Testing Time Ahead for Funds of Hedge Funds

Flows into the hedge fund industry turned positive in the third quarter of last year. There have been monthly blips, but a positive trend of quarterly inflows has been in place since. This year there was a net investment of $13.7bn into hedge funds in the first quarter, followed by $9.5bn of inflows in the second quarter. In the last quarter Hedge Fund Research calculate that a net $19bn of new capital came into the industry.


The third quarter of 2010 was also a period of decent return from hedge funds, most of the gains coming in September. The positive returns for the year to date on top of the recovery of assets through net subscriptions has taken industry assets back to their previous peak of one and three-quarter trillion dollars.


It has been well recognised that flows have turned positive and that the majority of those flows have been captured by the largest single manager hedge fund groups - those overseeing $5bn or more. Some funds of hedge funds received new money in the second quarter - nearly a third of funds of funds had positive inflows then - but still in aggregate funds of funds have been losing capital for two years. Up to now. In the third quarter just finished, funds of hedge funds had a net inflow of $250m, according to HFR.

Net Subscriptions for Funds of Funds

The timing is indicative of the new reality of institutional investing in hedge funds. Just over a year on from net new subscriptions to single manager funds, multi-manager funds as a group received positive net subscriptions. The buyers of single manager hedge funds to this point were experienced institutional investors. If the first phase of taking hedge fund exposure is institutions getting exposure to the investment strategies through replication (not recommended, but it happens) or diversified funds of funds, then there are naturally other phases to follow. The second phase is likely to be the development of selection by the investing institution. This could be expressing a preference for a particular investment strategy, say distressed, or emerging market hedge funds, through selecting individual hedge funds, or allocating to a specialist fund of hedge funds.



Sometimes stage two is driven by a fee reduction exercise, or to utilise growing internal expertise, or sometimes even to put into practise an increase in allocations to alternatives or hedge funds specifically. Whatever the motivation, stage two is as likely to result in a reduction in the size of mandate managed by a fund of funds as an increase.



Institutions new to investing in hedge funds would be wise to utilise the services of a fund of hedge funds provider. So neophyte institutions and those adding to strategic allocations within their plans will have used funds of hedge funds in the growth phase of the industry to mid 2008.



In the last year we have moved from the trough of disillusionment* and are onto the slope of enlightenment for the hedge fund industry. In that time the investing institutions that are seasoned hedge fund investors have been pulling money from funds of funds to put the capital into single manager funds in aggregate.



We seem to be entering a new phase now. The recent positive net capital allocations to funds of hedge funds suggest one of two causes: that new buyers are coming into hedge funds and/or the more conservative of those existing institutional investors in hedge funds have started to add to their allocations. It is widely appreciated that the due diligence process has lengthened. So if it took 6 months from first meeting to filling in subscription documents it now takes 9 months. Starting a new hedge fund investment programme for an institution via a fund of funds might take a year or more as there is double diligence to complete, at the fund of funds level and at the single manager level.



If this hypothesis is correct funds of hedge funds should have more and larger mandates heading their way from here on. This will be tested over the rest of 2010 (particularly in December, a key month for redemptions) and will be confirmed by positive flows in the first half of 2011.



Additional: Pictet & Cie, the Swiss private bank, confirmed that it had had net inflows of $340m into its fund of hedge funds this year bringing the total AUM to $8.2bn at the end of September.

*http://www.thehedgefundjournal.com/magazine/200907/manager-writes/through-the-trough-of-hedge-fund-disillusionment-.php

Brevan Howard Adds Strategies to Increase Capacity

When you are Europe's largest hedge fund manager and run one of the world's largest hedge funds you are bound to run into constraints on the amount of capital you can run successfully. Brevan Howard Capital Management Limited has around $32 billion under management, and three-quarters of that is in the Brevan Howard Master Fund Ltd., a global macro and relative value fund focused on fixed-income and currency markets. 

The only respect in which the BH Master Fund is concentrated is in the number of  major decision makers running it. Alan Howard has the largest risk budget at the firm, and there are a small number of other senior risk takers - the trusted lieutenants of  Howard who have worked with him and for him since the launch of the firm. This small cadre take most of the risk in the Fund. There have been few changes in the risk-taking leadership of the firm in either personnel or number. Alan Howard has to trust this macro and fixed income elite squad, and this trust is not earned quickly. 

A consequence is that unless the style of investment changes, and/or the level of risk assumption across the team changes it is difficult for the Master Fund to take in new capital. Alan Howard has been explicit about this - he has had no intention of changing the scope or style of the Master Fund - so when he opened the Fund to new subscriptions last year it was for a short period and was soon over-subscribed. 

For the firm to grow, Brevan Howard has to add new strategies either in the existing fund(s) or add new funds dedicated to new strategies. The Baker Street based macro mavens have decided to follow the latter route it was announced this week with this press release:

  

"David Gorton and Brevan Howard are pleased to announce the formation of a new joint venture, DG    Systematic Trading LLP, to pursue systematic trading strategies.  David Gorton is the Chief Investment Officer of the new venture with responsibility for the management and development of trading strategies based upon a suite of systematic models which have been running capital since May 2006 including capital allocated from Brevan Howard Master Fund since 1 March 2010.   

 DG Systematic Trading LLP will be FSA authorised and will act as investment manager of Brevan Howard Systematic Trading Fund, a systematic trading fund which utilises Brevan Howard's risk management and execution platform. Brevan Howard Systematic Trading Fund has been seeded with $300 million from Brevan Howard Master Fund and has been successfully traded by David Gorton and his team since 1 March 2010.  For the period from 1 March to 30 September this strategy has delivered returns on allocated capital of 9.3% net of fees." 

