the world plays catch up and Asia is no exception. Hong Kong's Securities and Futures Commission will make it easier for hedge fund start-ups next year by easing entry exams and relaxing work experience quotas. The minimum investment for funds of funds in Hong Kong is already down to US$10,000, while in Singapore it has been reduced to S$20,0001 (although the single manager minimum of S$100,000 has scared away many investors from the region). However, regulatory restriction must continue to loosen if inflows are to continue to outperform the US and Europe on a relative basis. While Australia and Japan both allow fund of funds for registered funds, Korea and Taiwan do not (the same is true for single manager hedge funds).
It is an encouraging sign, however, that since liberalisation in Singapore and Hong Kong a number of hedge funds have successfully applied for authorisation. Local institutional investment would provide impetus for funds of funds launches; however, such allocations are common in only half the institutions in Hong Kong (and even then only around 5% of portfolios) and are virtually non-existent in Singapore. In a perfect illustration of the more accessible fund of funds compared to single-manager vehicles, these investments in Hong Kong are almost entirely low volatility, low return funds of funds (clearly, the banks are barely getting their feet wet). Again, the growth of institutional hedge fund investment is expected to grow at between 20 and 25% over the next few years in Hong Kong, albeit from a low base. Concerns cited in Hong Kong are typically the complexity of the investment, while in Singapore it is transparency, a clear indicator of the changes that must be made in Singapore to cater to such institutional trepidation.
Most banks are still reluctant to distribute esoteric products, the risks of which they themselves often do not fully understand, to their retail clients. While almost every retail bank, in, say, Hong Kong or Singapore offers absolute return products to clients, the recommended allocation is still only 12 or 15%, and is restricted to high net worth individuals. These allocation figures are expected to rise in the next couple of years to a quarter or a third of the portfolio. More importantly, banks in these regions expect high net worth investor demand to increase substantially over the same period. Still, the lag between the introduction of a hedge fund to a client and the purchase of that fund (assuming an investment is made) is often around four months, a figure that implies lingering hesitation and timidity. Clients surveyed have expressed particular caution not just about the investment risks, but also the illiquid nature of hedge funds. Funds of funds, with their lower minimum investments and more frequent redemption periods, can help allay such reservations. More importantly, the authorisation of hedge funds will allow the fund house to do the educating, instead of the regulator: this shift in informational sourcing is crucial to a comprehensive understanding of the product.
This continuing education is crucial for the development of capital markets in the Asia Pacific, however, and the process of encouraging full scale, diversified investment opportunities in the region, while gradual, must be encouraged by governments there. In this regard, both investors and distributors still have a great deal to learn about the nuances of alternative investment products. The Eurekahedge Global Fund of Funds Directory 2005, with detailed information and performance figures on 1200 funds of hedge funds, helps you do just that.
1 Data is from “2004 Survey on Attitudes to Hedge Funds in HongKong and Singapore” by Pioneer Investments. *as of 1/10/2004, based on a sample of 734 funds from a population of 1139