For a while, hedge fund managers were the guys taking the blame for the financial crisis as banks plummeted amid short-selling. Once their bets turned out to be astute, we turned our attention to the bankers who broke their own institutions.
But the spivs of Mayfair have not been forgotten in Brussels and the future of the hedge fund industry – at least in Europe – is at the mercy of European Union horse trading as politicians consider the directive on alternative investment fund managers.
Battle of Brussels
Those debates in Europe will continue. The original European Commission proposal unveiled in April was attacked in some countries as being too timid and by many in the industry’s European base in London as excessively restrictive.
Parliamentarians and the current EU presidency want to tighten up rules on traders’ income, seeking restrictions similar to those being brought in on bankers’ bonuses and put an end to short-selling where fund managers bet on a stock going down.
Ranged against them are the European Central Bank and the British government, which warn that further restrictions could tilt the playing field against EU companies.
Hedge fund managers, for their part, are threatening to move their operations to offshore havens, arguing that their pay is no business of regulators.
Uncertainty in the sector actually means that it may be a good time for pension schemes to look afresh at the alternatives space. This regulatory chaos is seen as a driver behind the rising numbers of new onshore funds being launched by hedge fund managers using the more limited powers available under an EU directive known as ‘UCITS III’, which governs investment funds sold across Europe.
Managers of both hedge funds and absolute return funds can use techniques such as shorting (betting against the direction of a stock or index). However, the onshore UCITS III-compliant funds face more restrictions on these types of strategies.
As far as pension funds are concerned, the key advantages of UCITS III-compliant hedge funds over ‘full’ hedge funds are their transparency and liquidity. During the financial crisis, many investors struggled to remove money out of ailing funds. Many traditional hedge funds operated with a 30-day notice period for redemption and other restrictions.
UCITS III funds must have daily or weekly dealing – meaning, you can get your money out quickly if a fund is not performing as well as you expected.
Transparency can also be issue. Robert Howie, principal at consultancy Mercer says: "Hedge funds are often domiciled somewhere like the Cayman Islands, where there is regulation but not to the extent that there is in Europe". Onshore UCITS III funds are regulated like mainstream investment funds.
A New Trend?
Half of all European hedge funds are either planning to launch a UCITS III fund, dubbed ‘Newcits’ in some quarters or have already done so, according to a recent survey of 650 managers. Just over 20% have already launched a fund. A further 30% are looking at a launch. Big names such as Marshall Wace, Exane and Man Investments are already in the sector.
Among those about to enter is Hugh Hendry of Eclectica. His newly-launched Eclectica Absolute Macro Fund will be a mirror of Hendry’s renowned global macro hedge fund and will seek to provide an annualised 10% return over cash on a rolling three-year basis.
As an example of the breadth that such managers can cover, Hendry’s fund will invest in long and short global equities, global fixed income, commodities and currencies.
Hendry told Pensions Insight that the move was to get access to clients who are restricted, perhaps by the minimum investment level of £100,000, from investing in his flagship Eclectica hedge fund, which launched in 2002. In its worst year, Hendry’s hedge fund lost 3%. Its best was a gain of more than 50%.
The conventional fund management sector has also ventured into UCITS III. Big names such as BlackRock, Schroders and BNY Mellon all offer absolute return versions of some of their mandates to investors.
Robert Howie, principal at consultancy Mercer, says that looking outside conventional long-only mandates can help pension schemes access managers’ full range of skills.
Risk and Reward
But there is a price to pay for looking at the sector. For UCITS III funds, a 2% annual fee plus 20% of outperformance of a standard such as London Interbank Offered Rates (LIBOR) is common. Howie says: “The charges may be worth paying to the successful manager. But just because you run a fund does not mean you are successful”.
Hendry is highly critical of fund houses’ charges for UCITS III mandates: “I think it is absolutely outrageous that anyone launches a UCITS III fund with a performance fee. By all means, after three years, if you have been a tremendous success and have a lot of money coming into your portfolio, maybe to ration the demand, I think you have the legitimacy to introduce a performance fee”.
The freedom that managers have with UCITS III funds can also mean that they are unpredictable. Howie says: “These funds allow managers great freedom in terms of using derivatives, in using leverage and using shorting. These are all good to have, but if the manager is unsuccessful or there is operational failing, employing the ideas badly, they may lose money".
Some hedge fund managers argue that going to UCITS III is a ‘step back’ to a more simple approach while long-only managers are learning new skills. Howie notes the risk: “You may have a manager that is successful in the long-only world but cannot short stocks [successfully]”.
Eclectica’s Hendry, however, is deeply dismissive of previously long-only houses venturing into the UCITS III area. “The launching of UCITS III funds is just a greed trade. This is just another product being issued by the long-only investment community as a means of raising money,” he says.
“They tried focus funds, they tried concentrated funds, they tried 120/20 funds. Everything has failed and I am not hugely impressed by the notion of long-only managers launching UCITS III hedge funds. It is like a farmer going into the manufacturing sector. It is not their business”.
Hendry argues that they have neither the expertise nor the access to some deals that hedge fund managers have. At the same time, you have to ask if by using a hedge fund manager’s UCITS III fund, you are actually getting the full benefit of his skills.
Some try as best they can to replicate the hedge fund strategy, often by using derivatives based on a special index. Others focus on using their expertise, for instance, in identifying market trends without trying to copy the approach. Some have the same teams running each type of fund, others separate.
Asked if his UCITS III fund was a watered down version of the hedge fund, Hendry acknowledges "very much so". He notes that there are certain techniques he uses on his hedge fund that he cannot use on the UCITS III fund, such as trading in default swap spreads on sovereign debt. Some methods of betting on interest rate expectations are also close to him.
It is evident that the lines are blurring between long-only fund managers at one extreme and racy hedge funds at the other. But until the UCITS III market has proven that it can offer something that is not merely an unsatisfactory compromise between the two, pension schemes are wise to keep an eye on the sector but to tread carefully.
This article first appeared in the January 2010 issue of Pensions Insight. For more information, please go to www.pensions-insight.co.uk.