The End is Nigh for Smaller Funds of Hedge Funds

For some time there have been questions raised about the sustainability of the business models of funds of hedge funds as a category. There is no doubt that they will continue to exist and that there will be winners as well as losers. But the rising tide of assets in the hedge fund industry is not lifting all the FoF boats. Only this week quoted hedge fund company Man Group reported minor growth in its single manager businesses and minor shrinkage in its multi-manager business (see previous article).

There are solid reasons for the changing composition of the shape of the FoFs sector, mostly related to the source of the whole industry's net flows, i.e. American investing institutions. A typical example is the Ohio Public Employees Retirement System which had had allocations with FoFs Prisma Capital and K2 Advisors LLC. In the middle of last year the Ohio System hired specialist hedge fund consultant Cliffwater LLC to provide due diligence and manager recommendations to staff on a non-discretionary basis. The existing fund of hedge funds allocations of the Ohio System will remain in place, but from that point on new allocations to hedge funds would go to single managers with consultant input. 

The new "new thing" for state plans starting from scratch in hedge funds is to do as the State of Wisconsin Investment Board has done and go straight to single manager hedge funds without an interim phase of allocating to FoFs. The Wisconsin Investment Board has taken a decision to invest directly in 15-20 single manager hedge funds.The first allocation was to Capula GRV Fund, followed by MKP Credit Fund, Claren Road Credit Fund, Ascend Wilson Fund and BlueCrest's BlueTrend. The Employees Retirement System of Texas has announced an intention to do the same - direct investment in hedge funds, in their case a 5% allocation amounting to over a billion Dollars phased in over three years.

That is, the marginal flows to the industry are being disintermediated as far as FoFs are concerned, with consultants and advisors taking a bigger role in allocations. This has been great for the business of Albourne Partners and Cliffwater and the like, but what about the funds of hedge fund businesses? How are they getting on?

Fund of Funds In Aggregate

Each year PerTrac, the hedge fund software provider, produces an analysis of the composition and size of the single-manager hedge fund and fund of hedge fund industry. The 2011 study was produced by aggregating investment data from eleven of the world’s largest alternative databases - BarclayCTA, BarclayHedge, CogentHedge, Eurekahedge Hedge Fund, Eurekahedge Fund of Funds, HedgeFund.net, Hedge Fund Research, MondoAlternative, MorningstarHedge, Tass, and TassCTA. The combined number of investments from these eleven databases was nearly 56,000 entries. Duplicate records for single-manager hedge funds, CTAs and FoFs were removed so that a single record per fund was retained in the study to create a holistic industry list.

According to PerTrac's data,  the reported AUM of funds of hedge funds were essentially unchanged  y-o-y (+0.23%) at $447bn at the end of 2011. Given the industry had a negative return of between 5 and 8% at the single manager level last year, that implies some positive flows to FoFs in aggregate. Plus, the total number of funds of funds reporting to databases at the end of 2011 was down 4.8% on 2010 at 3,388. That is there were more assets by value overseen by fewer fund of funds managers. Someone in the fund of funds sector was doing a bit better last year!

The answer to  the question "who?" is the largest funds of funds. FoFs that reported managing in excess of $1 billion were the only group to experience a positive growth in fund numbers from 2010 to 2011 as shown in graphic 1 below.

Graphic 1. Number of FoHFs by AUM Size and Percentage Change from 2010 to 2011*

*Figure excludes515 funds in 2010 and 522 funds in 2011 that did not report AUM, source:PerTrac

Taking a look at the different size categories of funds of funds in turn, there is other evidence that  the very biggest funds of hedge funds are getting bigger. The top 10 FoF management companies (as opposed to individual funds, and as covered in the PerTrac study) added assets in 2011, according to InvestHedge data. The ten largest FoF groups managed $227bn at the end of 2011, an increase of 2.6% over the start of that year, and equivalent to 50.7% of the FoF industry's assets. In addition there were 16 FoF management companies with $10bn of AUM or more at the end of 2010. There were 17 at the end of 2011. So the very large funds of funds groups were slowly growing in aggregate.

The larger funds of hedge fund companies (those managing a billion dollars or more)  have shown stability in assets recently. The InvestHedge Billion Dollar FoF Club managed $622bn of assets between them at the end of 2011, only a tad down on end-2010 levels (-0.7%).

