25 Years in · which also include AsiaHedge, InvestHedge and Absolute Return, with responsibility for all of ... How the hedge fund industry has evolved in 25 years is obviously a

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Evolution of an industry over 25 years How the industry went mainstream P6

Separating fiction from reality Challenging hedge fund myths P20

Virtual roundtable of industry leaders Five years yonder... P38

25 Years in Hedge FundsA special publication to mark AIMA's 25th anniversary

Contents

Contributors

4.

IntroductionA global mantra

The international nature of investing, trading and regulation means it has never been more necessary for the hedge fund industry to have a global representative.

By Jack Inglis

6. Then and Now

Evolution of an industry over 25 years

Alternative investments have gone from the periphery ever more towards the

mainstream of the financial world in the past 25 years — and AIMA has played an

increasingly significant role along the way By Neil Wilson

12.

Timeline

14. How the landscape

has changed for hedge funds

The legal and regulatory environment for hedge funds has changed beyond recognition over the course of the

last 25 years By Iain Cullen

Neil Wilson, Wilson WillisNeil was for many years at HedgeFund Intelligence, starting in January 2001 as editor of EuroHedge, and then later becoming managing editor and editorial director for all of the HedgeFund Intelligence publications, which also include AsiaHedge, InvestHedge and Absolute Return, with responsibility for all of their associated online news, special reports and events. He has more than 25 years’ experience in financial journalism and publishing, specialising mainly in derivatives and alternative investments.

Prior to 2001, he was European editor of MAR/Hedge, editor of Futures & Options Week and assistant editor of The Banker. Over the years, he has contributed to various other publications including The Financial Times, The Economist and Risk magazine. He has a BA with honours in Philosophy, Politics and Economics from the University of Oxford.

Iain Cullen, Simmons & Simmons LLP Iain Cullen is a partner in the Financial Services Group at Simmons & Simmons LLP. He joined Simmons & Simmons in 1977, qualified as a solicitor in 1980 (working for the first 18 months in the firm’s Brussels office) and became a partner in 1986. Since 1993 Iain’s practice has concentrated on structuring hedge funds and advising hedge fund managers.

Iain has served as General Counsel of the Alternative Investment Management Association since its foundation in 1990, was Co-Chairman from 1991 − 1995 of the Commodities, Futures and Options Committee of the Section on Business Law of the International Bar Association and is the co-editor of Hedge Funds: Law and Regulation published by Sweet & Maxwell (2001).

Niki Natarajan, In Ink After writing and editing InvestHedge, a publication from HedgeFund Intelligence, for more than 12 years, Niki founded In Ink (London), a company specialising in creative content and communication consultancy. Niki has more than 20 years' experience as a financial journalist, specialising in investment management, with particular expertise of the global funds of hedge funds industry.

Prior to working at HedgeFund Intelligence, Niki launched the hedge fund and securities finance coverage at Financial News. Niki was also the launch editor of Global Fund News; editor of Foreign Exchange Letter; and reporter on Global Money Management, all formerly publications of Institutional Investor's newsletter division. A qualified NLP coach and trained yoga teacher, Niki graduated in Geography from Durham University.

This report was prepared in collaboration with Wilson Willis Management Ltd. Wilson Willis was founded in January 2014 to provide specialised services including analysis, commentary, bespoke research and conferences for the asset management world, with a primary focus on hedge funds.

The views and opinions expressed do not necessarily reflect those of AIMA or the AIMA Membership. AIMA does not accept responsibility for any statements herein. Reproduction of part or all of the contents of this publication is strictly prohibited, unless prior permission is given by AIMA. © The Alternative Investment Management Association Ltd (AIMA) 2015. All rights reserved.

2

20. Separating fiction

from realityDespite plenty of evidence to the contrary,

many myths have grown up about hedge funds during the last quarter-century that

still persist in the popular imagination By Neil Wilson

24.

Learning the lessons of the pastAs the hedge fund industry has evolved since 1990 it has had to learn a series of

important lessons By Niki Natarajan

30.

