But while the industry has proven to be robust, with a investor base that is confident in its long term abilities, the crisis of 2008 has provoked change. The hedge-fund industry is adapting to the current demand for more liquidity, transparency and ultimately a greater feeling of safety for the investor.
Despite the positive attributes of the hedge fund industry sector and how robust it has proven to be, we should not underestimate the impact of the crisis. There was a wave of redemptions leading to a record number of liquidations in 2008: about 1,500 hedge funds folded versus 850 in 2005, the previous record year. Consequently, about two
thirds of the fund of hedge funds had to gate, create side pockets or even liquidate, leaving many private investors and retail intermediaries such as private banks angry and disillusioned.
Yet there is evidence that family offices have, overall, been increasing their allocation to hedge-funds. A recent survey by the Wharton Family Alliance, an academic organisation dedicated to the study of single family offices, points to a doubling of the hedge fund allocation from 7% to 15% between 2007 and 2009 for US based family offices and a slight decrease from 11% to 9% over the same time period for European based family offices. As for other institutional investors worldwide, a recent Credit Suisse survey predicts an asset weighted 9% increase in their hedge fund allocation. The highest increase comes from the Pension/Insurance segment with a 20% declared increase at the end of 2010.
The state today
The size of the industry is still probably 10% below the pre-crisis level of USD$1.8 trillion to USD$2 trillion. But that is good news if we consider the only justification for the existence of hedge funds is outperformance. By definition, its total size cannot represent more than a few percentage points of the total worldwide financial assets.
As hedge funds live and die by their net risk-adjusted returns to investors and the industry is still alive and well, it must be owing to the fact hedge funds have continued to outperform other risky asset classes. Many research reports show that well managed funds of hedge funds, have outperformed most asset classes over any medium to long term period.
The delusion of perpetual positive performance may have been put to rest by this extraordinary crisis, however, professional investors have not forgotten the long term benefits of diversification and risk-adjusted returns. The facts are clear: over a 15 year period from January 1994 to September 2009 the CS Tremont HF Index showed an annualised return of + 9.3% with an annualised volatility of 8.1%, giving a Sharpe Ratio of 0.8 (risk free rate of 3%). The MSCI World Equity Index had an annualised return of 6.3% with a volatility of 17.5% (Sharpe Ratio of 0.2) while the Citigroup World Government Bond Index had an annualised return of 6.5% with a volatility of 7.0% (Sharpe Ratio of 0.5).
Increased regulation
The current debate on the EU Alternative Investment Fund Managers Directive is beyond the scope of this article. However, it is fair to say unsurprisingly the draft directive still suffers from ambiguity and a lack of clarity, as well as failing to take account of many idiosyncrasies of the businesses it intends to regulate, including private equity and real estate funds.
The original purpose of the draft directive was to help address vulnerabilities in the global financial system exposed by the financial crisis. As previously discussed, the necessarily small size of the hedge fund industry means the accusation of provoking systemic risk is certainly overstated - the entire hedge fund industry is smaller than one mega-bank. It should be remembered that not a penny of tax payers money has been used to bail out hedge fund managers or investors and this industry has dealt with its own ‘black swan’ without any help from governments or central banks.
Despite all this, it is clear given the current political climate in Europe, this directive in some shape or form will ultimately be passed into law. Consequently, if as a result of this directive, non-EU domiciled funds cannot market in Europe investors would be well advised to mitigate this potential regulatory risk by selecting EU-based funds of hedge funds rather than non EU.
UCITS III /Regulated Funds
Hedge fund strategies in a UCITS III wrapper have become very popular since the crisis. They offer greater transparency and improved liquidity for investors and quasi-automatic distribution authorisation across the EU for managers.
According to Eurekahedge, today there are 500 UCITS III hedge-funds managing about USD$50 billion. The four main restrictions of this format are: (i) limited use of leverage, (ii) eligibility of assets (iii) a high level of diversification and (iv) a minimum liquidity of two dealing days per month.
While it is obvious a UCITS framework provides better protection to investors compared to an unregulated offshore structure, investors should not be lulled into thinking this format addresses all operational risks.
The main issue is the restrictions automatically exclude many attractive opportunities, such as distressed and some arbitrage strategies. While UCITS III funds are probably here for the long-term, they should only be used as a complement to traditional hedge fund investments for investors requiring liquidity.
Also, many of the leading hedge fund managers are not planning to offer such structures meaning the quality and choice of the managers must be put in perspective against the advantage of better liquidity (and the real need of it) for the investor.
Managed accounts
These, in all their various forms, are segregated, fully transparent accounts over which the client maintains legal control and which have been growing in popularity – particularly among funds of funds – as a way of attracting institutional money. The cost and complexities of managed accounts probably limit their use only to large investors and again, as with UCITS III, the main issue is the negative selection risk (i.e. a limited supply of strategies or managers.) Again, history and common sense would dictate that if these structures are cumbersome and costly for managers to offer, many good hedge fund managers will simply not bother.
The recent focus on UCITS III and managed accounts hedge funds should not be seen as the perfect answer to the problems faced by the industry in 2008. They simply provide another way to invest in certain hedge fund strategies which can complement, but not replace, the traditional ones.
Let’s not forget the hedge-fund industry has been and always will be about identifying and investing with a handful of talented individuals and organisations that are able to deliver significant outperformance on a risk-adjusted basis to their investors.