  

The number of FoFs containing assets of $500m-$1bn shrank last year according to the PerTrac study - there were 5.9% fewer of them by the end of 2011 than at the beginning of the year, but that size category is not where the industry squeeze is most evident. More than one-in-seven of the FOFs sized between a quarter and half a billion dollars in AUM closed down last year. It is in this size band that numbers of funds of hedge funds are shrinking most. 

This has been a long time coming - the demise of the smaller fund of hedge funds was prophesised nearly ten years ago. Very few of the mid-tier FoFs benefited from the growth of the hedge fund industry through institutional flows in the period 2003-2008. But that is not the same as saying the circumstances forced smaller FoFs out of business - they just did not grow much.  

In the period since the Credit Crunch institutional investors have completely dominated the capital inflows to the hedge fund industry. And they go big for their suppliers. HNWI investors were a major source of redemptions in the industry in 2008-9, and there have been few-to-no net flows to the industry from HNWIs in the last two years or so. It was the HNWI that was historically prepared to invest through the smaller fund of hedge fund. So in aggregate the smaller FoF experienced, say, a 35% drop in capital because of redemptions and capital losses in 2008, and little or no recovery in assets since. 

So while 47% of the funds of hedge funds managing $1bn or more experienced positive inflows last year, their smaller bretheren have seen the industry tide of capital go out and not come back again. Most modest-sized FoF managers will be running a business with the same level of income as seen in 2004-5 with the cost structure of 2012. That is not sustainable.

Reaction To Conditions - M&A

Hence the corporate activity in the fund of funds sector. For example, Nexar Capital Group was founded to pursue a roll-up strategy amongst funds of funds, and bought Allianz's fund of hedge funds business in 2010 and Caledonia Investment's Ermitage fund of funds business last year. Nexar itself agreed to be bought by UBP at the beginning of March this year. Other FoF takeovers in the last year include William Blair's acquisition of most of Guidance Capital's assets under management; Athena Capital Advisors acquired Stonehorse Capital Management; and Cantor Fitzgerald started its planned expansion into hedge funds with the acquisition of Cadogan Management. Other forms of deal seen in the last year, apart from complete takeover, have been merger and stake sale. Evercore Partners bought a large minority stake in ABS Investment Management, the $3.5 billion fund of hedge funds. The  merger between Gorelick Brothers Capital and Access Fund Management may have been defensive as the combined entity  had only $100m under management when the deal was announced.

A dealer in second-hand hedge fund assets said this week that the wind-down of some fund of hedge fund businesses has given his own business a fillip. "I see another 18 months of funds of funds mergers and acquisitions. It is great for me because it throws up holdings in companies and funds to be disposed of - there are a lot of buyers for these sorts of assets out there," he said.  "But there is a limited window for this activity, and we are in it now." What has he seen as the driver? "The funds of funds business is dying at the lower level."

 

Related articles on this site:
Hedge Fund Takeovers - Martin Currie and Schroders Acquire (June 2010)

Race for FoF Acquisitions Starts with Thames River Capital (April 2010) 

Fund of Hedge Funds Consolidation: The gun has been fired (April 2010) 

Podcast 1 - Hedge Fund M&A (Oct 2009)

Update on Reuters:
New York-based Arden has won a mandate to act as Massachusetts' so-called transition manager as the $50 billion state pension fund shifts money away from hedge funds of funds directly into a select number of hedge funds. (link, 10th May 2012)

Out of the Box - Graphic of the Day – Why Hedge Funds Will Continue to Grow

One of the advantages of looking at the activities of institutional investors is that their behaviour follows decision-making which stands for years at a time. The Investment Committee of a pension plan changes the strategic asset allocation say every 5 or more years. There may be a decision made to have 25% of plan assets in domestic equities with a tactical band of 20-30%, which allows for variation on an annual basis away from the central tendency of 25%. But for most of the time over six or seven years the plan assets will be around 25% in domestic equities from that point onwards, after a period of implementation.

The implementation of the change in asset mix will often take place over a year or more as mandates are changed, contractual notice is given to the money managers with the mandates, and the underlying assets are bought and sold. Allocations to domestic equity have tended to shrink over recent years, so the process might involve a plan sponsor giving six month notice to a Trust Bank that their mandate will halve in size, and then, in six months time the bank will liquidate a portion of their large cap mutual fund and transfer the cash to the pension plan's administrators.

