The changing nature of hedge funds

Why should pension funds invest in hedge funds?

Pension funds, along with investors generally, have a need for diversification. That’s where hedge funds play a role, as they offer diversification to what the investors’ currently hold and what they are expected to make on their investments on a volatility-adjusted basis.

We are at the end of a 30 year bull market in fixed income, so many investors who have top-heavy fixed income portfolios are looking at the need to reduce this exposure as nominal yields are set to rise. Equity markets are highly volatile and historically they have had very large drawdowns, both in the 2000-2002 period and again in 2008. Investors witnessed equities on a global basis losing 50 per cent of their value in a very short period of time with all markets highly correlated. So we have seen the increase in allocations to hedge funds over the past few years as a function of the diversification needed by investors and this is expected to further increase.

What affect did the 2008 financial crisis have on hedge fund investment, and how have the problems that the crisis highlighted been addressed?

The 2008 financial crisis was in general a liquidity crisis for hedge funds, although in some cases it became a solvency crisis. The newcomers allocating to hedge funds do not have the scars of 2008 but they have probably read about it enough to understand what it means to not be able to get your money back when a hedge fund gates or suspends redemptions.

There was only one real place where generic hedge fund liquidity issues were managed and that was through managed account investments. Lyxor was one of the best examples that most people look at in the industry. We had a significant amount of redemptions in 2008 from our investors. We paid every single dollar back to them. Historically the governance of a hedge fund was with the directors who were probably closely linked to the hedge fund and took advice from the hedge fund portfolio manager, whereas Lyxor looks to directors that are independent from the hedge fund as well as complimenting that with an independent risk management process, including the monitoring of all underlying positions on a daily basis.

Also in terms of counterparty risk, a lot of hedge funds had exposure to Lehman Brothers. With Lyxor’s open architecture approach and ongoing monitoring of service providers we were able to avoid having assets tied to the biggest bankruptcy in history. Many hedge funds were not able to set up prime brokerage agreements with other providers but on the managed account platform this was a direct plug into the approved providers we have.

The 2008 crisis certainly highlighted liquidity and counterparty risk most prominently and even though we survived such a period we also improved our processes to make them more robust to various scenarios. That includes making sure that each managed account of a certain size has at least two prime brokers so that if one of them was to fail, or be on the verge of failing, we could transfer those assets straight away.

How will the Alternative Investment Fund Managers Directive (AIFMD) affect pension schemes investing in hedge funds?

AIFMD is a European regulation that allows managers, if they abide by it, to have a licence to market their fund in Europe. If you do not have this licence, you cannot market your fund in Europe. There are still other ways for investors to allocate to the fund, for instance, you could rely on private placement. However, the methods of private placement defer from country to country and overall the directive suggests that it may end by 2018, so it is not something we expect to be sustainable. The last route would be reverse solicitation. This is where an investor comes up to the manager and requests to invest with them. The manager never approaches the investor. That’s fine but there is going to be a lot more scrutiny as to how a manager can prove that it did not approach the investor. So going forward there is the expectation that there is only one way to invest within Europe and that will be through the onshore AIFMD format.

The intention of the directive is all about investor protection. The hedge fund industry historically has been opaque, so it is nice and comforting for institutional investors to know there is a regulator who is starting to dig deeper with these funds and ask for information. They are asking for processes to be explained regarding liquidity risk and operational risk management, they also want to understand any misevaluation risks, misappropriation, misrepresentation, they want to be on top of all that. This is all highly important for pension fund investors.

The regulation is detailed, and there is a lot of cost and effort required to comply. You have to employ specialist people, such as advisory, legal, a whole chain of people, and even then the regulator may want to have more information and in future may be expected to amend some of the directive. But asset managers have to be cognisant that regulation is happening globally, so in the US there is Dodd-Frank, and in Europe there is also EMIR, and UCITS V and VI coming. Regulation is happening so ultimately you need to embrace it.

We at Lyxor are certainly embracing the directive. We are one of the first movers. We have applied for both the managed account platform and the fund-of-fund portfolios at Lyxor to get an AIFM licence. We are an AIFM in France and are able to passport that to Luxembourg and launch managed accounts there, which are onshore, regulated managed accounts for pension funds and other institutional investors to access.

How do you see the hedge fund industry developing?

We are starting to see mutual funds and hedge funds, the traditional and alternative world, merging slightly. There’s a convergence between strategies, you see it in the US with a lot of daily liquidity funds. You also see it in UCITS format with some alternative investment managers adapting to the needs of investors and the regulations they need to abide with. Also several traditional players are trying to get into the alternatives space either through acquisitions or by providing a new offering.

AIFMD can play a very big part here. Investors that cannot invest offshore have a whole new onshore investment universe they can select from. Even those that can allocate to offshore less liquid alternative investments may decide they want to complement their traditional investments with AIFMD regulated onshore funds. This could add the desired diversification to their portfolios. For instance a long-short equity manager may be a good substitute for a typical long only active manager. In fact one could argue that the active long only manager is not truly active in the sense that they are still constrained in their ability to go short a position and be fully invested. A regulated hedge fund does not have this constraint and could better be described as the flexible active manager.

Another very important development that we are witnessing is the tailoring of investments. The larger the client, typically the more they want to customise the allocation to suit their or their end investors’ needs. One of the most popular ways for investors to do this in today’s environment is through managed accounts. At Lyxor we work closely with some of the largest institutional investors to create dedicated managed accounts solely for one investor. This provides the investor with flexibility on negotiating a fee or fee formula, restricting certain investments and adjusting volatility levels and performance targets. The investor is also provided with the full transparency of the managed account, of course so long as the manager agrees to this framework. This is a very powerful tool for an investor and one of the developments we increasingly see for many investors.

AIFMD will help the hedge fund industry develop and from an investor perspective AIFMD certainly sounds promising. But I think one of the biggest developments over the next few years will be the customisation of managed accounts. For those investors that want transparency, security, and customisation, managed accounts tick all the boxes.

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