Hedge Funds: The Alternative Mainstream?

Expat Briefing Editorial Team, 10 June, 2014

Although now a well-established feature of the global investment landscape, the hedge fund industry still generates a great deal of controversy; often perceived by politicians, the public and the popular media as the 'outlaws' of the investment world, they have been blamed for causing one financial crisis after another. Critics contend that hedge fund returns aren't all they're cracked up to be, and that an investor would have been better off sticking to conventional "long-only" equity investment over the last few years. Yet the industry continues to grow, and hedge fund assets under management are poised to break new records this year. This feature therefore attempts to shed light on the little-known world of hedge funds.

What is a Hedge Fund?

The first fund to be dubbed a 'hedge' fund was the A.W. Jones Group in 1949. The fund derived its nickname from its strategy of taking long and short positions in the stock of companies (a strategy which continues to be central to many hedge fund managers, and which will be explained in greater detail below). This meant that it could hedge against macro-economic factors, while at the same time benefiting from the individual performance of specific companies.

Hedge funds offer the potential for attractive returns, and are a lot more nimble than traditional mutual funds or other investment structures, which makes them an especially suitable option in volatile or falling markets. Until recently, they required high minimum investments (many still do), and were only allowed to accept 'accredited', or 'qualified' investors.

It has only been in the last 20 years or so that the industry has really taken off. According to estimates, in 1990 there were as few as 300 hedge funds in existence. However, by the year 2000, this number had multiplied to over 3,000 funds controlling around USD400 billion. By 2005, hedge fund assets had more than doubled, with estimates placing the size of the industry at more than 8,000 active hedge funds. The turbulent, uncharted waters of 2007-2009 shook out some of the smaller and weaker hedge funds – but it is estimated that there are about 10,000 hedge funds active in 2014.

Investment Strategies

Broadly speaking, hedge fund managers (or general partners, as they are more usually known), unlike mutual fund managers, are able to change the style or strategy used by the fund without prior investor consent, and the spectrum of styles available is enormous. The following (by no means exhaustive) list outlines some of the main strategies utilised by hedge fund managers, and the way in which each hopes to affect the performance of the fund:

There are many more strategies open to hedge fund managers, of course, and they are able to chop and change as market conditions dictate.

Hedge fund managers are usually highly skilled and experienced, as the system and rates of compensation for successful managers tend to be very attractive. General partners are compensated in a very different way to mutual fund managers, as the majority of their fee is based on how well the fund performs. Generally, their fee is something like 1-2% of the total assets of the fund, plus a performance or incentive based fee. Some funds also stipulate a 'watermark' or 'hurdle' which the fund must outperform in order for the manager to profit. Hedge fund managers are also usually more heavily invested in the funds they run themselves, and so have more of a vested interest in ensuring that the fund performs exceptionally. Mutual fund managers usually base their fees on the volume of assets managed, regardless of performance.

Hedge Fund Regulation

Until quite recently, describing hedge funds as unregulated would have been a fairly accurate statement. For a long time, it didn't seem to matter that hedge funds weren't regulated, at least not to the extent of conventional investment funds, which are entrusted with managing trillions of dollars of ordinary people's savings, investments and pensions. Twenty or more years ago, hedge funds were more akin to private investment clubs for high-net-worth individuals (HNWIs) with wealth of at least USD1m and not on the radars of most regulators who were probably happy to stand by and let a relatively small number of multi-millionaires risk their money in such a way.

Things have changed rapidly on the regulatory front for hedge funds however, broadly for three reasons: a) as the hedge fund universe has become more crowded and competitive in the last decade or so, the industry has broadened its marketing horizons to include potential clients who, although relatively well-off, aren't in the same league as the usual HNWI hedge fund client; b) it has become almost standard that financial institutions and pension funds will place some of their assets with hedge funds, leading to greater demands for transparency; and c) the financial crisis was seen by governments the world over as a failure of regulation, and the free-wheeling and increasingly influential hedge funds were said to have played a major role in helping to de-stabilize the financial systems of the United States, Europe and other parts of the world.

So while it remains the case that most retail investors do not have the means or the risk appetite to invest in hedge funds, alternative investments, of which hedge funds remain the largest segment, are being paid much closer attention by regulators in the major investment markets, notably the United States and the European Union, than they were just a few years ago.

In the United States, the Dodd Frank law, widely considered as the largest overhaul of US financial regulation since the 1930s, means hedge funds must register with the Securities and Exchange Commission for the first time.