The reverse process is expected to happen for hedge fund allocations over the next few years if the survey of investment consultants by Casey Quirk and eVestment Alliance is to be believed. The survey*, conducted in Dec 2010 and January 2011, asked investment consultants to forecast investment preferences and buying behaviour among North American institutional investors during 2011. One of the key trends that Casey Quirk identified was "The increasing role of heretofore "alternative" investments—hedge funds, private equity and real estate—which are emerging as the centerpiece of active asset management moving forward."

This trend in the use of alternatives reflect the new frameworks with which institutional investors and their consultants are building portfolios, with exposure defined less by product packaging or home bias, and more by the specific contributions investments make toward overall objectives. The framework is part of the new emerging paradigm for asset allocation amongst investing institutions in North America, shown in the Graphic of the Day below, and which will reinforce hedge fund growth.



Graphic of the Day  - Hedge Funds Break out of The Box
The Emerging Institutional Investment Framework

Source: Casey Quirk (Note Not to Scale)

The key point in this is that the way institutional investors see how they can use hedge funds is changing. It was hedge funds as part of an alternatives category - in a segmented ghetto by risk/return. This is changing towards hedge funds as sources of alpha within broader asset categories.  Hedge funds are breaking out of the box!

Putting this framework, and the consequent asset shifts, into practise over coming years will not benefit all asset management businesses. Amongst the attributes of the winning asset management firms, according to Casey Quirk and eVestment Alliance, will be

• Managers offering non-correlated investments.
  
• Firms offering both "traditional" and "alternative" investments will stand the best chance of providing institutional clients with a total portfolio solution.
  
• Product development and innovation will remain critical competitive differentiators.
  

The survey collators go on to turn their gathered insights into a product opportunity map – showing where demand for product will be strongest.



2011 Product Opportunity Map

Source: Casey Quirk, eVestment Alliance

It is important to understand that the product opportunity map compares expected search activity for the upcoming year relative to forecast from the previous year. What is clear is that consultants continue to believe that longer-term trends in search activity favour hedge funds, funds of hedge funds, and non-U.S. equities. However, there is a perceived shift in the demand for funds of hedge funds:

"Consultants focused on larger investors, as well as those focused on non-profit funds, expect more searches for direct investments in hedge funds than they did in 2010. This reflects three realities.

• First, most North American institutional investors selected a core fund of hedge funds in recent years, and few are yet convinced they need a change.
  
• Second, and more importantly, larger investors now seek more specialized FOHF strategies in place of, or in addition to, a diversified FOHF mandate. This challenges many FOHF vendors who do not offer a focused product.
  
• Finally, larger institutional investors—particularly well-funded non-profit funds—still seek to avoid higher fees and pooled vehicles offered by FOHFs.
  

FOHFs remain core investment vehicles among smaller pension plans who lack resources to select or access direct hedge fund investments. Additionally, investors increasingly are using outsourcing firms to provide exposure to a portfolio of hedge funds."

 
The trends identified by the survey authors will likely persist for some years, as allocations in pension plans change slowly, and allocations to hedge funds are going up – doubling in some forecasts. So hedge fund capital flows should be positive at the industry level on a multi-year outlook. There is still a role for funds of hedge funds serving American institutions, and indeed there should be growth in assets this year and next for funds of hedge funds as a whole. But to benefit from those allocations funds of hedge fund businesses are going to have to be in the top quintile of performance ranking over 5 years, and in 2008 specifically, or have a very good specialised product (by geography or investment strategy) to offer.





*This year, 55 investment consultants, representing an aggregate $10.4 trillion of assets under advisement participated in the survey.

London Losing its Allure as a Trading Centre if Guggenheim Partners' Decision Making is Indicative

The politicians don't believe it when the British Bankers Association or AIMA say that tax-paying talent will leave the country, or when supply-siders say that the percentage tax take is hurting growth from entrepreneurialism. But there is evidence. UK based firms (including large cap names) have moved their tax domicile to Switzerland. Hedge fund firms founded and grown in London have opened offices elsewhere in Europe to avoid increasingly high personal tax, and to take some corporate revenue out of the UK. Several high profile leaders of hedge fund firms have left London. 

