Desperately seeking alpha

The global hedge fund industry is still recovering from a turbulent few years, but there are signs that the recovery will be enduring

 

Since 2007 the hedge fund industry has faced extremely tough market conditions, and while the world began to show signs of recovery in 2012, hedge funds faced the most adverse year yet.

Extreme market volatility, adverse global macroeconomic landscapes, underperforming markets and low consumer confidence all colluded to create an extremely hostile environment for hedge funds. But in many ways, 2012 was rock bottom, and the hedge fund industry inevitably became stronger in the face of that challenge.

That is why 2013, despite a growing regulatory burden, is shaping up to be a better year, paving the way for sustained growth in the near future.

Emerging from a bad reputation
According to Deloitte’s 2013 Hedge Fund Outlook, the global hedge fund industry emerged from 2012 with more assets under management and absolute number of funds than in 2007, before the crisis and “those that remained settled into a more measured and sustainable pace of growth, with money flowing mainly to hedge funds who altered their routines by adjusting to new demands from regulators and investors while looking for new ways to streamline back office operations.” And while this might be encouraging, there are still plenty of challenges ahead.

Hedge funds seemed to have acquired something of a bad name during the global financial downturn, being associated – somewhat unfairly – with the worst excesses of the financial industry. The situation has not been helped by the fact that between 2008 and 2012 assets under management were in quick decline, and funds were often stuck between a rock and a hard place.

That is why many are welcoming the new regulatory framework, which will help rehabilitate the image of the industry and reassure the public of the value of hedge funds within the financial world.

“The 2008 financial crisis has led to increased investor demands for higher levels of regulation,” write Paul Farrell, Gayle Bowen and Catherine Fitzsimons of Walkers Ireland, in the IFC 2013 Review. As a result, financial regulation has risen to the top of the political agenda.

“While it is widely acknowledged that hedge funds neither caused nor played a significant role in the 2008 financial crisis, concerns regarding the impact of highly leveraged funds on the stability of the financial system and the perceived lack of transparency associated with hedge funds meant that increased regulation was inevitable,” continued Farrell, Bowen and Fitzsimons. Europe in particular has been proactive in setting up a solid a comprehensive regulatory structure.

The Alternative Investment Funds Managers’ Directive (AIFMD), which has come into effect over the summer, is a set of directives that unifies the regulation of hedge funds based in and marketed within Europe. The directive was written specifically to include both European and non-European fund managers of most types of fund structures operating within the region, which in effect prevents a flight of capital to unregulated jurisdictions.

“AIFMD introduces new obligations on both funds and their managers, which include obligations in relation to capitalisation, the appointment of an independent depositary, to hold fund assets, risk and liquidity management and additional investor disclosure have all been introduced”, write the Walkers Ireland lawyers.

“However, in exchange for this regulation AIFMD provides access to a pan-EU passport allowing funds to be marketed to EU professional investors once a fund is authorised in any EU member state. This will mean that, for example, Irish funds complying with AIFMD may be marketed across the EU, without being subject to further marketing requirements in each jurisdiction.”

New regulatory framework
Globally, regulators have been keen to focus on over-the-counter derivatives, which have also acquired a bad name during the financial crisis. In the wake of the 2009 G20 Summit, in which all members agreed that standardised OTC derivatives should be centrally cleared and reported to trade repositories, the EU has devised the European Market Infrastructure Regulation (EMIR).

This imposes a number of reporting and central clearing obligations for these instruments. EMIR – though a European directive – has a number of crossovers with the Dodd-Frank Act, enforced in the US since 2010. “The focus on increased regulation will continue to be a focus throughout 2013,” according to Farrell, Bowen and Fitzsimons. “Increased costs, transparency, liquidity, and consolidations will also shape the hedge fund landscape over the next few years, as hedge fund managers continue to adapt to this ever-changing environment.”

The financial crisis has had the effect of driving regulation and policy for the hedge fund industry, which had previously enjoyed little to no regulatory oversight. For Richard Baker, President and CEO of the Managed Funds Association, these reforms accompany “great opportunities to learn from the past to forge a stronger market place,” he wrote in the 2013 Prequin Global Hedge Fund Report.