Accessing hedge funds

How 'solutions' are the new FoHFs

The roles of consultants and funds of hedge funds (FoHFs) have increasingly converged

over the years, with significant ramifications for both fund managers

and investors By Niki Natarajan

34. The next five yearsThere is a wealth of research from recent surveys and studies looking to the future

— and how hedge funds are likely to continue to grow, but are also grappling with various complex challenges ahead

By Neil Wilson

38. Virtual roundtable

Five years yonder...After 25 years of rapid growth and change

in hedge funds since the foundation of AIMA, a group of leading players from

around the world give their views on the outlook ahead for markets, investors and

the industry Compiled by Neil Wilson

3,000

2,800

2,000

2,200

2,400

2,600

1,800

1,600

1,400

1,200

1,000

AuM

Fund

s

800

600

400

200

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

10,800

7,920

8,640

9,360

10,080

7,200

6,480

5,760

5,040

4,320

3,600

2,880

2,160

1,440

720

0

Assets $bn Number of funds

48. Big Data

The growth of the global hedge fund industry

25 Years in Hedge Funds

3


I am proud to introduce this special publication to mark the 25th anniversary of AIMA. Founded in Europe in 1990 by fewer than 20 managers and service providers who recognised the need for mutual representation, AIMA has grown into a truly global

organisation, with offices in every region of the world and members in well over 50 countries.

Most financial industry bodies are country and jurisdiction-specific, but ‘global’ has been AIMA’s mantra. The international nature of investing, trading and regulation means it has never been more necessary for the hedge fund industry to have a global representative.

From small European beginnings, an impressive international network encompassing Asia-Pacific, EMEA and the Americas has been constructed. The US has the dominant market share in the industry and represents over 50% of the aggregate AUM of our global membership; our Americas presence is further augmented by the existence of our National Groups in Canada and Cayman as well as our activities in Brazil. In Asia-Pacific, we have National Groups operating in Hong Kong, Singapore, Japan and Australia, combined under a single regionally-focused operation.

The growth of the association in terms of membership and staff reflects the expansion of the industry. In 1990, what was then still very much a boutique sector, managing less than $40 billion in assets, was served by a part-time secretary and volunteers; in 1994 we were still operating out of shared office space in Paris.

As recently as 2005, by which time we had around 900 corporate member firms, and our head office had relocated to London, we still had only eight staff members. Today, we have a total of 38 staff; 25 in the London head office and a further 13 in our representative offices around the world. The industry manages around $3 trillion in assets, much of it on behalf of institutional investors such as pension funds.

Well over 1,500 corporate member firms and almost 10,000 individuals take advantage of AIMA membership.

It is of course our members who are the backbone of the association. They comprise both the largest and smallest firms around the world, all contributing to important output such as responses to regulatory consultations, updates to DDQs and new industry guides. We have more than 70 committees and working groups globally, comprising more than 600 individuals from over 350 firms. It is that support that allows us to continue to deliver all the services our members ask us for; and to undertake, with the help of the members who volunteer their time, all our work on behalf of the industry around the world.

We are hugely grateful to our various sponsor organisations. Our Sponsoring Partner members continue to provide unstinting and important support − Bloomberg, Clifford Chance, Dechert, Deloitte, EY, K&L Gates, KPMG, Macfarlanes, Man, Maples and Calder, Permal, PwC, Simmons & Simmons, Societe Generale, State Street, UBS, Wells Fargo and Willis.

Special thanks are also due to the sponsors of the 25th Anniversary Annual Conference and Dinner, whose advertisements you will see in this publication − Simmons & Simmons, EY and State Street. Iain Cullen of Simmons & Simmons, our General Counsel since inception, provides a wonderfully rich recent history both of the industry and the association within this publication.

How the hedge fund industry has evolved in 25 years is obviously a theme of this publication. The sector has changed substantially in a generation. Challenges and occasional crises as well as tremendous opportunities have punctuated a period marked more broadly by institutionalisation, globalisation and increased regulation. The next 25 years will doubtless see even more change. Ever present will be AIMA, the global hedge fund industry’s representative. •

A global mantra

The international nature of investing, trading and regulation means it has never been more necessary for the hedge fund

industry to have a global representative

Introduction by Jack Inglis, CEO, AIMA

4

AIMA — 25 years in Hedge FundsAIMA expanded into Hong Kong in 1999

Traders in the City of London stop for lunch in this 1991 photograph

Back in 1990, the year of AIMA’s founding, it would be safe to say that both managed futures and hedge funds — indeed, alternative investments in

general — were regarded as somewhat peripheral to the financial markets, very much on the outer fringes of the mainstream financial world.