These are examples of indiginous tax paying people and entities moving outside the scope of the UK tax authorities, but there are also decisions being made not to come into the UK tax environment. London is the long-standing hub for global financial activity in the European time zone. There is no doubting London's historic position and ranking. Their is a complete range of markets in the UK's capital from capital markets to insurance and shipping to commodities and foreign exchange. So the talent pool is broad and deep, and the service support infrastructure is excellent for any sector. It is possible to find lawyers and outsourced I.T. firms and back office capability across the spectrum of tasks in London. London is expensive, particularly for real estate, and the physical infrastructure is strained, but it mostly works and everything necessary to start a business is readily available. 

The positive factors for London may not be enough any more. Guggenheim Partners LLC is a privately held global financial services firm with AUM of $85bn and offices in nine countries. It is setting up a proprietary trading platform to take advantage of the decline in bank trading with proprietary capital. Outside the United States Guggenheim Partners has offices in Dubai, Dublin, Geneva, Hong Kong, London, Mumbai and Singapore. The new venture, Guggenheim Global Trading (GGT), will have an Asian office (place to be decided), and it was a shock to read today that the European office for GGT will be in Geneva.  

These kind of decisions, to not come to London rather than actively leave the UK tax and regulatory burdens behind, are not headline grabbing and not something that can be taken as positive proof of the case. But there is collateral evidence that London is losing its allure as a trading centre.

      


Addition of 12th April 2012
It is unlikely to be related to recent tax changes in the UK Budget, but another hedge fund manager has left London for a lower tax regime. Changes on the FSA register show that the senior investment and operations staff of Tyrus Capital are no longer under the UK regulator's jurisdiction. Tyrus Capital was set up by Tony Chedraoui, the well-regarded former head of Deephaven's European investments, and is one of Europe's top 50 hedge fund firms by size.  Reports suggest that the management of the $2.7bn of assets run on an event-driven basis has moved to Monaco. 

RELATED POSTINGS: 
Hedge Fund Tax Drain (June 2010)
Mixed Messages on Health of HF Business (Nov 2010)

A Shift in Risk Appetite?

I believe in Marshallian K – so excess money creation goes into financial assets if the real economy doesn't need it. This is what is going on now in American financial markets. We are seeing narrow money creation but not broad money growth. The St. Louis Federal Reserve is showing that the current money multiplier is less than 0.9, that is, printed money is not being multiplied by the banks to the typical extent (2.0-3.0).

What is interesting so far in 2011 is the change in where that money is going. In my last article I made a logical case for flows into stocks rather than bonds based on valuation. I doubted that the flows of mutual funds would reflect that logic, but I have been proved wrong by the data releases* of the Investment Company Institute since. Here is a table showing mutual fund flows on two time frames – the top part of the table is monthly data and the bottom part is weekly data for mutual fund flows this year.

U.S. Mutual Fund Flows

Source: Investment Company Institute

The Table shows some interesting shifts. The pattern last year was for positive bond flows and negative equity flows. Whenever equity flows went net positive last year it tended to be because positive flows to emerging market mutual funds outweighed outflows from domestic equity mutual funds. So for three quarters of the year in 2010 there was a large negative bias towards mutual funds investing in American stocks.

Towards the end of the year holders of mutual funds caught on to the increasing fragility of the finances of municipalities in the States and there were net redemptions from muni bond funds. The outflows from muni bond funds have continued this year. There has been a minor pick up in flows into taxable bond funds this year, and it looks like straight switching within bond mutual funds to safer havens. Net flows across total bond funds are a small positive – and really quite small compared to last year's positive net flows. So the key word in the bond mutual fund story in 2011 is small.

The key words in equity mutual funds investing in 2011 to date are growing and domestic. After some minor end year tidying up, the U.S. mutual fund investor has continued to buy overseas equity focused equity mutual funds as before, but the new new thing is the emergence of significant buying of domestic equity mutual funds. The market for mutual funds in the United States is not like in some European territories where the largest investor in a UCITS funds can be the sponsoring insurer or bank. In the United States, apart from money market funds where institutions own around a third of the assets, mutual funds are held by individual investors. Individuals own 89% of bond funds and 91% of equity funds. And the man in the street in the US has been buying domestic equity mutual funds to an extent not seen in at least four years.

