Commentary

Hedge Fund Branding Drives Asset Flows

Since the market correction of 2008, a vast majority of hedge fund net asset flows have gone to a small minority of hedge funds with the strongest brands. A recent report from Hedge Fund Research shows that approximately 69% of hedge fund assets are controlled by firms with over $5 billion in assets under management and 91% are controlled by firms with over $1 billion in assets. This is a significant increase from the 2009 percentages of 61% and 86% respectively.  

Each year many hedge fund investors are inundated with thousands of emails and phone calls from managers requesting a meeting. To filter through the overload of information, investors are turning more and more to a firm’s brand when choosing which funds to meet and ultimately invest with. However, having a strong brand is not limited to just the largest managers.

For example, many investors will allocate to startup firms that spun-out of other high profile organizations, despite the fact they have no audited track record. In reality, a strong brand is even more important for hedge funds with less than $250 million in AUM. Despite the fact that these managers represent a vast majority of the approximately 15,000 hedge funds, they only represent 2.94% of assets.

What’s New in Washington

As the Trump presidency completes its first 10 weeks, the administration is celebrating big wins on the regulatory reform front while nursing some wounds from a major defeat on efforts to repeal and replace the Affordable Care Act (ACA). While health care reform is on pause for the moment, Republicans are turning to tax reform as the next major policy priority and continuing to use executive orders (EO) and the Congressional Review Act to roll back Obama-era regulations. Funding for the government expires on April 28, 2017, so Republicans and Democrats will face the first test of bipartisanship in the next few weeks as they seek to fund government agencies, including the Department of Defense, through the end of September. All eyes will be on the Senate next week as the Supreme Court nomination of Judge Neil Gorsuch takes center stage.

Here are 10 things that we believe are worth focusing on from the last two weeks:

Life Beyond the Founder

In 2017 hedge funds have effectively made the transition from investment niche for the super wealthy and risk-hungry endowment to becoming an established asset management model that is part of the investment mainstream. However, the nature of the business does not lend itself to deep existential thoughts on the future of the firm. Invariably hedge funds are founder-operated businesses. They are often opportunistic, possess deep skill-sets in one or more trading strategy or asset class, are increasingly systematic and quantitative, and usually have distinct cultures which allow them to take risks, think deeply about the market and recruit/reward those people built in their own image.

But after two decades the natural life-cycle of any business kicks in and thoughts turn towards the future and founder succession. Hedge funds face a unique set of challenges when it comes to succession planning since the reason they can raise capital and manage money in the first place is due to the skill and reputation of the founder(s) themselves.

In this article I will look at succession planning in its widest sense. Not just as a means by which a hedge fund lives beyond its founders but also more holistically; what a hedge fund might look like in the future beyond the specific set of strategies and operating model that the founders conceived initially.

The maturity of the industry over the past two decades, the rise of passive managers and the 2008 financial crisis have all meant that allocators have become more discerning (e.g. in terms of fees/performance), regulators have become more concerned about systemic risk in the market, and LPs have demanded more transparency into portfolio performance and risks.

Hedge Fund Benchmarking and Absolute Returns

How can we test whether a hedge fund programme is adding value to large institutional investor portfolios? This question has grown in importance since the financial crisis, as an eight-year equity bull market has made hedging unattractive. Frequently, hedge fund programmes are compared to the asset class they most resemble (for example, a hedge fund programme is sometimes compared to a long-only equity index, such as the MSCI All Country World Index). In this context, the performance of many hedge fund managers has lagged significantly since 2009. Given that hedge funds may have lower market exposures than a long-only equity benchmark, is this fair? If not, how should they be measured? We argue that a beta-matched mix of stocks and bonds is the most appropriate measuring stick for customized hedge fund programmes, as it compares them to the risk profile that investors could achieve using traditional markets.

Determining the appropriate benchmark mix
To determine the appropriate mix of stocks and bonds to use in comparison with a hedge fund programme, first consider its long-term equity beta. While the beta exposure can vary from one year to the next, over a reasonable three-to-five year evaluation period, the beta of most diversified programmes does not vary greatly.

