Can Hedge Fund Strategies Really Be Offered via Absolute Return Funds?
Supermarket chains have recently started trying to drive their customers to buy their own brand ranges by promising that they taste at least as good as famous brands. They just lack the fancy packaging.
Fund management companies are trying to do the same with the launch of absolute return or UCITS III funds. Investment houses want investors to believe that they are getting more or less the same product as their hedge fund but without the mystique and risk of the Cayman Islands domicile.
Added to this, by launching absolute return funds, hedge fund managers can try to recoup some of the losses seen in 2008 when redemptions blighted the industry. But do they live up to their billing?
There are two good arguments for investing in absolute return funds which, unlike conventional funds, have extra freedoms, notably the ability to short stocks. One is that it allows access to a strategy pursued by a hedge fund manager without the complications and risk of using a largely unregulated structure. The second is that it can allow a previously long-only manager to utilise the research insights he already has to more effect.
Tim Cockerill, head of research at wealth manager Rowan, says: “I think the UCITS III powers are useful and will be able to add value for investors; however, the absolute return-type strategy is not a panacea. It is not the answer to every investor’s problem because at the end of the day, you are still relying on a fund manager, an investment process and an investment house, whatever you want to call it, to make the right calls on stocks and asset allocation. It is not the Holy Grail of investment management”.
Some funds are run by managers who made their name in the long-only space. Mark Lyttleton of BlackRock has garnered £1.8 billion of assets in just four years on his BlackRock UK Absolute Alpha fund with the promise that he can utilise the house’s copious research to bet against as well invest in stocks.
Some managers such as Roger Guy of Gartmore, who is behind the £305 million Gartmore European Absolute Return fund with colleague Guillaume Rambourg, have a hedge fund pedigreed but have also run retail funds. This list includes Philip Gibbs, the specialist financial fund manager at Jupiter, who runs the Hyde Park hedge fund.
But increasingly, houses that focused on hedge funds are coming to the retail market. This includes Marshall Wace, Exane and Man Investments.
Cockerill is confident that most of these hedge fund managers will only need to tweak their strategies to convert them from use on a hedge fund to a retail fund.
There are several key restrictions, however. Absolute return funds are not allowed to undertake naked or physical shorting. They can only mirror such positions using contracts for difference, derivatives that allow investors to speculate on share movements without owning the underlying shares. The fund also has to provide a margin to the brokerage to maintain the position.
Concentration limits stipulate that no single security can represent over 10% of net asset value and the total number of holdings exceeding 5% cannot add up to more than 40% while leverage is capped at 200%.
Also, UCITS funds must offer at least bi-monthly dealing although the vast majority in practice offer daily dealing. And UCITS funds are required to calculate volatility daily with most using a value-at-risk model to quantify potential losses.
Christopher Peel, chief executive of funds of hedge funds manager Blacksquare Capital, launched the IFSL Blacksquare Multi-Manager Absolute Return fund on 18 January. He says: “A certain number but certainly not all hedge fund trading strategies can be employed within these guidelines in an onshore regulated format. Around 50% of the traditional hedge fund trading strategies will not be possible. Only the most liquid strategies can be employed”.
This, he argues, means that strategies such as equity long/short can easily be employed in a UCITS structure. But he says that others, particularly strategies targeting the credit market which are often among the most highly geared in the hedge fund industry, are not possible.
Hugh Hendry of Eclectica acknowledges that there are a number of the strategies that he employs in his hedge fund that will not transfer across to his new Eclectica Absolute Macro Fund. He invests in long/short global equities, fixed income, commodities and currencies.
Hendry 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 closed to him.
Part of the problem for hedge fund managers moving into the retail space is that of managing liquidity. Daily dealing quickly became a sector norm and is highly valued by retail investors.
But Peel notes that some strategies which might theoretically be permissible under the rules will simply not work in practice because of liquidity demands. He says: “Event driven strategies maybe liquid, but the fact that some of these deals are opportunistic and have to be unwound because of a redemption request within a day’s notice means they are untenable. No type of strategy that cannot just rely on secondary market liquidity should come over to this space”.
Peel also argues that this still means that lots of the most successful trading strategies of recent years can still be brought onshore, however. But he says that investors should be cautious of inappropriate strategies being used in UCITS vehicles.
Added to this, Hendry warns that many launches are “greed trade” and merely a way of raising assets. “It is like a farmer going into the manufacturing sector. It is not their business”. Hendry argues they have neither the expertise nor the access to some deals that hedge fund managers have.
Cockerill has some sympathy for this view: “Personally, as an investor and as someone who invests clients’ money, I do not want to give money for someone to practice on”. Certainly a case of caveat emptor.