Whilst individual investors are recent converts to the attractiveness of equities, institutional investors crossed that line some time ago and at this point are expressing fervour for the concept.  The Merrill Lynch Fund Manager Survey for February (survey period 4th-10th February) contains extreme conviction on the part of institutions. The Survey overview states "The February FMS is one of the most bullish in years. Institutions have record equity and commodity overweights, very low cash levels and the strongest risk appetite since Jan‘06." It also says that "Hedge fund net exposure rose to 39%, highest since July’07. Cash balances fell from 3.7% to 3.5%, triggering our FMS cash trading rule equity sell signal." 

A mirror of the rated attractiveness of equities is an aversion to bonds in the Survey - nominal bond allocations were very low; the lowest since April of 2006 and near record lows. This is the corollary of the view on inflation (and implicitly commodities) that expectations for global inflation were the highest since June of 2004.  There is a consistency of world view too in the consensus for economic growth. Just 13% of respondents expect the global economy to weaken in the next 12 months. 


Parenthetically it is interesting that professional money managers express the same sentiment now that mutual fund flows have expressed this year  - a strong bias towards the equity markets of the developed world rather than emerging market equities. The expressed appetite for U.S. equities is the second highest ever in the Fund Manager Survey. 

The mental positioning, and Dollar positioning, of investors in equity markets combined with expressed survey views on growth and inflation give a clear road map for contrarian investors. For example I would suggest that the views of Hugh Hendry put across here (Hugh Hendry's views) were for something other than where the consensus has got to. Equity markets are overbought, and extended to the upside. However, overbought conditions can persist and there is little internal inconsistency in the market action for a tape reader to find. One of the market observers I respect puts it that the broad market "continues to demonstrate bullish resiliency".

*Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals in the weekly data. Data for previous weeks reflect revisions due to data adjustments, reclassifications, and changes in the number of funds reporting.

Stocks over Bonds for 2011

Just over a year ago I featured as my Chart of the Day the mutual fund flows for U.S. bond funds and equity funds. At that point I summarised the attitudes of retail investors as "keep me out of Wall Street, I want the return of my cash, and I can only trust Uncle Sam with my money at the moment, thank you." The updated chart (Fig 1 below) shows that 2010 had more of the same, that is, huge inflows to bond funds and net outflows from equity mutual funds.

                                  Fig 1. Monthly Net New Cash Flows to U.S. Mutual Funds by Asset Class

As at the previous point of review (December 2009) the logical case now is very strong for a preference for equities over bonds based on valuation. Looking at the P/E ratio of American shares in isolation the case is not particularly convincing as Figure 2 shows. The S&P 500 trades at 13.6x forward four quarter earnings – this level is neither cheap nor dear in an absolute sense. But the context is very constructive: inflation is low at the consumer level; interest rates, whether real or absolute, are low and will remain so for some time; and earnings growth may be a positive surprise in 2011 as expectations are low.

                                    Fig 2. P/E Ratio of U.S. Stocks based on 12m Forward Estimates

The earnings surprise at the market level could come because expectations are low and the American corporate sector is well set in several regards. First the operating leverage is good after staying lean and mean, and hiring has only recently begun. Secondly the level of the Dollar makes the U.S. internationally competitive (and exports accounted for 1.1 percentage points of the 3.2% increase in real GDP in 2010). Thirdly, and this will be very important this year, unlike the consumer and the government, the corporate sector has a good balance sheet in aggregate. I place an emphasis on the balance sheet because there is good scope for capital spending as well as hiring, and, most importantly for investor psychology, conditions are good for a lot more mergers and acquisition activity this year.

However, even if the earnings growth for 2011 only turns out to be in line with the current consensus, a strong case can be made for a preference for stocks over bonds on the basis of relative valuation. This is illustrated in Figure 3.

                                                      Fig 3. Yield Comparison for Stocks v Bonds 
                                               (Earnings Yield on S&P500 v Real Yield on 10 Year Treasuries)

The widening gap between the real yield on the highest quality bonds and the earnings yield on American blue-chip stocks (the inversion of the P/E ratio) reflects the neglect by investors of stocks relative to bonds. The risk premium for stocks now is higher than it has been for more than 80% of the last decade, and at nearly 3.9% is 1.6% higher than the average over the last 10 years. The logical case is very strong - on the basis of valuation investors should switch out of bonds and into stocks.