Jersey Private Funds

With effect from 18 April Jersey is introducing a new regime in respect of private funds - simplifying the regulatory regime, and extending the benefits of flexibility and speed across Jersey’s private funds space.

EXECUTIVE SUMMARY
Under the Jersey private funds regime:

  • All funds with up to 50 investors will come under one simple regime.
  • The regulatory framework will be consistent across the private funds space, extending the current benefits of Jersey’s existing very private regime to all private funds.
  • A fast track 48-hour regulatory approval process will apply, with no prior approval of promoters or key persons being required.
  • The features and operation of private funds will be relatively unconstrained, with a variety of legal vehicles being able to be used, funds being able to be closed- or open-ended, requirements for Jersey connections being relaxed, and offering documents being permitted, but not required.
  • Private funds will be able to be promoted to “professional” and other “eligible” investors, with the eligibility criteria being both straightforward and relatively broad: for example including those whose ordinary business is managing, holding or advising on investments, as well as persons who can meet certain asset or investment thresholds (such as making an investment of at least £250,000 (or currency equivalent).

Alongside the various elements of flexibility, appropriate regulatory oversight will be maintained. This will be achieved through a requirement for a Jersey-regulated ‘Designated Service Provider’ to be appointed to all Jersey private funds, following the trend of focusing regulation on a key service provider, rather than the product.

French Elections

With the Dutch elections over, the Euro has breathed a sigh of relief. As Geert Wilders’ nationalist Freedom Party fell short in the parliamentary elections on March 15, the euro gained nearly one percent against the US dollar, albeit on a day when most currencies strengthened versus the greenback. While Wilder’s party suffered a spectacular collapse in polls in the immediate run up to the election, there was never any serious concern that he would be running the Dutch government. By contrast, the upcoming French Presidential election in April has the potential to be a much bigger source of volatility for the euro, as well as other currencies, equities and bonds.

France votes in two rounds. Round one takes place on Sunday, April 23, and the top two vote getters will proceed to the second round on Sunday, May 7. On both days, the French government will issue an exit poll at 8:00 pm Paris time (7:00 pm London, 2:00 pm New York and 1:00 pm Chicago) with a preliminary projection of the winner. It appears likely that one of those two top vote getters will be Marine Le Pen of the National Front who promises, among many other things, to hold a referendum on France’s memberships in the European Union (EU) and in the Euro currency that spans 19 countries. As such, a Le Pen victory holds the potential to roil the markets in the way that the surprise Brexit vote did in 2016.

On the face of it, she seems unlikely to win. Recent polls have put her at 20-30% behind her most likely second round opponent, the pro-European centrist Emmanuel Macron (Fig.1). She trails her next most likely second round opponent, the center-right Francois Fillon, a former Prime Minister, by a 10-20% margin (Fig.2). Fillon is also pro-Europe.

Culture Change

Dr. Janet Yellen’s term as Chair of the Board of Governors of the Federal Reserve (Fed) System ends in early 2018. While she could be reappointed for another four-year term as Chair, reading the tea leaves in Washington D.C. suggests a scenario where we may see a person from a business career take over the gavel. And not just as Chair. There are three vacancies on the Board of Governors, and we also expect a new Vice-Chair in the summer of 2018. That is, there is a potential for five new board members on a seven-member board, and some or all of those seats could be filled with business-career credentialed individuals instead of persons with academic or central bank experience.  This could usher in a major cultural change at the Fed. Such a cultural shift might make a very big difference in how decisions about interest rate policy may be made.

Our intuition is that more business experience on the Fed Board of Governors and fewer economists will shift the debate away from academic interpretations of monetary policy and increase the focus on the interplay of rates and debt. More specifically, the high debt loads in the U.S. will create a bias for lower than otherwise rates, so that increases in debt-service expenses do not derail an economic recovery. Over the long haul, if this scenario prevails, a bias toward lower rates relative to inflation is likely to also lead to a weaker trend for the U.S. dollar as well.