“This effort is not without significant challenges – most critically, effectively communicating the value of our industry to those who may mistakenly view us through a lens that mischaracterises hedge funds as ‘secretive’ and ‘risky’.” For Baker, this ‘educating’ of the general public is a vital step in rehabilitating the industry’s image, which is still suffering the aftershocks of the crisis.

“The task of educating is always an uphill battle in the US where elections and a rotating cast of regulators requires constant and vigilant outreach,” he writes, while “in Europe, ESMA [the European Securities and Markets Authority] is charged with overseeing many of the reforms implemented by the EU, but the agency is not yet two years old.”

According to Deloitte, over 1,500 new private fund advisors registered with the US SEC in late 2012, and while it is good news that the industry is growing again, competition for new assets has been fierce. “Despite the increased scrutiny from regulators, the industry’s assets under management broke through the $2trn barrier, and may be poised to rise even higher as institutional investors shift more of their investments toward risk-driven classifications and expand the pie of their alternative asset allocations,” reads the report.

Fundamental to this is the return of risk appetite in the industry, which had been lacklustre since the crisis.

“But risk appetite alone does not translate into high returns, and the report warns that some hedge funds will inevitably generate outsized returns in 2013, but the search for alpha will likely remain elusive to most.” In today’s environment, the balance of power is tilted in favour of investors, where before the crisis fund managers held the trump cards; this means that while some funds will be able to grow fast, competition for investors is fierce.

Signs of growth
In the US, the newly effected Jobs Act has lifted the restrictions on funds and private equity groups on the general solicitation of investors. This means that companies are now allowed to market their business a little more widely, in the hopes of attracting more clients.

The bill was also supposed to bring more transparency to the industry – particularly when it comes to entrepreneurs raising capital. However, only few venture capital groups have chosen to publicly advertise, with many in the industry suggesting that the bigger players will opt to continue to raise funds privately – and discreetly.

“The Goliaths in our industry are not going to advertise,” Anthony Scaramucci, founder of SkyBridge Capital, a hedge fund of funds, told the FT. “They think it’s gauche and declass, and their partners already have their private planes and their beachside mansions in the Hamptons, so why disrupt the business model?”

However, with the largest industry players not getting involved, it presents a golden opportunity to smaller market participants and newcomers to attract new investors. “If you choose the right weaponry, you can take out Goliath,” Scaramucci added.

The hedge fund industry is still distributed unevenly geographically, with 62 percent of all 5,200 fund management groups located in North America and 23 percent in Europe, according to research by Prequin Hedge Fund Analyst.

The same survey saw that 70 percent of the total industry capital is managed by North America-based managers. “Because Asia-Pacific-based managers tend to run smaller funds than their North American counterparts, firms based in the region only manage five percent of industry capital despite making up 12 percent of all hedge fund managers by numbers,” reads the Prequin report.

“The bulk of investment in Asia-Pacific based hedge fund managers comes from investors within the region or through funds of hedge funds and institutional investors, such as US-based pension funds, have yet to invest in the region in large numbers.”

Hedge funds are still relatively new in Asia, which can mean that there are a lot of opportunities for the industry to grow and develop in the region, particularly as emerging markets like Indonesia and Malaysia continue to outperform Europe and the US in terms of growth.

In the first five months of 2013 hedge funds attracted net asset inflows of $56.9bn, a huge gain on 2012, which saw outflows of $3.8bn over the course of the year. These are extremely encouraging figures, and Hedge Week has reported that gains are on trend to beat 2012 in terms of returns; average rises in September contributed to the estimation of an annualised industry increase of 7.7 percent in 2013, a growth on the 7.2 percent increase recorded last year.

Additionally long and short equity is also on track to record the best year since 2009, and second best since the pre-crisis levels of 2006. However, Deloitte have warned that in order to sustain this type of growth and the new added regulatory burden, “hedge funds are being forced to invest in their infrastructure,” in their 2013 industry outlook. “When those demands lessen, hedge funds will emerge stronger and more structurally capable of winning investors’ confidence.”.