A lot has changed in the past 25 years. Both hedge funds and managed futures have grown enormously over the intervening years. And AIMA has played an increasingly central role in championing the cause of the industry, developing sound practices and providing a forum for industry practitioners.

Of course, hedge funds and alternative investments were not completely new in 1990. Alfred Jones invented what was generally regarded as the first modern hedge fund — a fund with the ability to use leverage and to go short as well as long — way back in 1949. And the first notable boom in hedge funds had occurred in the US back in the early 1970s.

That first wave of funds was largely snuffed out by the rampant inflation and fierce bear market in equities that followed the oil price

Alternative investments have gone from the periphery ever more towards the mainstream of the financial world in the past 25 years

By Neil Wilson


Thenand

now

7


shocks of that decade. But by 1990, there were still a few hardy survivors of the early period left — including legendary ‘global macro’ players like George Soros, who had survived by making the right macro calls over the years across multiple asset classes; and Julian Robertson’s Tiger group, which had done so too though with a greater focus on equities in particular.

It was no accident, however, that the first group of players who decided to form a trade association were focused on the managed futures space. By the early 1990s, many of the biggest players in alternatives globally were either macro managers like Paul Tudor Jones and Louis Bacon, who had strong roots in commodity futures, or pure commodity trading advisors (CTAs) — operating primarily in the futures markets, often with systematic trend-following strategies.

When EMFA, the forerunner to AIMA, first appeared, it was not clear yet that Europe — and London in particular — would become such a major centre of the nascent industry. But even at that time, there were London-based firms like ED&F Man group that were already thinking a lot bigger. In the early 1990s, seeing a need to source new capacity, Man had the foresight to acquire the UK-based managed futures firm AHL and also spawned a range of further top rank CTAs including Winton Capital and Aspect Capital.

Today, the US remains by far the biggest region for hedge funds by assets under management — with New York by a long way the top single centre, alongside significant clusters in other regions around the country in Connecticut, Massachusetts, Illinois, Texas, California and elsewhere.

London has for many years been the second biggest centre globally. And in the managed futures space, in particular, many of the world’s operators are now based in Europe — and all around the Continent too, including the likes of Transtrend in Rotterdam, Lynx in Stockholm and Capital Fund Management in Paris.

Sterling crisis Arguably, the first time that hedge funds reached the public consciousness, at least in Europe, was in 1992 — when the Bank of England was forced to give up its policy of trying to keep sterling within the European exchange rate mechanism (ERM), the forerunner of the euro. That was not until after the Bank of England had suffered major losses in a failed attempt to keep sterling inside the ERM — and various hedge fund managers, led by Soros, famously made massive profits by betting successfully against it.

While there was much hot air expended by critics at the time — venting about these ‘buccaneering’, ‘upstart’ hedge funds being allowed to humble the stately Bank of England — the resulting exit of sterling from the ERM proved a boon for the UK economy.


AIMA was early to establish a presence on the ground in Asia — at a time when feelings were still running high about hedge funds' perceived role in the Asian financial crisis.

During the 1990s, while many CTAs continued to thrive and generally make good returns (not without some volatility), they were gradually over-shadowed by managers investing instead in a long-running bull market in equities. TT International had launched what was widely regarded as the first hedge fund managed in Europe in the late 1980s. And notable early long/short equity managers who emerged in Europe during the early 1990s included Crispin Odey, who launched his first hedge fund in 1992, and John Armitage, who went live with Egerton Capital in 1994.

The pace of development, however, was quite slow in Europe in those early days. In the US, by contrast, the industry was already growing rapidly — and not just in equity-related strategies, but into other areas such as convertible arbitrage, distressed debt and fixed income relative value. It was in the latter strategy area that hedge funds next made big headlines — after the Asia and Russia crises of 1997 and 1998 was followed by the sudden and shocking implosion of Long Term Capital Management.

