Man FRM Early View

At the end of last month’s piece we concluded with some gnomic optimism about hedge funds’ alpha this year, and as this may have come as a surprise, we thought to pick up where we left off.

In recent years, Central Bank policies have dominated the developed markets. Since the European Central Bank (ECB)’s decision to expand their asset purchase programme two years ago, these policies have been aligned to the point that asset class correlations moved up to levels last seen in the aftermath of the Global Financial Crisis, significantly above the levels that prevailed almost without interruption between 1991 and 2007. As a business, Man cares about CTA performance, and consequently keeps a sharp eye on this correlation, because when it is low, CTAs have historically done better, and some of their worst years coincide with the higher levels. It isn’t hard to see why this relationship persists: low correlation means that volatility-scaled portfolios can run with more exposure because diversification is higher. Well, with synchronised central banks the markets were monothematic, macro opportunity was thin and CTAs did poorly.

Managing Event Risk in 2017

Event risk provided some abrupt market turnarounds in 2016, emanating from political processes such as the Brexit referendum and US elections. This year is shaping up with the potential for even more turbulence from event risk – and not just from politics, but possibly from changing patterns in economic data and even the weather.

Characterising event risk
We like to categorise event risk into three distinct types. First, there are “binary dates,” such as elections, with near-certain potential for a divergent outcome. Second, there are “information dates,” which are typically data releases, and which have the ability to surprise with an unexpectedly extreme data point. Finally, we have “surprise!”, where neither the date nor the event/outcome is anticipated. Surprises can come from political statements, military actions, or natural disasters, as a few examples.

Here, we look at each category and provide some commentary around potential dates to watch in 2017. Then, we will explore a few different approaches to managing event risk, highlighting sophisticated options.

Editor’s Letter - Issue 120

The defining qualities of a “hedge fund” were traditionally held to include: offshore domicile; freedom from regulation; secrecy; restricted investor base; substantial manager co-investment; performance-related fee structures and an unconstrained investment mandate including the ability to hedge. Yet with every passing year most of these attributes, which we touch on in turn, are becoming less unique to hedge funds.

All sorts of funds, including long only ones, use offshore domiciles, and it is onshore-domiciled liquid alternative hedge funds - mainly ’40 Act funds in the US and UCITS in Europe - that have seen fastest asset growth in recent years.

Onshore and offshore jurisdictions alike permit unregulated fund structures, but we seldom see seasoned hedge fund managers using them. Hedge funds are usually regulated, albeit somewhat more lightly in some offshore fund domiciles. Hedge fund managers are nearly always regulated at least as heavily as other asset managers dealing with the same classes of investors.

Regulation is one source of portfolio transparency, along with most audit reports, some administrator reports, exchanges’ reporting requirements, and investors’ due diligence demands.  A black box hedge fund is rare indeed.

Many hedge funds restrict access to variously defined professional/sophisticated/qualified investors, but many hundreds of millions of individuals outside these criteria have indirect exposure via pooled savings such as pension funds, and can invest directly through liquid alternatives.

US mutual fund managers’ holdings of their own funds have been disclosed since 2005. This has revealed that significant proportions of them are “eating their own cooking”, but clearly not to the same degree as hedge fund managers, some of whom have returned external capital altogether and become family offices.

Outsourcing Trading

Being an asset manager in today’s market can be a bruising experience. Margins are shrinking and fees are under pressure, while operating costs have grown out of proportion. This is happening in tandem with unpredictable markets, making alpha creation for clients exceptionally difficult. Cost-saving opportunities have to be identified wherever possible in a way that does not compromise the integrity and success of the business. Linear Outsourced Trading has sponsored this paper to look at some of the trends which are pushing asset managers towards outsourcing their trading desks to third parties.

The cost burden
It is no secret that active asset management returns have not been in line with investor expectations. In a forceful indictment, the UK Financial Conduct Authority (FCA)’s Asset Management Market Study Interim Report stated that active asset managers routinely underperformed their benchmarks after fees. It also questioned why the industry’s fees had not fallen as competition proliferated, something which has occurred in the passive fund sector, where there has been a race to the bottom on investor charges. All of this has contributed to the enormous growth in lower-margin passive products, which, despite a fivefold increase in the UK since 2005, are still expected to gain market share.

MiFID II: The Final Countdown

MiFID II has been a long time in the making, and the repeated delays may have led some to think that 12 months is plenty of time to get ready. However, this is a far-reaching directive with implications across trading, transaction reporting and client services, encompassing IT and HR systems. Firms need to get on the front foot now to ensure they can meet the requirements of the directive this time next year.

Fail to plan, plan to fail
Anyone relying on Brexit to create further delay, or to be repealed, should think again. While the Brexit timelines are not yet confirmed, MiFID II will pass into UK law this summer and will come into effect in January 2018. Even after it formally withdraws from the European Union, the UK is expected to follow the MiFID II regime.

So now is crunch time. There are a number of obvious challenges, as well as some that may have slipped under the radar. Some business changes may prove relatively straightforward, such as creating formal documentation for existing processes, but others could well involve sweeping changes to how managers run their business, interact with counterparties and even how the industry itself is structured.

Reporting obligations
In line with the overall goal of increasing transparency and improving market abuse detection, MiFID II will usher in sweeping changes around transaction reporting. Hedge fund managers have typically relied on the sell-side to fulfil both sides of the transaction reporting obligation on their behalf.

In Principle: 10 Things You Need To Know For 2017

On 23 June 2016, the UK shocked the world, and perhaps itself, when it voted in favour of a “Brexit” from the European Union. While the referendum result has brought significant uncertainty to the financial services sector, the Financial Conduct Authority (FCA) has made it clear that, from a regulatory perspective, it is “business as usual”. Indeed, it is clear that firms cannot afford to stand still in the wake of the referendum result, since financial regulation has, as always, continued to evolve.

