Mixed Messages on Health of Hedge Fund Business in Europe

Around three-quarters of the capital in the European hedge fund industry is managed out of London. So looking at the health of the British hedge fund industry effectively reflects the European industry, even taking account of leakage to Switzerland at the margin.

Corporate finance firm Imas Corporate Advisors has done some good work in tracking the investment professionals at hedge fund firms that are registered as Approved Persons with the FSA. Most senior and middle tier staff fall into that category, and it includes everyone that takes investment decisions and those with responsibilities for the direction of the individual firms.

The analysis done by Imas focused on middle-sized and large hedge fund management companies - all those with 10 or more Approved Persons on their staff, amounting to 70 firms. These top firms by size account for the majority of hedge fund assets under advisement in London, as the industry is fairly concentrated.

The result of this collation is given in graphic 1 below:

Graphic 1: Approved Person Employment Change, Q1-Q3 2010, in Larger Hedge Funds

source: IMAS Corporate Advisors/Financial Service Authority

So of the 70 largest firms, nine increased their staff during the first nine months of 2010, six held their investment staff at the same level and 55 firms reduced their staff numbers. Totting all the numbers up gives a decline in aggregate from 1288 to 989 in the year-to-date period covered - not much of surprise given the migration of staff at BlueCrest and Brevan Howard and the like to the Continent.

The second point to arise out of this part of the research carried out by Imas is that nearly half the top tier of hedge fund management companies in the UK are owned by foreign entities. Given the way that some of the very top tier of global managers downsized in 2008-9, it won't be a surprise that the firms owned by foreign entities and nationals cut investment staff numbers slightly more than their UK counterparts. 

The second area examined in the research was regulated company formations. From Graphic 2 it can be seen that the recent low point for hedge fund management company registrations with the FSA was a year ago - the hedge fund industry bottoming just before other financial sectors on this analysis of growth from the bottom up.


Graphic2: Quarterly FSA Firm Authorisations by Sector (2009-2010)

source: IMAS Corporate Advisors/Financial Service Authority

Since then there has been a run rate of around 19 new hedge fund management companies a quarter being approved for registration with the FSA, until the last quarter. The third quarter of 2010 showed a pronounced increase in the number of new hedge fund management companies being approved by the FSA. This looks to be a conseqence of the Volcker Rule, whereby banks must separate own-book risk taking from other activities, whether within the hedge fund format or proprietary capital. The second driver of hedge fund formations in London is the ongoing second-generation effect, as staff spin out of the orbit of brand name hedge fund companies to strike out on their own. Between them these two categories account for 22 of the 28 hedge fund management companies approved by the FSA in the 3Q.  

Net net hedge fund employment at the level of Approved Persons in the UK is down on the year to date, through September. Most of the hedge fund jobs lost to Continental Europe will not return to the UK in short order because the tax disincentives look like they will remain in place for some years. In addition the strategic thrust of the global hedge fund management companies is expansion into Asia ahead of a return to Europe. That written, single manager hedge fund assets across the whole of the hedge fund industry are near record levels, and more funds of funds are expected to receive net positive capital flows after the year-end re-shuffling of portfolios of hedge funds. So shortly the nadir will have been passed for most of the industry by assets, if not by number of funds, as the long tail of the industry lingers on.

Strategy Allocation in Funds of Hedge Funds - IAM as an example

International Asset Management Limited is Investment Manager for Alternative Investment Strategies Limited, a Channel Islands Listed diversified portfolio of hedge funds. Through the Channel Islands Stock Exchange some top level information is made available.

For example, the strategy allocation as at 30 September 2010 was

Long/Short Equity	30.7
Macro	18.4
Credit	11.4
Fixed Income Rel Val	10.9
Event Driven	10.3
Multi-Strategy	9.4
Trend Followers / CTAs	5.3
Cash & Receivables	3.5
Fund of Funds	0.1

Source: International Asset Management Limited

Strategy allocation at a fund of hedge funds at any one time is a function of a range of factors covering the practical and the structural:
forecast returns per strategy, fund, and underlying market;
macro factor forecasts;
correlation and variance forecasts (or at least assumptions of stability);
fund historic performance compared to peer groups and strategy index returns;
benchmark weightings, normal allocation range per strategy;
strategic biases, and tactical shifts; 
cash flows, and liquidity of the underlying funds (notice period for redemption); 
frictional costs (spread on fund dealing, forward pricing, spread on underlying securities, redemption fees, premium or discount on traded funds, commissions);
and illiquid security constraints (side pockets and side cars).