The huge scale of the leverage deployed by LTCM caused what looked like a potential systemic problem — raising serious questions for the first time that hedge funds were perhaps becoming so big that they could constitute a danger to the whole market. For the first time in 1998, hearings were held in Washington to investigate this notion — with Congress even summoning George Soros to answer for the industry.

At the time, industry representatives were able to argue successfully that LTCM was very much a one-off case — and that hedge funds in general were just too small and too

8

modestly leveraged to pose a genuine systemic risk. But, over the years since, regulators and legislators have continued to be pressed by sceptical or hostile public opinion — re-ignited whenever there has been any significant hedge fund-related ‘blow-up’ or scandal. So 1998 turned out to be just the first in a series of debates about potentially damaging new regulations that have continued all the way through to the present day.

Global reachIt was very timely, therefore, that in 1997 the managed futures-focused and still largely European EMFA evolved to become the broader, and globally-aspiring, AIMA — seeking to represent the increasing community of hedge funds as well as CTAs. The importance of this development was again probably not widely appreciated at the time — given what was still a nascent industry driven by fiercely competitive and independent-minded individuals.

As a breed, hedge fund managers and CTAs have of course always been entrepreneurial, and fiercely competitive among themselves — and hence by nature very hard to rally together behind the same banner.

Yet the new AIMA was not slow to take up the task with enthusiasm. As early as 1997, AIMA was issuing its first due diligence questionnaire. In 2000, AIMA’s first Regulatory Forum was held. And by September 2002, AIMA’s first Guide to Sound Practices had been published. The association was also beginning to expand globally — first into Hong Kong in 1999, and then into Australia and Japan in 2001. Canada, Cayman, Singapore and other locations would gradually follow.

AIMA was early to establish a presence on the ground in Asia — starting at a time when feelings were still running high about hedge funds in many parts of the region following their perceived role in ‘shorting’ various markets during the Asia crisis. In the late 1990s, there were very few funds managed from within the region itself and they were mostly focused on Japan. Over the years since, while assets have waxed and waned in what have often been volatile markets, the ex-Japan markets have grown dramatically — with Hong Kong and Singapore emerging as the leading centres for managers to be based in the region.

Meanwhile, by the late 1990s the industry in Europe was also taking off in a very significant way, with a whole new generation of managers being inspired to leave the institutions where they worked, set up on their own and deploy the most sophisticated asset management techniques to deliver the best risk-adjusted returns.

The LTCM affair — given not least the pedigree of a management team including Nobel laureates — had certainly been a shock when it happened. But in retrospect it looks more like a mere blip — with funds launching at the time finding it more difficult than they had expected to raise capital, but most of them going ahead anyway.

Those launching their first funds during that period — including AQR, Marshall Wace, Viking Global and Lansdowne Partners, and firms like BlueCrest that were leading a new wave of fixed income and macro focused players — have gone on to become some of the biggest names in the global hedge fund industry of today.

This was despite the fact that markets at the time continued to be volatile and

challenging. By 1999, the ‘dotcom bubble’ was in full swing — making it hard for hedge funds, including the growing community of long/short equity managers, to stand out from traditional long-only funds that were riding a raging bull market.

But hedge funds began to look increasingly compelling after the dotcom bubble burst — during the subsequently sharp bear market of 2001 − 2003. While equity markets were plunging 30% and more, hedge funds on average were generally retaining their value — and many individual managers, even in equity strategies, were continuing to produce gains.

The process of institutionalisation In the early years of the industry, hedge funds and CTAs had attracted money mainly from wealthy individuals and clients of private banks (which formed many of the early funds of hedge funds), plus like-minded family offices. Over time, more money had also started to come in from investors with tax-exempt status like endowments and foundations, and corporate sources like insurance companies.

After hedge funds outperformed so clearly during the dotcom era, the investor base started to become increasingly institutional, with corporate and public pension funds and sovereign wealth funds becoming more and more significant allocators. Hence a more ‘institutional’ sort of hedge fund industry started to emerge — one that needed to cater to the ‘institutional standards’ in money management required by those investors.

