Arjuna Sittampalam, Research Associate
Convergence of mainstream asset management and alternative hedge funds has been much talked about for some years but has not been realised on any significant scale until recently. Several forces are accelerating the trend on both sides of the Atlantic.
The benign influence of the UCITS III directive coming into force a couple of years ago has been the major impetus behind convergence. It allowed mainstream fund managers to supply hedge fund-type though regulated products to their traditional customer base while also permitting hedge funds to reach out to the same customers.
The second driving force arose from the credit crunch as many of the hedge funds’ traditional clients deserted them and the attractions of a more loyal retail base proved alluring. However, the convergence is not all that it is made out to be, and critics and problems are aplenty.
Examples of mainstream asset managers offering hedge fund strategies are BlackRock, Schroders, Janus, JP Morgan, Pimco and Putnam. On the alternatives side, illustrious hedge fund names adapting their strategies into the mutual fund structure include Man Group, Brevan Howard, GLG Partners, Odey and RAB Capital. It is fascinating that the Man Group will allow an investment of just £100 into its flagship AHL vehicle.
The offer of complicated products to retail investors is attracting fierce criticism. About 20% of the asset management professionals taking part in an Ignites Europe survey stated that it was unethical to offer retail investors hedge fund-like products. Hargreaves Lansdown echoed this concern about excessive complexity.
However, Schroders countered by saying that the new type of funds will not be actively promoted to the public but only sold through private banks and small institutions.
What fees will be charged is another contentious area. Will they come down from the usual 2/20 formula? While it is generally accepted that there will be a performance fee element allowed for by UCITS, the level is unclear. The problem for hedge funds is that, if they reduce their fees to the retail public, they could then have a hard time with their bigger customers.
Hedge Funds Do Not Like to Short
While hedge fund groups and mutual fund companies are busy invading each other’s turf, it is rare for a hedge fund firm to actually abandon its spots and transform itself into a long-only fund. The latest, though not the first, to do this is William Von Mueffling’s US-based Cantillon Capital Management, which announced in June 2009 the closure of its hedge funds and conversion into a traditional long-only business. This created a sensation as this company was one of the 2003 hedge fund launches that achieved a stunning billion-dollar inflow.
Von Mueffling came to fame at Lazard’s by shorting the tech bubble that burst early this decade. Despite this shorting record, what might explain his startling move is that he was never really cast in the mould of the typical hedge fund manager. He always adhered to a fundamental philosophy in stock-picking, preferring to buy-and-hold rather than trading as hedge fund managers are wont to do.
Though Cantillon has converted to the long-only approach, it has by no means abandoned all its hedge fund characteristics. It offers only monthly liquidity and imposes no long-term lock-up. Investors pay up to a fixed 1.5% plus a 10% performance fee, which, though lower than the standard 2/20 hedge fund fee, is still substantial.
The Cantillon change of heart is significant not only for the convergence story but also because it highlights another aspect of hedge fund activity, referred to in the article as “the industry’s dirty little secret”. Apparently, many hedge funds do not like to short but prefer to go long. According to Randall Rose, president of a family office, it is hard to consistently beat the market by shorting and even more difficult in large-sized deals.
In fact, those familiar with Von Mueffling feel that his decision to abandon shorting was not the result of a philosophical change of heart but based on a pragmatic view of a lack of shorting opportunities and better prospects for long-only in the next five years.
Uncertainties from increased regulatory scrutiny and obstacles to stock borrowing, together with the controversies over shorting in 2008, may also have contributed to the decision.
Though Von Mueffling created a sensation, it is not a new trend. DE Shaw with $20 billion and AQR Capital Management with $23 billion pioneered by adding long-only funds to their suite in 2000. Abandoning hedge funds altogether is more recent. Peter Uddo, having founded Praesidium Partners, a long-short equity fund, in 2004, wound it down in 2007 in favour of a long-only fund, holding a concentrated 15 stocks.
Industry participants query whether hedge fund players can perform as effectively in their new guise of long-only managers. The issue is where their skill in running long/short funds lay. If it rested on stock selection skills, then transplanting is feasible. But if their effectiveness in the previous life was to do with shorting and derivatives skills, then success in long-only would be more dubious.
Another relevant consideration is the increasing correlation between long/short hedge funds and equity markets, suggesting that in general, long/short is really more long, bearing out the above “secret”, hedge fund’s dislike of shorting. But this raises the question of whether hedge fund-type fees are justified.