On the basis of investor psychology investors won't switch. The aversion of the man in the street to anything to do with Wall Street will continue. ETFs have continued to grow whilst equity mutual funds remain out of favour suggesting that Americans don't want to give money to stock-selecting money managers. Individual investors are dis-engaged with markets to an extent rarely seen before. In short, America has fallen out of love with stocks.

Chart of the Day – Funds of Hedge Funds Flat-line in Asset Flows in North America

My Chart of the Day comes from The Eurekahedge Report which looks at 2010 hedge asset flows and investment returns. The chart compares the monthly asset flows to North American hedge funds and funds of hedge funds since the start of 2008. The contrast in flows in the recovery phase is very striking: single manager hedge funds net redemptions stopped four months earlier than net redemptions to funds of funds; and there have been net subscriptions to single manager funds in most months since April 2009, and net subscriptions to funds of funds have flat-lined over the same period.

Monthly asset flows to North American hedge funds vs North American funds of hedge funds

The North American component of the hedge fund story is very constructive at the single manager level. Not only have NAVS recovered well since the Credit Crunch but in doing so last year the Eurekahedge North American Hedge Fund Index was ahead of the S&P 500 until the last month of the year. Over the last three years North American single manager hedge funds produced annualised returns of just over 7 1/2 %, versus 5 1/2 % for the Global Eurekahedge Index. Indeed American hedge funds produced better returns than funds managed from other developed regions in each of the last three years. So American single manager hedge funds have done better in performance terms than those in other regions.

The three year annualised returns of North American funds of funds are negative according to Eurekahedge, just as the MSCI North America had negative returns over the same period (to end November 2010). Further the 3-year annualised standard deviation of returns of funds of funds is the same as that for single manager hedge funds. So that on a three year basis funds of funds have not delivered absolute returns, and the volatility of returns over that period has not been lower than single manager funds (which historically had previously always been the case). So the return-for-risk argument is weak for funds of funds relative to single manager funds in North America.

As a source of capital for the whole hedge fund industry American investing institutions have become dominant. Survey evidence shows some recovery of appetite amongst institutional investors in hedge funds – questions on investment intentions produce a net positive balance from respondents on a consistent basis since the end of 2009, with US investors more positive than investors in other regions. But the "intentions" have turned into net positive flows only for single manager hedge funds in aggregate (though around 30% of funds of hedge funds report net inflows in the second half of last year). There several plausible explanations for the contrast in flows depicted in the chart.

The gap in performance between single manager hedge funds and funds of funds may have got too wide for investing institutions to bear. Historically there were a few years, over the course of decades, in which multi-manager hedge funds out-performed single manager hedge funds. So in those years there was a (relative) pay-off for strategy allocation and avoiding the under-performers and blow-ups – which is for what investors pay funds of funds. It was commercially crucial that funds of funds did that in the key year of 2008, and they didn't, as a whole. It is now many years since funds of funds in aggregate even got near single manager returns.

Given the return records for single manager and multi-manager hedge funds the additional layer of fees in the latter cannot be justified in the minds of institutional investors. Fund of funds' management fees have been falling for more than a decade, reflecting the balance of supply and demand over that time. In contrast single manager fees have held up much better, with the exception of the immediate post Credit Crunch period. Indeed Eurekahedge record that the average management fees for single manager start-ups in 2010 was higher than for 2009's start-ups.

A third plausible explanation for the difference in asset flows to the two hedge fund sectors in North America is the increased accumulated knowledge and experience of the investing institutions there. The model seems to have shifted. For most of the last decade funds of funds were the mechanism for investing institutions to allocate to hedge funds, but a knowledge transfer has taken place. The senior staff at institutions now have a familiarity with hedge fund concepts and can interpret hedge fund data readily. Whilst funds of funds companies can demonstrate advantages in due diligence process, depth of understanding of investment strategies, and risk management and portfolio construction of funds of funds compared to the dedicated resources available to most investing institutions, the latter can now comfortably find these capabilities on an out-sourced basis. External advisors for strategic decision making and tactical monitoring of hedge funds have usurped the role of the dedicated funds of funds. The same tasks are being carried out, but maybe by a combination of a very small dedicated in-house team with input from an external advisor on a fixed fee basis. A number of funds of funds companies may be retained by investing institutions to give a plurality of opinion and form of analysis, for benchmarking, but experienced investing institutions may not feel the need to pay the old fee scales. Plus the marginal increases in allocations to hedge funds by pension plans is increasingly going to direct investing in single manager funds.