In the EU, the Alternative Investment Fund Managers Directive (usually shortened to AIFMD) imposes registration, reporting and initial capital requirements on alternative investment funds, in an effort to enhance fund industry safeguards. Under the directive, a European AIFM with a portfolio of more than EUR100m (USD140m) will be required to obtain an authorization from national authorities to operate. This permit will entitle them to market funds throughout the EU single market.

Parts of the hedge fund industry have actually welcomed some of the steps to make the industry more transparent and accountable because clients now have a lot more confidence about investing in hedge funds. The flip side though is that regulatory costs for hedge funds have soared, which could mean that many smaller, more niche types of hedge funds are being squeezed out of the market. Indeed, a September 2013 report by KPMG concluded that the industry had already spent around USD3bn on compliance requirements since 2008, equating approximately to 10% of their annual operating costs. This report suggested, based on a survey of fund managers, that the average cost of these new rules for small hedge funds was USD700,000, rising to USD6m for a mid-sized fund and USD14m for a large fund.

Hedge Fund Performance

This is one of the most controversial aspects of the hedge fund industry. The belief is still widely held that the objective of a hedge fund is to beat the performance of the major equity markets whether these markets are rising or falling. But the reality isn't quite as simple as that.

Since the financial crisis, hedge funds have often been criticised for failing to live up to expectations in terms of returns. The year 2013 was a prime example. Although hedge funds produced fairly healthy returns of just over 11% according to the 2014 Preqin Global Hedge Fund Report, this benchmark still lagged behind the some of the leading global equity indices. However, the industry defends its recent performance track record by countering that hedge fund investment is not all about "absolute returns", but about producing consistent returns in an unpredictable and often volatile investment universe. And over the long-term, the industry contends that the benefits of hedge fund investment are undeniable. According to the Alternative Investment Managers Association (AIMA), a hypothetical USD100 investment in the S&P 500 Total Return Index in the year 2000 was worth USD121 by August 2012. However, a USD100 in the HFRI Fund Weighted Hedge Fund Index stood at USD201 at the end of the same period.

As Amy Benstead, Head of Hedge Fund Products at Preqin, noted: "Much of the recent criticism faced by hedge funds has focused on hedge fund benchmarks being outperformed by leading equity indices, such as the S&P 500. In 2013, the Preqin Hedge Fund Index, a benchmark of average hedge fund returns, again lagged the S&P 500; however, despite this, investors are satisfied with the performance of hedge funds in 2013. Investors are now looking beyond absolute returns; they are also looking for funds to produce strong risk-adjusted returns with low volatility on a consistent basis. The performance of hedge funds over 2012 and 2013 has certainly delivered this."

AIMA says that it is wrong to compare hedge fund returns with equity benchmarks which it likens to an "apples and oranges" comparison. In an attempt to better educate investors on measuring hedge fund performance, AIMA recently published a guide which suggests that the following five steps should be used to increase understanding in this area:

Jack Inglis, AIMA's CEO, said: "It is striking that recent surveys have highlighted high levels of investor satisfaction in hedge funds at a time when many commentators have claimed that the industry is being out-performed by the 'market'. The reason for this is that investors are not allocating to hedge funds to beat the S&P 500 but to allow them to meet their asset-liability management objectives in terms of risk-adjusted returns, diversification, lower correlations, lower volatility and downside protection. Put simply, many investors value getting steadier returns with lower volatility over higher returns with much greater volatility."

Hedge Funds: Small, Medium or Large?

Of course, with the number of hedge funds having reached the double-digit thousand mark, the benchmarks of hedge fund performance disguise some wide variations in individual hedge fund returns, and they do not necessarily tell you how many hedge funds were in the red in a given time period, or indeed how many went bust. On the other hand, some hedge funds may have considerably outperformed the benchmark, and annual returns exceeding 20% are not uncommon.

The perception is that the large hedge funds, i.e. those with assets under management of USD1bn or more, are the "safest" bets for investors, as they are much more able to absorb losses, they have a reputation and a track record, and because of their financial clout are able to recruit and retain the best investment expertise. It therefore follows that the failure rate is going to be higher among smaller hedge funds. This may well be true, but again the picture is worthy of closer inspection.

According to Preqin, it was actually mid-sized hedge funds that were the best performers in 2013 compared to other fund sizes. Mid-sized hedge funds with assets under management (AUM) of USD100-499m and USD500-999m posted 12-month average returns over 2013 of 13.79% and 13.71% respectively, beating large funds (AUM of USD1-5bn) and small funds (AUM of less than USD100m), which posted 12.08% and 11.45% respectively.