In this publication, we focus on 10 key issues that authorised firms should be aware of going into 2017:

  • Brexit – key challenges ahead for financial services firms
  • FCA Mission Statement – a new mission for the FCA?
  • MiFID II – a whistle-stop tour for investment managers
  • extension of the Senior Managers and Certification Regime
  • Market Abuse Regulation – market sounding guidance for buy-side firms
  • mandatory clearing obligations under EMIR
  • AIFMD – ESMA advice on non-EU AIFM passports and proposed changes to Annex IV reporting requirements
  • increased regulatory scrutiny of the asset management industry
  • regulation of distributed ledger technology-enabled financial services
  • key takeaways from enforcement matters involving the FCA in 2016.

We begin by assessing the immediate challenges in the regulatory environment that Brexit would bring for financial services firms. We also examine the key themes in the FCA’s new mission statement, which we expect will form the foundation of the regulator’s 2017-2018 Business Plan.

Alternatives: A Traditional Fixed Income Replacement

As 2016 becomes less visible in the rear view mirror, investors are once again compelled to look forward as they construct durable portfolios. While markets may look uncertain to many sage investors, there have been some key uncertainties removed from the market including the US presidential election, crashing oil prices, Fed-direction uncertainty, and the positive/negative sign on global growth. Very significantly, one key driver of portfolios, global bond returns, appears to have come to the end of a 35-year bull run. The professional allocator is thus faced with the usual conundrum of how to position the portfolio differently, if at all, in 2017 and beyond plus the fiduciary pressure to replace bond exposure with another asset class. Despite the press widely reporting on the death or at least new paradigm of the hedge fund, it is again worth considering adding a lower-volatility, well-diversified hedge fund exposure to make up the gap left by traditional, long-only fixed income returns.

Editor’s Letter - Issue 119

Average hedge fund performance for 2016 was in line with the majority of institutional investors’ expectations, per Preqin; few now expect double-digit returns. EurekaHedge reckon the industry made 4.48%, the SS&C Globe Op Performance Index was up 5.11% and the HFRI Fund Weighted Composite Index advanced 5.6%. These returns are consistent with industry history, when defined as a spread over risk-free rates: still near zero in most OECD countries. Still, some event-driven, distressed debt, emerging markets and energy related strategies were well into double digits for 2016.

Yet the worst-performing strategy of 2016, managed futures (on average, with some notable outliers particularly among short-term traders) received the largest inflows, according to eVestment. This illustrates how many allocators are motivated by portfolio diversification rather than rear view mirrors. The search for uncorrelated returns remains the single most important reason for hedge fund allocations, as the 2016 EY Global Hedge Fund and Investor Survey (EYHFS) found.

Hedge fund industry assets remain at record levels of $3 trillion and the EYHFS finds that most institutional allocators intend to maintain stable allocations. After six consecutive years of asset growth, the industry paused for breath but we expect that the growth will resume. Liquid alternatives launches of high-calibre UCITS and ’40 Act funds continue, and are reaching out to wider audiences of investors. Meanwhile some vast asset management markets, such as the world’s fourth largest – Australia’s – are becoming easier to access.

A Measure of Certainty

International developments are giving fund managers and practitioners a lot of food for thought: Brexit, the US election, market volatility and an evolving regulatory landscape, particularly as the European Commission continues to consider third party passporting under the Alternative Investment Fund Managers Directive (AIFMD).

With so much international activity it’s understandable that managers, promoters, legal advisers and service providers to hedge funds are focusing on what it means for their operating models and how it might impact their fund structuring options.

As the sixth largest centre for hedge fund management globally, Jersey takes a keen interest in these developments, and the latest figures show that alternative funds business conducted through Jersey is holding up well. At the end of June 2016, for instance, the value of funds under administration in Jersey stood at just over $300 billion (up 2% from June 2015), with the number of funds established in the jurisdiction remaining stable.

For Jersey at least, the overall picture is one of stability. There has been very little volatility in Jersey’s funds figures over the past few years, in hedge or other classes. At the top end, some larger fund managers are continuing to raise significant funds, but there is also a trend for a growing number of smaller, new managers to use Jersey as a domicile for their funds.

ESG Under Scrutiny

Environmental, social and governance considerations continue to rise in importance among the investment community, across all asset classes. Yet, with ESG priorities and principles varying hugely from investor to investor, the fit between fund manager and allocator is by no means straightforward.

For this paper, we looked back at five very recent customised manager searches in public and private markets where ESG played a significant role. Two of these engagements - a Private Debt selection exercise for the UK Environment Agency Pension Fund and a Public Equity search for a European family office - are presented in detail. These asset classes sit at opposite ends of the spectrum in terms of the extent to which ESG has become embedded and marketed. The subsequent discussion draws on insights from other relevant searches in private equity, public equity and even renewable infrastructure during the past three months.

We hope that specific insights drawn from practical examples, as opposed to broad generalities, will be useful for both investors and managers involved in this sector. Many of these lessons relate to manager analysis, or how to dig beneath increasingly sophisticated window-dressing to assess actual practices. Whilst the number of ESG-branded offerings continues to rise across all asset classes, it has become increasingly challenging to distinguish between box-ticking and substance.

Overall, the universe of products and strategies continues to shift away from exclusions and screens, towards bottom-up factor integration and active engagement. Indeed, recent press from the likes of CalPERS on the underperformance caused by negative screens is likely to intensify the pre-existing trend. Yet each of these approaches, particularly integration, can take many forms.


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