In addition managers have the subjective influences to cope with - there will be anchoring to the selections made previously, both by strategy and by manager. There are relationships with managers to maintain, and not a single hedge fund manager likes receiving redemption notices, even if they are described to the fund manager by the investor as "rebalancing" or "just trimming an overweight". One investor I know told me that when he tried to diversify away from his very large holding in Soros' Quantum Fund by recycling just some of his gains in the fund, Soros told him it was all or none. He could take it all out or leave it all in but could not limit his exposure at the margin.This is where rationality meets a business man overseeing a business, and it is not seen as constructive in any way by the latter.

Still and all, the fund of funds managers have to manage. In former times, when positive fund flows extended to funds of funds as well as single manager hedge funds, the job of strategy/fund allocation was a lot more simple. The new inflows could be directed to the currently preferred funds and those that were being de-emphasised could be diluted down without any need for redemption notices.  That all stopped in mid 2008. Since then strategy allocation in funds of funds has required (for most funds of funds for most of the time) a redemption for every subscription. Given that there was a persistence of net redemptions as a businesss background for funds of funds well into this year it has been very challenging to activelly allocate to strategies and individual hedge funds since.

One of the advantages of the Listed (funds of) hedge funds is that they are closed-ended vehicles: the capital, if not permanent capital, is there for a finite medium-to-long-term period. This does not get over the need to redeem from one fund to subscribe to another, but at least for the Listed funds of hedge funds there has not been a wall of redemptions to cope with. And if market demand allows there may be tranches of new capital raised for quoted vehicles, to mimic the positive allocation/dilution tactic of open ended funds of funds that have positive flows.

The way that International Asset Management (IAM) has used this capacity to allocate to strategies is shown in the following table.


Strategy Allocation at Quarter End through 2010

	3Q	2Q	1Q	4Q’09
Long/Short Equity	30.7	27.4	38.2	35.4
Macro	18.4	17.7	16.9	17.2
Credit	11.4	9.5	9.2	8.3
Fixed Income Rel Val	10.9	11.4	8.9	8.2
Event Driven	10.3	11.9	9.5	12.1
Multi-Strategy	9.4	10.3	6.9	6.9
Trend Followers / CTAs	5.3	7.6	10.5	9.5
Cash & Receivables	3.5	4.1	-0.2	2.1
Fund of Funds	0.1	0.1	0.1	0.3

Source: International Asset Management Limited


A couple of strategy shifts are clear from this time series. In early 2010 capital was taken from Event Driven funds and allocated to Long/Short Equity. After the first quarter CTAs and Equity managers were used as sources of capital for additions to weightings in Multi-Strategy, Credit and to raise cash.


Rather like the approach to hedge fund investing taken by the Common Fund in the U.S., it seems that IAM used a core/satellite approach to portfolio construction, as the Top 10 holdings in Alternative Investment Strategies Limited has been very stable over the last year. The funds listed at the latest data point are shown below.

The Top 10 Holdings as at 30 September

Cobalt Offshore	5.82%
IAM Trading Fund	5.25
Claren Road Credit	4.87
SCP Ocean	4.86
Capula Global Relative Value	4.72
Arrowgrass International	4.71
WCG Offshore	4.66
York European Opportunities	4.64
Prologue	4.41
Diamondback	4.40

Source: International Asset Management Limited

The funds are the same as at the start of the year with only one exception (highlighted). The Top 10 funds accounted for 48.34% of the capital at the three-quarter stage.

The Top 10 Holdings of Alternative Investment Strategies Limited as at 31st December 2009

Cobalt Offshore	5.5%
SCP Ocean	4.75
IAM Trading Fund	4.74
Plainfield	4.62
York European Opportunities	4.20
Capula Global Relative Value	4.15
WCG Offshore	4.13
Claren Road Credit	4.11
Diamondback	4.06
Prologue	4.01

Source: International Asset Management Limited

There is a continual battle in reality and in marketing pitches about the relative contribution of the top-down (strategy allocation) and bottom-up (manager selection) in funds of hedge funds. The long list of practical difficulties given here shows that specifically since mid-2008 funds of funds have had less degrees of freedom in both of those regards than they had previously enjoyed, and that though there may be disappointment over the returns from funds of hedge funds over that period, there are also generic reasons why they have been as limited as they have been. There are other reasons for the under-performance relative to hedge fund indices and hedge fund averages, but they can be explored at another time.