How institutionalisation changed the hedge fund investor demographic: Breakdown of allocators to hedge funds by investor type today

Source: Preqin, 2015

15%

15%

9%

8%

7%

4%4%

7%

12%

19%

FoundationFund of hedge funds managerPrivate sector pension fundEndowment plan

Wealth manager

Family office

Asset manager

Insurance company

Other

Public pension fund


9

This process of institutionalisation was to continue over a number of years and did not really reach its zenith until after the financial crisis of 2008 — with the assets managed for institutional allocators like pension funds eventually coming to exceed the amount hedge funds managed for their traditional private bank, high net worth and family office type of clientele.

Over the five years just before the crisis, from 2003 − 2007, there was largely a slow and steady rising market in equities, plus a major boom in credit markets — where an increasing number of hedge funds also began to focus. These were conditions in which numbers of players and assets could grow robustly — as indeed they did. In that period, HFI was routinely recording well over 1,000 new hedge fund launches a year.

The combined assets of AIMA’s global membership had reached the $1 trillion mark as early as 2005. And the long-running Hedge Fund Research database put aggregate global assets at a peak of almost $1.9 trillion by 2007, though some other data providers put the number even higher. HedgeFund Intelligence reported assets breaching the $2 trillion level that year — and (albeit very briefly) even exceeding $2.5 trillion just before the financial crisis hit.

As the industry became more institutional during this period, there was an accompanying trend towards more consolidation too — with an increasing number of managers monetising the value of their firms through selling stakes, such as to Petershill, a private equity vehicle managed by Goldman Sachs, or by creating listed vehicles all the way through to full-scale IPOs.

The impact of the financial crisisWith assets growing so robustly, there were however mutterings among investors that overall performance — which had been strong historically — had become increasingly tepid or lacklustre, which was indeed being reflected in the indexes of composite performance as that period wore on. But few investors seemed to be prepared for the sort of aggregate performance that came through after the ‘credit crunch’ of 2007 gave way to the collapse of Lehman Brothers and the full-blown financial crisis of 2008.

Many of the newer investors, in particular, had been sold on the notion that hedge funds were ‘absolute return’ products. And so, somewhat naively perhaps, they were simply not prepared for the eventuality that hedge fund performance in aggregate could be significantly negative — even if there was a complete meltdown of the whole financial system.

In the febrile, panicky conditions of late 2008, the situation was made significantly worse by a virtual tidal wave of redemption requests hitting the industry. This led some

hedge funds to suspend redemptions or ‘gate’ investors — in order to avoid realising massive losses in a collapsing market. At the same time, many other managers were criticised for realising major losses — precisely because they were obliging investors by liquidating assets in a market with no buyers. For many hedge fund managers, it was an invidious position to be in.

In the circumstances, it should have been no surprise that the databases were showing average losses of 15 − 20% for hedge funds in 2008 — although that was of course nothing like as bad as equity market returns at the time. Alongside the simultaneous flood of redemptions, asset levels overall suddenly dropped by 30%.

The Madoff affairThere were further aggravating factors. At the depth of the crisis in December 2008, the wave of redemptions finally caught out Bernie Madoff — who was revealed after many years to have been running a fraudulent ‘Ponzi scheme’. The smattering of fraud cases involving (supposed) hedge funds which had occurred intermittently over the years before were mostly small and obscure cases with minimal impact. But Madoff was truly shocking in its scale — and for the fact that, although Madoff was not strictly a hedge fund manager himself, he had been acting as a sub-adviser running feeder funds or accounts for many investors in the industry.

The Madoff affair took a heavy toll on the fund of hedge funds (FoHF) sector, despite the fact that most FoHF groups had no exposure to him. Research published by InvestHedge showed that only 22 of the top 150 FoHF groups were known to have exposures to Madoff, and the vast majority of the money Madoff had raised had not come via FoHFs but from direct investors, sometimes via feeder funds or managed accounts and even some in onshore structures — on all of which he was reporting bogus returns.

Nevertheless, following the crisis and the Madoff affair, the proportion of assets allocated to the industry via the FoHF sector began to drop — from over 50% before 2008 to around 20% — 25% today.

The recoveryAssets started to recover quite quickly after the crisis — within a year or so after the equity market bottom in March 2009. That was after it became apparent that aggregate hedge fund performance had not in fact been all that bad during the crisis — not when you considered that global equity markets had plummeted 30 − 40%, more than twice as much as hedge funds on average had fallen.