Editor’s Letter

UCITS compliant hedge funds go from strength to strength in what is a European success story. Assets have surpassed $300 billion, or 10% of global hedge fund industry assets of around $3 trillion. Granted, most hedge fund assets still come from US institutions, allocating to Cayman or Delaware vehicles, but not all managers are able or willing to distribute to the US.

Some managers run UCITS parallel to ’40 Act funds in the US, but UCITS can appeal to more managers. No special structuring is needed to receive performance fees from a UCITS. And the potential to offer weekly or bi-monthly dealing in a UCITS contrasts with the strict ‘40 Act requirement for daily dealing. The UCITS risk constraints can comfortably accommodate many strategies. For instance, the diversification criteria, capping positions sizes at 10%, need not apply to many developed government bond markets, which can leave more latitude to pursue macro strategies. Customisation can also be obtained by asking managers to sub-advise managed accounts under the umbrella of a UCITS fund.

The advent of UCITS IV - introducing greater flexibility - in 2011, spawned the growth of so-called “Newcits” but some hedge fund strategies have been structured under UCITS III for at least 20 years. A significant number of managers now launching UCITS have been around for 30 years or more. Though rising barriers to entry have arrested some launches, our 2017 UCITS Hedge Award winners range in size from around $10 million to several billions. The smallest funds tend to be part of larger groups, however. Some funds outsource to a range of service providers, including some very visible platforms – such as Lyxor, MontLake or Deutsche, and some virtually invisible platforms in the form of white label infrastructure providers that maintain a lower profile.

Will India Trump China as US Policy Shifts?

Neighbours and rivals, China and India have the distinction of being the world’s two most populous nations. With between 1.3-1.4 billion people each, they account for 36.5% of humanity. The similarities largely end there. Over the past three decades, China has become more prosperous than India, with an economy five times larger. While India’s 4-8% growth rate has been solid, it lags China’s red-hot pace, which has topped 10% for much of the past few decades.

However, this dynamic has begun to change. Since 2015, India’s economy has begun to pull ahead of China’s (Fig.1).

The drivers of China’s economic miracle, namely: a productivity-enhancing transition from being rural- to urban-based, and the impressive build-up of infrastructure, are past the point of diminishing marginal returns. In addition, the country is awash in debt. China’s total debt (public plus private) has grown to levels comparable to those in Europe and North America, and this portends slower growth. By contrast, India’s rural-urban transition, while well underway, is less advanced than China’s and could boost India’s productivity for many years to come. India’s debt ratios are only half of China’s and have not been growing during the past decade (Figs.2–4). This, too, could set the stage for many years of solid growth in India that could begin to exceed that of China as we move into the 2020s. We note, however, that short-term growth in India could lag China’s as a result of the damage to the economy from Prime Minister Narendra Modi’s withdrawal of high-denomination currency notes in an effort to crack down on the country’s vast shadow economy.

UK Lending Funds in the Post-Brexit Environment

While the Brexit vote might have injected a note of political uncertainty into the future of the United Kingdom, and while the falling pound has raised the spectre of inflation again, many of the fundamental investment stories that support inward investment to the UK remain in place.

Interest in the UK as a market for investment does not seem to have dissipated: speaking purely from the Prestige perspective, we have continued to see enthusiasm for lending strategies focused on the UK in the wake of the Brexit vote, with both website traffic and site visits from foreign investors reflecting an interest in both the uncorrelated nature of lending, and the stability of the value of the assets against which lending is secured (e.g. British farmland).

Foreign clients, if anything, see an opportunity from the weaker British pound to increase their exposure to the UK. While we have seen this in the short term from the rise in the price of UK-listed companies, there is also considerable interest in the long-term prospects for the UK economy and yields to be earned from effectively managed lending strategies. Interestingly, enthusiasm for UK lending strategies from abroad far outstripped domestic demand throughout the Brexit news cycle. But why is this the case?

The UK as a destination for loan finance
The UK has always been regarded as one of the top prospects for foreign direct investment – international money flowing into the property sector is just one indicator of this. Lending funds, which have been expanding their share of the alternative assets market as government bond yields have hit correspondingly negative territory, represent both an uncorrelated source of returns and, in the case of the rural sector, bring the additional attraction of loans often secured against prime UK farmland.

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