Footnote: The net asset value performance of Alternative Investment Strategies since inception in December 1996 to 30 September 2010 is 146.84%, equivalent to an annualised rate of 6.75%.

ADDITIONAL: UBP ON STRATEGY ALLOCATION  (from their Outlook for 2011)
Larry Morgenthal, CIO of Alternative Investments at UBP Asset Management, believes that reports of the demise of hedge funds are premature. He is quite positive about the industry and believes hedge funds remain an attractive proposition: they provide diversification benefits and they have strong alpha generation potential.

With respect to the various hedge fund strategies, Larry Morgenthal goes on to say, "Allocating between hedge fund strategies is in some respects like dating - we have had a great relationship with credit, are having an affair with long-short equity and think that emerging markets could be marriage material, while macro is like an old flame - not large in the picture now but one we expect to get back together with in the future."

ADDITIONAL TWO: Send me some examples of funds of hedge funds strategy allocations (letters) and I will post a range of them here.

Hedge Fund Portfolio - "The Nemesis of Any High-Octane Hedge Fund"

I don't put a blogroll on this site, but that does not mean I don't appreciate the high quality output carried on other hedge fund related blogs. A case in point is the "Hedge Fund Portfolio" written by Kris Chikelue, and which you can find at http://hfpf.blogspot.com. Although I haven't read all of them, I have yet to read a posting there I didn't think was good or excellent.  With his kind permission you can read Kris's latest posting below - Simon Kerr.



If you’re an investor focused on high-octane hedge funds, a high quality problem to have is to find that a small, young hedge fund you invested in has outperformed AND ballooned past $1B after a relatively short period. Believe it or not, even in today’s difficult fundraising environment, more than a few funds have achieved this feat (certainly many in credit-related strategies like MBS, Distressed, and Converts). This “problem” is a high-quality one; nevertheless it is a problem if you demand high-octane performance. Why is it a problem? Size. While this answer isn’t a surprise for most folks, what is an area of contention is the exact number at which size becomes a problem. I won’t weigh in on that debate; instead I will discuss other relevant topics.


First, exactly how can size impede performance? The most obvious is it introduces liquidity constraints on what a manager can trade. There is also a less obvious yet “structural” issue: a large fund has a narrower opportunity set of trades that meet a high-octane bogey. Let’s use a quick example: Imagine Warren Buffett has just $100M to invest; he would likely identify a long list of securities that meet his very strict investment criteria. At $40B, it gets substantially shorter. Finally, there are “soft” obstacles created by size: A large fund will likely have a sizable headcount and, as such, non-trivial managerial demands. A large fund will have a LP base that has diverse demands: some focused on performance while others are watching the fund’s correlation. In contrast, a small fund is more likely to have investors that are uniformly focused on high-octane performance (unless of course, you have family/friends that are there for unconditional support). To be clear, I am not against large funds; being big has its benefits including having access to first-class information on macroeconomic trends, etc. These advantages are important for large funds; yet they have not frequently translated into high-octane returns.


Let’s go back to the original problem – what should you do after a young superstar in your portfolio has outperformed and attracted substantial assets? I’ll be honest – my first instinct is to take some (if not all) chips off the table, particular if the size is greater than >$800 and the strategy is in stock picking or credit. However I think it’s important to diligently investigate a few issues before deciding. In particular, I think it’s relevant to first, determine how important high-octane performance is for you. With your superstar, you have achieved a level of comfort that another fund has to surpass. Is it worth leaving this comfort to search for another fund (and potentially fail in finding such a fund)? It also might help to determine the fund’s new bogey. Ideally your superstar has grasped his new context, (i.e. he has a smaller universe of applicable trades) and has made adjustments to his performance target, among other things. Finally, it might help to understand adjustments to the fund’s coverage format. Ideally your superstar has determined a robust format for covering his opportunity set and the appropriate headcount he needs.