Moreover, while the dispersion in returns across the industry had been enormous

during the crisis, many individual funds had indeed continued to deliver positive returns in 2008 — on some measures up to around 20% — 25% of those trading at the time.

Those who made profits during the period included some huge gains from managers who had called the credit crunch correctly; from some big macro funds; and across the board from CTAs — who once again reaffirmed their non-correlation with average gains of 15 — 20% in 2008, with many of them up considerably more.

As the dust settled on the crisis, and investors began to take these sorts of facts on board, asset levels began to recover — as they have continued to do steadily year after year since 2010. Both the HFR and HFI databases now show global assets surpassing previous peaks and reaching record highs around the $3 trillion level, including a rising proportion in onshore structures like UCITS and 40 Act funds.


10

Increased regulationYet the image of the industry — as indeed of the whole financial sector — took a battering during the crisis. With governments (and their taxpayers) in the major economies being asked to borrow hundreds of billions to bail out the banks, it provoked widespread hostility to the financial sector as a whole. If anything, the fact that some hedge funds had correctly diagnosed the mounting problems in the financial sector only seemed to attract greater opprobrium.

Other key facts — such as the reality that hedge funds had not caused the crisis, or that many of them were badly impacted by it — and had never received a penny of bail-out money — were very difficult to get across to the press, the public and the politicians. In such a hostile atmosphere, it was inevitable that pressure would mount on politicians for ‘something to be done’ to address what had caused the crisis — and prevent it from happening again.

Thus, it was critically important that AIMA was there — with a long record of

encouraging good standards in the industry — to fight the industry’s corner, and to prevent the results from being too negative, and perhaps even destroying the industry. Extremely effective campaigns were waged on a variety of fronts particularly in Europe and the US.

The world changed in 2008/9, and with it, AIMA changed too. Following the crisis, the Association built new structures and brought in new people to address the challenges posed by the crisis and the regulatory reforms that followed. Amid a spirit of constructive and proactive engagement, AIMA and the industry achieved significant amendments to proposals that could have threatened the industry’s very existence.

Instead, we have an industry that has been growing again at a good pace of around 10% a year or more since 2009 — though one that looks very different from before. While assets under management have been growing, the numbers of players trading has not — with higher barriers to entry reflected in a falling number of new funds coming through, especially in Europe, and the big

getting bigger, with an increasing concentration of assets among the biggest firms of the Billion Dollar Club. According to HFI figures, these top 400+ firms globally now account for close to $2.5 trillion of the industry’s assets — well over 85% of the total.

Challenges, and risks, remain. The industry today is more global, more institutionalised, and more diverse in terms of investment strategies than it has ever been, even allowing for the consolidation that inevitably has occurred. It remains a source of innovation and entrepreneurialism. It is playing an ever increasing role in the ‘real economy’. Its investors continue to earn significant sums and allocate ever greater shares of that portfolio.

The past 25 years have been instructive, they have been incredibly difficult at times, but ultimately it has been a rewarding period. For the new generation of hedge fund managers, the next 25 years could be yet more exciting.•


11

Timeline

1990 20031992 1994 1997 1998 1999 2001 2002

EMFA (the forerunner of AIMA)

established

AIMA sets up operations in Canada and South Africa

EMFA becomes

AIMA; first AIMA

DDQ published;

AIMA Journal launched

AIMA expands

to Hong Kong, its first

international branch

AIMA establishes a presence in Australia and Japan

AIMA launches CAIA

qualification with the CISDM

Sterling exits ERM

Equities start new bull market

Asia financial crisis

Russia crisis

Dotcom ‘bubble’ starts

Dotcom ‘bubble’ bursts

LTCM collapses

Amid a stock market rout, hedge funds outperform

As greater numbers of institutional investors seek

out hedge funds, the industry begins to institutionalise

Mexican peso crisis

George Soros, others profit

AIM

A de

velo

pmen

tsM

arke

t ev

ents

Indu

stry

eve

nts

Timeline

12

2004 2005 2006 2007 2008 2009 2010 2012 2015

AIMA establishes Singapore

branch

Securitisation drives a credit

bubble

AIMA creates Cayman Islands

branch

AIMA membership

rebounds

AIMA opens an office in New York

Global hedge fund assets reach

$1.5tr

AIMA member assets

exceed $1tr for first time

Credit crunch starts

Global financial crisis;

