Race for the middle ground
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In today’s low yield environment, the need to search out returns without creating undue risk to investors’ capital has become more important than ever. Pension funds, insurers and sovereigns have looked increasingly to hedge funds, which, using a wider range of instruments, including derivatives, have developed an array of strategies to achieve uncorrelated absolute returns. As hedge fund managers have seen their investor base shift from one dominated by HNWIs and ultra-HNWIs to one dominated by institutional money, they have had to adjust their offerings – particularly around reporting, transparency and fees - to become more like those of conventional managers whose businesses evolved to serve this client base.
Conventional managers, meanwhile, have seen their business models threatened by the growing popularity of hedge fund products. They have responded by building up their own capacity to manage and distribute hedge funds, hiring specialist managers and widening the range of instruments and markets they trade in. In this way, to attract some of the new flows to their funds, they have shifted their business closer to that of hedge fund firms, driving the process of convergence from the other end.
New investors, new standards
In the first case, hedge funds have had to change how they structure, deliver and charge for their funds to please their new institutional clients. They have looked to established long-only players for new staff with the distribution and sales expertise to sell their products to a wider audience, too.
They have had to change how they package their offerings. The growth of segregated funds has been driven by institutional investors’ reluctance to have their assets mixed with those of other investors.
Greater transparency has been a second shift. More granular, more frequent reporting has been required in part by higher investor standards and in part by more searching regulations. Hedge funds once feared this greater disclosure could reveal ingredients to the secret sauce of the trading strategies that gave them the edge over competitors. But segregating client mandates in separate accounts has helped: the hedge fund managers can control who is seeing what. And in many cases, the new investors into hedge funds, such as sovereign wealth funds, are themselves very secretive and cautious. Relationships typically take months or years before investments are made, during which time the sensitivities of both parties have become clear. Investors are therefore unlikely to act as leaky vessel for trade secrets.
Finally, alternatives managers have had to compromise on fees. Management costs have been a subject of discussion across the industry with the growth of cheap passive investing. But they have come under special pressure in the alternatives sector where institutional investors now comprise such a large share of hedge funds total business. The traditional ‘2-and-20’ charging structure is now rare.
Long only managers respond
As conventional managers have seen which way the tide is going, they have moved to protect their existing assets by developing alternatives-style products. Clients, they reason, are unlikely to look to a hedge fund firm they don’t know if their existing manager can provide similar strategies that compete in terms of performance and risk.
Equally, by building capacity to manage and distribute their own hedge funds, they should be able to attract a share of the sizeable new flows heading for hedge funds from the burgeoning sovereign sector.
Their strategy has taken the form of reaching into the alternatives space for staff and skills. Acquisitions have been one feature of this: long-only houses have favoured the purchase of a specialist alternatives firm or the hiring of an entire trading team from existing hedge fund, over growing their offerings from within. They have also hired operational and legal experts to ensure that they can achieve regulatory compliance – no mean feat considering the speed with which regulation covering alternatives funds has been issued by global, US and European regulators – as well as meet the high levels of disclosure reporting and client servicing required by the new generation of institutional investors.
Shifts in regulation have accelerated convergence while providing opportunities to both camps. The introduction of fund structures – such as UCITS III, which first introduced the use of derivatives to the European fund standard – and devoted hedge fund regulation – notably the Alternative Investment Fund Managers Directive (AIFMD) – has brought more investors online for hedge fund managers that have the resources to package their funds correctly or comply with European rules. UCITS has proved popular for insurers, for example, since regulators like the asset safety provided by the obligations placed on the custodian as depositary.
Future regulatory reform is likely to drive the convergence further as, supported by a regulatory regime, investors become more comfortable with the range of alternative strategies and increase allocations. It may be, for example, that the AIFMD rules prove a welcome endorsement of a manager distributing into Asia, as UCITS did before.
Limits to convergence
There remains some differentiation between the conventional and alternative fund sectors. Many hedge fund groups still perceive themselves as different: leveraging a more specialist type of knowledge, a higher degree of expertise in certain instruments or strategies – typically those they made their name with – and a specific approach to the selection and development of staff.
The next frontier
What is the next frontier? Providers as well as investors will shape the answer to this question. For their part, conventional fund managers will only be drawn to increasing their hedge fund range for as long as the fees and size of investors’ assets makes it worthwhile to do so.
Precisely how ‘alternative’ investors are prepared to go with their hedge fund allocations, meanwhile, depends on their individual risk-return appetites. There may be a limit to convergence when it comes to strategies that are highly leveraged, deeply illiquid or comprise very high levels of portfolio turnover.
But low yields are pushing institutional investors along the liquidity curve for sustainable future income; asset classes like infrastructure and real estate provide reliable long-term yields well suited to the long-term asset-liability requirements of many insurance and pension investors. They are likely to become an important area of growth for both traditional hedge fund groups and the conventional houses with which they have increasingly converged.