Preqin's research shows that a lower proportion of mid-sized hedge funds saw losses in 2013 compared to large and small hedge funds. Among mid-sized hedge funds with USD100-499m and USD500-999m in AUM, only 12% and 8% of these funds respectively saw losses in terms of cumulative returns over the year.

Over one quarter (27%) of mid-sized hedge funds with AUM of USD100-499m posted returns in excess of 20% in 2013, higher than the proportion of larger hedge funds (AUM of USD1-5bn) that achieved this (19%).

In something of a contradiction to Preqin's earlier findings, almost half (48%) of hedge fund investors surveyed stated that returns are a key factor when looking at a fund manager and in particular 21% of investors surveyed by Preqin stated the potential for better returns from smaller managers is a key reason for preferring funds with less than USD1bn in assets.

Yet, funds in the group USD1-5bn are the most sought, with 57% of institutional investors seeking funds of that size in 2014, followed by 52% and 47% of investors looking at funds between USD100-499m and USD500-999m respectively.

"Much of the capital inflow into the hedge fund industry over the past few years has been to just the largest funds, with investors looking for the proven track record and experienced investment teams that these larger hedge fund managers often provide," observed Amy Bensted. "However, our analysis shows that investors are looking at a variety of fund sizes for investment in 2014 and different investors have different return objectives and risk appetite from their hedge fund investments. Performance remains a key factor in the selection process and Preqin's latest research demonstrates that it is not always the largest funds that are providing the best performance in terms of risk and return."

"As funds become larger, the distribution of returns among the best performing funds moves towards the lower end of the return spectrum," Benstead continues. "Funds in the midsized groups i.e. those from USD100-499m or from USD500-999m, have shown the highest mean and median returns in 2013. The size range USD500-999m had the lowest proportion of funds suffering a loss in 2013, and the longer term return and volatility characteristics of these funds are similar to funds with assets of more than USD1bn. Therefore, those investors which are looking to move away from investing in just the largest funds, but without taking on too much volatility, may choose to look towards investing in those funds with more than USD500m in assets."

Hedge Funds Vs ETFs

An interesting piece of research was published by Ernst & Young (EY) in February 2014 suggesting that the exchange-traded funds (EFTs) industry could surpass the hedge fund industry in terms of assets under management (AUM) within 12-18 months.

ETFs are a relatively new addition to the investment universe, and despite their rapid growth in popularity they are still regarded as an 'alternative' equity investment. First developed around 20 years ago as a means to give investors access to a basket of stocks at a low cost, ETFs first began life in the United States, but have slowly caught on in other areas of the world, notably Europe, and they are also making headway into the Asian markets.

ETFs are usually linked to a particular index, for example the Dow Jones Industrial Average, the Standard & Poor's 500, or London's FTSE 100. They may track a certain sector within these indices, like technology companies, mining companies or pharmaceutical firms, but they do so within a single share. ETFs have also been developed that track company sectors across different exchanges in a certain geographical region, for instance, Western European technology stocks. This gives investors the chance to diversify their portfolios by taking exposure to international equities that may have been off limits to smaller investors through complex cross-border regulatory concerns.

On the surface ETFs appear very similar to mutual funds, but in actual fact, there are a couple of key differences. One of the main differences is that ETFs can be traded openly throughout the trading day, unlike mutual funds which can only be redeemed at the closing price of each day. This means that ETFs may be equally suitable to the more conservative buy-and-hold strategist, or the more active trader looking for short-term speculative gains. The other major advantage of ETFs over their mutual fund cousins is that the former can be sold short, whereas the latter cannot.

Furthermore, costs are also much lower for ETFs, varying between 0.1% and 0.2%. This compares to average mutual fund fees of around 1.4%, while unit trust charges can be as high as 1.75%. ETFs are also generally more tax efficient than standard mutual funds. On the other hand, frequent intra-day trading of ETFs means that costs will increase the more an individual trades. As with direct stock purchases, investors must also absorb the bid/offer spread, meaning that an ETF may have to be bought or sold at a higher or lower price than desired. So, as with any other security, there are many considerations for the investor to weigh up when choosing to construct a portfolio.