In each of these regards the North American part of the industry is in the vanguard. Most of the assets of the hedge fund industry are managed by managers in the United States. For a U.S. investor to visit (and allocate to) an American hedge fund manager is a lot easier than for a Japanese investing institution – hence there will always be a place for funds of funds for Japanese investors in hedge funds. American investing institutions are the largest contributors of capital to the hedge fund industry at the moment, and will be for some time. Given all the above - relative performance, regional strengths, fee structures etcetera - plus the fact that large, branded hedge fund groups are highly likely to be American, is it any wonder that 85% of the global flows into hedge funds are going into American single manager hedge funds? 





To see more postings on multi-manager hedge funds click on "funds of hedge funds" in the LABELS gadget on the lhs of the page.
 

Update on York Capital

In writing about the China Investment Corporation (http://simonkerrhfblog.blogspot.com/2010/07/china-investment-corporationthe-next_07.html I wrote about York Capital Managment being the latest hedge fund to receive their capital. The article has been augmented twice, one of the changes being made today, with additional information on York Capital. The latest addition strongly reinforces the CIC decision.

The Year-to-Date return for the flagship York Investment Fund was 2.77% through the end of September.

The Hedge Fund Registration Act Ensnares Non-US Funds

Up to now overseas-based investment advisors to offshore hedge funds did not have to register with the SEC. It used to be that the American system of fund regulation was based on regulating the products that were sold, rather than the firms carrying out the business. The old form of regulation was about mitigating mis-selling of products to individual investors. So a form of investment that did not allow unqualified investors in a fund regulated in another country (offshore hedge funds) was not covered by domestic US regulation. John Doe of Main Street was not allowed into hedge funds, and the funds were not allowed to be marketed to retail investors in the United States. So there was no need for protection of the little man.

Today, offshore hedge funds are still not allowed to be marketed to retail investors in the United States, and unqualified investors still may not buy hedge funds. However, first there was the enforced registration of all (domestic) hedge fund advisory firms, and now the the US legislators have gone a step further by seeking to regulate non-US entities with hedge fund clients in the United States.

In the first week of this month the US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Bill"), which contains The Private Fund Investment Advisers Registration Act of 2010 (the "Act"). The Act requires all private fund investment advisors to register with the SEC, whether they are US-based or overseas-based.

It is a curiosity, at the least, that the SEC has this role. Speaking to a House Financial Services subcommittee this week, SEC Chairman Mary Schapiro said “it’s really not clear” what (systemic) risk, if any, the hedge fund industry presents. Even if she is not clear, I am: it is quite feasible, given the scale and activity scope of hedge funds that in combination hedge funds can have systemic impacts. In the UK this addressed through the FSA monitoring exposures of the largest hedge fund groups operating in its jurisdiction. The hedge fund industry assets are not managed by many groups, so this focus on the bigger groups is very sensible and practically readily achievable. The SEC should follow suit and limit the number of hedge fund groups it (or another regulator if it doesn't want or see the need for such a responsibility) tracks. However that is not enacted by the new US hedge fund legislation, and the scope is broad, too broad.

That written, there is, I should point out, a Foreign Private Adviser Exemption, but the criteria are set at a level that all non-US hedge fund groups would have a business aspiration to exceed. The Act provides a limited exemption from registration for a "foreign private adviser", which is defined as an investment adviser that: (i) has no place of business in the U.S.; (ii) has in total fewer than 15 clients in the U.S. and investors in the U.S. in private funds that it advises; (iii) has less than $25 million (or such higher amount to be determined by the SEC) in assets under management attributable to clients in the U.S. and investors in the U.S. in private funds that it advises; and (iv) does not hold itself out to the public in the U.S. as an investment adviser, or advise an investment company registered under the Investment Company Act of 1940, as amended (the "Investment Company Act") or a business development company. 

It might take a few marketing trips to bring in 15 US clients to a European or Asian hedge fund, but it is certainly do-able for a Billion Dollar Club member (or a fund with a track record of more than two years) to have that number already. And $25m of US-sourced capital as a threshold will exclude few commercially-sized hedge funds

And what is a "business development company"? Does this include an offshore marketing company that an overseas hedge fund group might have in place to mitigate tax payments within the hedge fund management company?