All Credit to Moore Capital for This Year's Bounce Back

One of the biggest decisions that hedge fund managers in any investment style have to make is how they respond to significant losses, even if they are relative in nature. So think back to the response last year of Paul Tudor Jones in reconfiguring the capital allocations within his funds. Even though he made good money in 2009, his flagship BVI Global Fund was up 16.51% last year, he rejigged allocations - reducing some systematic strategies, cutting out some emerging market exposure altogether and increasing the classic opportunistic trading element. This was intended to be something of return to its roots for the Global Fund, as Tudor Jones himself managed a bigger proportion of the assets, and macro in total was re-emphasised as it made up 88% of Fund assets from the 3Q of last year. The call was that the markets environment would be more suitable to that big-picture type trading that served Tudor Investment Corporation so well in the 90's, as QE created a time-warp.

This re-think of capital allocations to strategy enabled Tudor to be more nimble in moving capital around in the year since, and since part of the rationale was to enable capital preservation, in that he has broadly succeeded. Tudor’s flagship BVI Fund is up about 3% year to date.

Like systematic CTAs, global macro hedge funds like to ride emergent trends. Macro funds give themselves some scope to argue with markets to a degree, so they will try to buy/sell around turning points of assets based on a macro-economic viewpoint, but the big money money is made from being on trends that persist more so than catching a bottom or top.

Given the switch-back nature of some markets there has been scope to win and lose out of equity exposure. Hard commodities have had both bull and bear phases this year, and softs have become the new game in town for those that didn't know what a bushel or crop report was a year ago. Put these market outcomes together and no wonder that we have a good range of returns within the universe of macro managers. The meaningless average return was over -5% at the end of July for global macro funds.

As ever there is a path dependency in macro returns - how did the managers respond to their changes in P&L; when did they lock in the gains; and to what degree did they argue with markets? -  the responses determined outcomes over the year. One bulge bracket firm that had this challenge this year was Louis Bacon's Moore Capital Management. 

Moore Global Investments, the flagship fund is now up 2.75 per cent for the year as of October 14. The average hedge fund was up 4.8 per cent for the year as of the end of September, according to Hedge Fund Research. Although the gain at Moore Global Investments is modest relative to the hedge fund industry average, it reflects a significant bounceback for the fund from its nadir in May, after the fund was hit by a 9.15 per cent loss in a single month  - the worst ever month for the fund.

A Long Hard  Look

After such a significant loss even as experienced a hand as Louis Bacon, with a 20-year track record with his own firm, will have had to take a hard look at where their tactics went wrong. The scale of the loss was such that risk management disciplines would have been reviewed for appropriateness, and the allocations of capital within the firm and across the markets assessed in the light of the depletion of investors capital.

Having checked through all these inputs, Louis Bacon took the toughest of the range of responses available. The natural thing to do, indeeed the classic response to preserve capital, is to cut the extent of risk taking. Not just trimming the curve risk of the portfolios - the positions which are outliers in risk terms - but hacking into the core of the portfolio to take Value-at-Risk down by, say, a half. The traditional concept of trading is to take down risk whilst re-assessing the fit of the inherent view of the porfolio with the market environment. This allows more dispassionate views to be taken of the state of play, and the traders can then put risk back on with a refreshed palate for risk assumption.

This is not what Moore Capital did. Instead the positions were maintained, risk levels were unaltered and in effect, a confidence was expressed in the original conception of how they were going to make money for the regime prevailing in markets. After the worst single monthly loss experienced in 20 years it was a very tough call to make, because a continuation of the markets moving against the positions taken would be debilitating psychologically for the traders, and investors would be calling in by 'phone for comfort to a much greater degree than in the previous month.

Of course it helps that Moore Capital has a 20-year record of delivering big returns to clients. On average, the fund has returned more than 19 per cent annually. But even such a stellar long-term return profile can be challenged by a YTD figure running at minus 7 per cent when other funds have positive returns.  It is to Louis Bacon's credit that he stayed firm enough of his convictions to hold on to positions and bounce back to the extent he has. Tough call, successful call.


Addition of 28th January 2011: Peer Group Fund Returns for 2010