For those who can't quite place the name, Gorton is the former JP Morgan trader who was co-founder and is still co-Chief Executive of London Diversified Fund Management. London Diversified Fund Management ran the London Diversified Fund and the London Select Fund, using a style similar to that of former hedge fund giant Vega Asset Management in fixed income/macro. The eventual commercial outcomes of the LDFM funds were also similar to those of Vega.  At the start of 2008 LDFM managed $5bn and today is thought to run somewhere North of $500m. It may be indicative that around $200m of those funds are in a managed account.

The Brevan Howard press release emphasises that the investment strategy to be utilised in the new fund are based on a "strictly quantitative approach". It is also important from the BH perspective that the new Fund utilises the Brevan Howard risk management and execution platform. Each trade and the overall risk profile of the portfolios can be monitored real-time by the BH risk professionals and compliance with the mandate can be verified readily. It is an interesting commercial arrangement in that a joint venture has been formed, and that David Gorton remains running an independent asset management entity, even if he has had to be additionally registered for FSA purposes at Brevan Howard.





Additional: This week Brevan Howard announced that they are set to float a new investment company – BH Credit Catalysts limited - on the London Stock Exchange in December. As the name suggests the Fund trades in the credit markets, and in this particular case with a bottom-up catalyst-driven credit trading style. The underlying Fund is advised by DW Investment Management, headed by David Warren, and has been running for over two years. The DWIM Team consists of 22 professionals based in New York.

David Warren joined Brevan Howard in January 2008 with a mandate to build a credit team. The team spun out from Brevan Howard in June 2009 and continues to use Brevan Howard’s infrastructure and risk management. DWIM’s credit team has a strong track record producing total return performance of +44% in the period from May 2008 to August 2010, a period characterised by some of the most volatile markets in recent history (2008-2010). Over this period the existing credit fund has been the best performing fund at Brevan Howard.

The Listing of the investment company does not necessarily increase capacity for new capital at Brevan Howard, but does allow for the creation of permanent capital for the money management firm, as this is a closed ended vehicle. What Alan Howard did not do is allow more capital into the BH Master Fund and then allocate from that to the Credit Catalyst Fund. This is an externally visible signal that confirms the confidence that Howard has in DWIM.
 

Borrowing, Shorting and a New Wave of Talent for Hedge Funds

The International Securities Lending Association held a briefing last week which disclosed some good industry level data on stock/security borrowing: the arrangements that facilitate shorting.

One of the effects of the Credit Crunch of 2008/9 was that counterparty risk became a major concern. Who you lend to, the quality of collateral, and documentation related to these factors became major operational issues. In a climate in which it became difficult to know for sure who would be around to deliver either collateral or borrowed securities back again the next week, it was inevitable that the willingness to lend declined. Graphic One illustrates that the assets available to borrow fell by 30% in the 4Q of 2008.  

Graphic One

 

The low point for lendable assets coincided with the low for equity markets in March 2009. As a result of implicit government guarantees and the move to bank holding company status for some banks, clients regained comfort with the securities lending market, and lendable assets have been increasing to pre-Crunch levels.

Whilst the willingness to lend has returned to levels seen previously, the desire to borrow securities has not returned to anything like the same degree. On-loan balances, that is the amount of securities actually borrowed, remains at around half the level seen in the first half of 2008 (see Graphic Two).

Graphic Two 

There are a number of reasons why the volume of securities borrowed has declined and stayed at a new lower level. The borrowers of securities would be hedge funds and proprietary trading teams. Capital in the hedge fund industry dropped by 40% from mid-2008 to mid-2009. In the period of the Credit Crunch proper the capital used by prop desks was needed elsewhere in the businesses. In the period after there were regulatory inhibitions on capital devoted to prop trading.  For both types of borrowers of securities many of the those that engaged in running funds or prop capital had reduced risk appetites or measured such high correlation and volatility in the markets in which they traded that they need less capital to put the same amount of risk on. 

Graphic Three

Of course another, if not the, major factor was that financing new borrowings of any sort became extremely difficult - so leverage fell across all activities funded by short term borrowing, including prop trading and hedge fund position financing. The massive de-leveraging is illustrated in Graphic Three, which shows a 62% fall in leverage from 2008 to 2010.

Capital allocated to prop desks today is down by an estimated 90% from the 2008 levels, and will go lower as banks such as Goldman Sachs and JP Morgan have announced they will withdraw from the activity. 

Securities are borrowed in order to carry out a number of shorting strategies: hedging activity to offset long exposures, arbitrage trading to capture mispricing opportunities, and strategies to benefit from corporate changes such as mergers and acquisitions. Whilst there may still be a need for large scale hedging, and there have been gross arbitrage opportunities in the last 18 months, the volumes of M&A deal flow have been down significantly (see Graphic 4).

Graphic Four

The data generated and shared by the International Securities Lending Association also prompted a constructive thought for the hedge fund industry and those who invest their capital in it. A lot of great investment talent is coming out of the investment banks. Not all of them will thrive within independent businesses, but the precedent is strong. A lot of the best talent running big hedge funds now have come out of Goldman Sachs and JP Morgan, and they won't be the only banks to run down their proprietary trading desks further. Let's hope the new wave can reinvigorate hedge fund returns in 2011.