Also, who is this regulation for, who is it protecting? The likes of CalPERS and other giant state pension plans, sophisticated family offices like the Rockerfeller Foundation, the Endowments of Harvard and Yale, all invest in hedge funds, but given they are qualified investors and large in their own right shouldn't they operate under a "buyer beware" philosophy?  To repeat, the man in the street in the United States cannot buy a domestic hedge fund, still less an offshore hedge fund. 

A few consequences of the implementation of this Advisers Registration Act are: that the costs of being in the hedge fund business have gone up again, reinforcing the tendency for the industry to concentrate; non-US funds will find it more difficult to obtain seed capital from US-based incubators and early stage backers; the Gucci tasseled loafers/Bass Weejun penny loafers division within the hedge fund industry will be reinforced. Across the Atlantic we are being forced apart from our American cousins in hedge funds, by the EU Commission and the US Congress.



Addition of 22nd July: a comment from Andrew Shrimpton, Member at Kinetic Partners: “The expanded authority of the SEC will have a far reaching effect on the alternative investment industry, both in the US and in Europe. Not only will asset managers who handle significant assets in the US now be required to register, they will also be faced with more onerous compliance and monitoring obligations. Therefore, managers in the UK and Europe need to consider whether they are obliged to register with the SEC and respond appropriately to the heightened scrutiny and new demands.”

According to Kinetic Partners SEC registration will have the following bring with it the following requirements of managers: 

•  comply with applicable SEC filings such as the Form ADV I, Part II and accompanying Schedule F;

• develop a compliance manual, code of ethics, employee investment policy (personal account dealing policy) and a compliance monitoring programme that meet with SEC requirements and industry best practices;

• undertake an annual review and testing of the compliance programme; and

• undertake annual compliance training.

Where applicable, firms should also consider their global group structure and how the Bill may affect non US managers within their group. For example, many managers operating in the UK also have an offshore, non US, manager which delegates to the UK. 

This posting used information made publicly available by law firm Seward & Kissel LLP and a press release from Kinetic Partners.

After An Unusual Month

Listening to Hugh Willis of BlueBay Asset Management on a conference call on Monday I was struck that twice he mentioned that May was a very unusual month in markets. Indeed it was; and in equity markets it resulted in losses of 8% (SPX) to 10% (MSCI Emerging Markets). Willis noted that such monthly losses had occurred only 5 or 6 times in his career.



So how infrequent are such losses? To find out I looked at the S&P over the last three decades. There were 34 months for which the monthly loss was 5% or greater. Below is table showing all these losing months.

Monthly Losses of 5% or More on the S&P500 Index from 1980 and Onwards

(Note that the great bull market started in August 1982)

A few observations:


• There is increased clustering through time and far more observations of big losses in the neutral decade of the Noughties compared to the bull decades of the ‘80s and ‘90s.


• The frequency of subsequent 1 month positive returns was lower post-2000 than in the great bull market.


• For longer holding periods after a fall of 5% or more in stocks in a single month the outcomes have been distinctly worse in the Noughties than in the bull market decades. Holding stocks for a month or up to a couple of quarters after a 5% fall in stocks would tend to make you money in the ‘80s and ‘90s and lose you money in the last ten years or so.


• As a mechanistic strategy, buying for a month after a 5% fall in markets would have cost you money in the Noughties.


• As a mechanistic strategy, buying stocks after a monthly 5% fall in markets and holding for a quarter or two quarters would have cost you money in the Noughties, and made a ton of money in the ‘80s and ‘90s.

Chart of The Week - Increasing Significance of Chinese Growth

I haven’t posted a chart of the week for some months. It has to be very telling; it has to be important.

This graphic qualifies on both counts:

Monthly change since January in real retail sales (in January 2007, US$ bn)

Source: Goldman Sachs Global ECS Research


What does it show? Over the period of the recent downturn in global economies, the loss of US real retail sales through recession was about the same in absolute Dollars as the gain in retail sales in absolute Dollars in China.



If ever there was a way of capturing the increased global significance of Chinese economic growth this is it. Chinese growth is so large that it rivals in absolute dollars the significance of the United States in changes in marginal contributions to real global growth, at least as far as the consumer is concerned.


Of course we already had on board that China’s growth in commodity consumption can overwhelm the significance of that of the rest of the world. But it is not just through industrialisation that China is making it’s impact.