One reason why hedge fund managers are offering long-only funds in addition to, rather than in place of, their usual business stems from the lessons of the credit crisis. Typical hedge fund clients proved to be unreliable and it is felt that long-only customers are much stickier.
Mutual Funds Invading Hedge Fund Turf
Twenty-four new mutual funds mimicking hedge funds have been launched in the US in the last 18 months.
One of the driving forces has been that, badly burnt by the crisis, investors have been demanding downside protection.
The impetus towards this new type of fund comes not just from the mutual fund industry but also from the hedge fund sector. Many in the latter are attempting to cater for an increased demand for transparency, liquidity and regulatory oversight available from a mutual fund.
Not all hedge fund strategies can be transplanted to the mutual fund process. Most long/short funds are equity funds. Those hedge fund strategies requiring illiquid securities or leveraging would find no place within traditional mutual funds.
But more complex strategies than just long/short are now being seen in mutual fund launches. For instance, the ASG Global Alternatives Fund, launched in September 2008, invests in futures across various asset classes, in order to provide the diversification characteristics of hedge funds. However, restrictions on leveraging and the need to have liquidity militate against complete replication.
Because the fee structure in mutual funds is typically lower, hedge funds moving into this sector suffer margin erosion while the opposite is the case for mutual fund companies going into hedge fund-like strategies, charging higher fees than they usually do.
Having both hedge funds and mutual funds in one stable can also create conflicts of interest. There is the danger that a higher priority could be given to the fund bringing in more fees. The illegal practice of booking the best trades to the more remunerative fund could happen. The reputational risk of the firm seems to be the major factor restraining these abuses.
If fees do not come down, there is not much point to this convergence story from the perspective of end-users’ interests, given that most hedge funds do not justify what they get. If the main asset managers charged hedge fund-type fees, they would in turn expose themselves to criticisms faced by hedge funds in the past.
The point of hedge funds in the past was not just their innovative strategies but that a few highly talented individuals were being given unconstrained opportunities to make big money for themselves and their clients. It would be difficult for such players to be incorporated within a mainstream fund management house, given issues such as risk to reputation should things go wrong, and pay comparisons with other, non-hedge fund managers.
The hedge fund industry has over-expanded, with many mediocrities coming in, and the convergence trend should in the long run lead to these average players being squeezed out by the mainstream houses. But a slimmer hedge fund industry with the highly talented and the pioneering entrepreneurial types is likely to remain separate.
Whether long-only customers are more loyal is a moot point, considering the massive outflows that mutual funds have suffered from during the crisis and institutions’ penchant for hiring and firing fund managers on the back of short-term performance figures.
Though hedge fund managers not liking to short may have been secret, it is not surprising. While there is no shortage of recent academic work pointing out the theoretical logic of allowing shorting, to maximise the use of stock selection skills, such research largely overlooks the practical difficulties of going short.
It would be dangerous if the conflict of interests issue were left to the companies concerned. Strict regulatory oversight seems called for. How strong is the convergence story?
Large swathes in the hedge fund sector cannot be exported to mutual funds – those involving leverage or illiquid securities, as mentioned above, and global macro funds taking huge bets.
Likewise, there are major areas within mutual funds that are also out of bounds to hedge fund managers. The point here is that the phrase “hedge fund” is a misnomer. “Hedge” implies some risk reduction and hedge funds offer anything but that. The crux is that safety and performance fees are mutual contradictions and large numbers of mutual fund clients seek safety.
There are two other kinds of players in this game, structured products and ETFs, which have some characteristics in common with mutual funds and hedge funds, but other features are different.
So, while highly fashionable, the convergence story is very much overblown and the rivalry between the four sectors is likely to be part of the investment scene permanently, though their relative size might vary.
"Crisis spurs alternatives to enter mainstream", Steve Johnson, FTfm, 05.10.09
"Plan for UCITS with hedge fund strategies", Heather Dale, FTfm, 07.09.09
"Risk management of Joe Six-Pack", Virginia Munger Kahn, Institutional Investor (US edition), October 2009
"Taking the easy path", Katrina Dean Allen, Absolute Return – Alpha, November 2009
Dr Arjuna Sittampalam is a research associate with EDHEC-Risk Institute and editor of Investment Management Review.
This article first appeared in Investment Management Review. For more details, please visit www.edhec-risk.com.