Lehman collapse

Markets start to recover Eurozone

crisis start

Major new regulations for hedge funds

proposed in Europe and the US in

particularMadoff fraud

revealed

John Paulson, others call the crisis correctly

Hedge fund assets drop

sharply, many shutdowns; but many

hedge funds and CTAs

outperform

Hedge fund assets,

performance rebound strongly

Global hedge fund assets approach

$3tr

AIMA member assets exceed

$1.5tr; more than 1,500

firmsAIMA membership declines 10% following the

crisis


13

How the landscape has changed for hedge funds

How the landscape has changed for hedge fundsThe legal and regulatory environment for hedge funds has changed beyond recognition over the course of the last 25 years

By Iain Cullen

14

Little did those of us who sat around the table in a hotel in Montreux Switzerland (some say it was in Lausanne, others Geneva!) in the summer of 1990

imagine that what started out as a fledgling idea of a few individuals involved in various capacities in the managed futures and futures broking business, would grow into an organisation of the size, influence and reach of AIMA.

Reflecting its founders’ affiliations, the association was initially called the European Managed Futures Association (EMFA). Some seven years later, in 1997, in recognition of the evolution of the alternative investment management industry to encompass a much broader range of strategies, EMFA changed its name to the Alternative Investment Management Association (having for a mercifully short intervening period been known as the European derivatives and investMent Funds Association).

From a boutique association for a boutique industry at launch, AIMA has now become a global association for a global industry. When formed, it had between 11 and 17 members (recollections also vary on this!). By 2003 (when the SEC held its first Hedge Fund Roundtable in Washington D.C. which I attended on behalf of AIMA) it had 500 corporate members from 29 countries. When AIMA celebrated its 15th anniversary in 2005, it had 870 corporate members from 46 countries, and now it has in excess of 1500 corporate members based in over 50 countries.

From the legal perspective, the most important development came about due to the growth in the size of AIMA’s membership

Hedge fund manager registration and reporting became mandatory in the US under the Dodd-Frank Act, which was enacted by Congress in the wake of the financial crisis.

15

25 years in Hedge Funds

when, in 2002, AIMA was converted from an association with unlimited liability to a company with limited liability.

Whilst there have been substantial developments in the regulation of hedge fund managers in the 25 years since AIMA’s foundation, the way hedge funds are structured has not changed to the same extent. In the early days, it was common for separate standalone funds to be established for different types of investors, with such funds investing in parallel. This gave rise to the need to rebalance the portfolios of such parallel funds whenever investors subscribed or redeemed therefrom, leading to unnecessary operational complexity. As a result, it became common for such funds to be established as feeder funds into an offshore master fund, such that there was a single portfolio of investments to be managed and thus no requirement for rebalancing.

Similarly, in the early days, where it was desired to offer investors the ability to subscribe for shares denominated in different currencies to reflect investors’ preference for a particular currency exposure, separate offshore funds were established with shares denominated in the desired currencies. This resulted, however, in the existence of additional parallel funds and it was not long before separate classes of shares in a single fund but denominated in different currencies began to be launched.

Around the same time, managers who had been rebating to their partners and employees the management and performance fees charged on shares held by them in their funds, on the basis that it made

no economic sense for them to be paying fees to manage their own money, began to realise that such rebates constituted taxable income in the recipients’ hands. As a result, many funds started to create so-called management shares for partners, employees and, sometimes, family and friends which were identical in all respects to shares issued to investors save that no fees were payable thereon.

In terms of domicile, most offshore corporate funds have always been established in the Cayman Islands, although for largely historic reasons certain managers have established their funds in the BVI. So far as limited partnership funds are concerned, the majority have tended to be established in Delaware although for various reasons in more recent times a sizeable minority have been and continue to be established in the Cayman Islands.