There is an extensive and growing range of ETFs. In the United States, most ETFs trade on the American Stock Exchange (AMEX). The largest and most popular among them include the S&P 500 Index Depository Receipts (known as Spiders), the Nasdaq 100 Index Tracking Stock, otherwise known as QQQ, and the Diamonds Trust, which tracks the top 30 stocks on the Dow Jones Industrial Average. However, there are a growing number of ETFs traded on the London Stock Exchange via the ishares platform, which is marketed by Barclays Global Investors, tracking both the FTSE 100 and the broader FTSE250 indices, the top 100 European firms, the Dow Jones Eurostoxx index, the S&P 500 and Japanese shares.

According to EY's Global ETF Survey, Asia is the region where most of the new ETF growth will be found, with the more mature US market growing at a slower pace. However, EY predicts that the growth drivers will be the same across all markets: foreign currency share classes, fund of fund ETFs, new emerging market funds and commodity ETFs.

Antoinette Elias, EY's Oceania Wealth and Asset Management Leader, says: "Growth will come from innovation, from more wide-spread users of, and uses for, ETFs as they take market share from competitors."

The EY Global ETF Survey interviewed more than 60 promoters, market makers, investors and service providers over 13 markets, including promoters representing 87 percent of the industry's global assets. The interviews were conducted during October and November 2013.

Growth rates in Asia-Pacific are among the highest in the world at around 20-30 percent per annum, compared to an average of 15-20 percent in Europe and 15 percent in the US market, which holds around 70 percent of global ETF assets, the survey found.

Expectations of retail growth have become more upbeat across the globe this year, with 49 percent of respondents expecting retail investors to drive strong growth, compared to just 20 percent last year. Asian respondents in particular see strong potential for retail take up of ETFs (57 percent).

Nevertheless, this isn't to say that the hedge fund industry is set to stand still. On the contrary, some analysts predict that 2014 could be the year that hedge funds break the USD3bn AUM barrier for the first time.

Deutsche Bank's 12th annual Alternative Investor Survey, released in February 2014, concurs with these predictions, based on investors' predictions that the industry will see inflows of USD171bn, and performance-related gains of 7.3 percent, worth USD191bn. 2013 saw performance-related gains of 9.3 percent. Of the 400 respondents to the survey, 80 percent said that their investments' performance was as expected or better than expected during 2013. 63 percent of respondents are targeting returns of less than 10 percent in 2014.

Anita Nemes, Global Head of the Hedge Fund Capital Group at Deutsche Bank, said: "With the majority of investors happy with hedge fund performance, we expect institutional investors to further strengthen their commitment to hedge funds. Last year's respondents targeted 9.2 percent for their hedge fund portfolios, and hedge funds delivered – the weighted average return for respondents' hedge fund portfolios this year was 9.3 percent. Looking forward, respondents are targeting 9.4 percent for 2014."

EY's ETF survey also reveals an increasing awareness of how vulnerable the ETF industry could be to the negative effects of a scandal, especially in the retail market. Those surveyed think that regulators should be focusing their attention on leveraged ETFs and ETFs not covered by European Securities and Markets Authority and Undertakings for Collective Investment in Transferable Securities (UCITS).

The report also finds that achieving scale remains the leading barrier to entry into the ETF market and is a greater challenge in 2014 than it has been in previous years. In addition, lack of liquidity is the most frequent reason that fund launches fail. More than 90 percent of those surveyed view USD50m as the minimum size for an ETF to be viable, with more than a third saying USD100m was the minimum requirement.

"The importance of liquidity and its close link with scale continues to act in a self-reinforcing way," Elias said. "As a result new entrants are finding it increasingly difficult to compete directly with the industry's largest players. Eighty percent of those surveyed said they expected the top three's market share to remain stable and a further 15 percent expect it to grow."

There are some who predict that the onslaught of new financial regulation in the wake of the financial crisis will cause hedge fund assets to plateau, or at least grow at a much slower pace than they have done over the last 20 years.

Either way though, it is clear that the hedge fund industry, even if it has changed quite dramatically in the past decade, and will likely continue to change in the years ahead, is here to stay. Indeed, additional regulation could well have strengthened the industry's foundations by allowing funds to be marketed to a wider audience, and not just HNWIs. So it probably won't be too long before this alternative investment is considered a mainstream one.

Tags: compliance | interest | Investment | Europe | Invest | currency | Investment | investment funds | hedge funds | equity investment | investment | alternative investment | Japan | United States | regulation | law | services | retail | fees | tax | trade |


Features Archive