Whilst the dominance of the Cayman Islands has continued, both Ireland and Luxembourg have also attracted a number of hedge funds, usually where the manager wished to target European institutional investors. Such investors are generally considered to prefer, and to some extent are restricted to, investing in funds established in jurisdictions where they are more highly regulated.

Lastly, it is perhaps worth mentioning that there was a time when many new funds sought a listing of their shares on the Irish Stock Exchange which it was thought would assist in marketing the fund to institutional investors. It was also thought a listing might give investors in an offshore fund established in a more lightly regulated jurisdiction, such as the Cayman Islands, a level of comfort


The LTCM debacle in 1998 was the catalyst which led to the world's leading regulatory authorities first seeking to understand what the hedge fund industry was about.

16

Knowing your business

“A dominant presence in the hedge funds market… …They are a top firm and provide excellent service.” Chambers & Partners 2015

Simmons & Simmons has a highly specialised international financial services team. We advise on the full range of domestic and cross-border legal and regulatory issues for market participants on both the sell-side and buy-side.

Together with our award-winning hedge funds practice, the financial services team provides a service specifically tailored to the asset management industry, including a dedicated online resource for start-up hedge funds – Simmons & Simmons LaunchPlus.

To discuss how we can help your business, contact Iain Cullen or your usual contact at Simmons & Simmons.

Iain CullenPartner

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As a founding member of AIMA, Simmons & Simmons would like to congratulate AIMA on its 25th anniversary

Simmons & Simmons is an international legal practice carried on by Simmons & Simmons LLP and its affiliated practices. Simmons & Simmons LLP is a limited liability partnership registered in England & Wales with number OC352713 and with its registered office at CityPoint, One Ropemaker Street, London EC2Y 9SS. It is regulated by the Solicitors Regulation Authority.

that some body (albeit not a regulatory one as such) would have an ongoing oversight role in relation to the fund’s activities under the stock exchange’s continuing obligation rules. In more recent years, however, the number of such listings has substantially decreased.

Although the structure of hedge funds may not have changed much, there have been many changes in the way hedge funds are operated, driven frequently by the demands of an increasingly sophisticated investor base rather than by regulation. These include the appointment of administrators, unaffiliated with the manager, to provide an independent valuation of a fund’s assets, though in this regard the EU Alternative Investment Fund Managers Directive has to some extent turned the clock back as it places the responsibility for valuation on the manager. Another change has been an increased focus on corporate governance which has led increasingly to the appointment to the boards of funds of a majority of independent directors who are unaffiliated with the manager or the fund’s service providers.

LTCM debacle AIMA’s industry views were not always sought or welcomed in the early days by regulators, politicians or the press. It was the LTCM debacle in 1998 that was the catalyst which led to the world’s leading regulatory authorities first seeking to understand what the hedge fund industry was all about. That the willingness to listen to AIMA’s views and those of its membership changed, at least so far as the regulators are concerned, is demonstrated by the willing participation of regulators from the US and Europe at AIMA’s first International Regulatory Forum in 2000. Despite serious concerns about the potential of hedge funds to cause systemic risk, the main consequence of LTCM was that prime brokers began to demand greater portfolio transparency from their clients.

In the years leading up to 2005 when politicians (who can forget the senior German politician’s description of hedge funds as a “swarm of locusts”?), journalists, central bankers, academics and company managements first began to comment on the need for increased regulation of hedge funds, AIMA actively pursued, in line with its objectives, an agenda which involved: educating its members on the benefits of sound practices; publishing its first DDQ in 1997; the first edition of its Guide to Sound Practices for Hedge Fund Managers in September 2002; and in 2005 the first editions of its Offshore Alternative Fund Directors’ Guide and of its Guide to Sound Practices for Hedge Fund Valuation.

The first occasion when regulation was actually mooted was in January 2004 when the European Parliament submitted to the European Commission a proposal for a directive introducing the concept of a sophisticated alternative investment vehicle (the so-called “Purvis Report”). Subsequently

this was quietly dropped; indeed, very few people now recall its existence.

Later the same year, the French Autorité des marchés financiers (AMF) worked with AIMA and the French fund managers’ association on the development of the AMF’s new regulations for French domestic hedge funds, in particular with respect to their relationships with prime brokers. Approximately one year later, in June 2005, the UK Financial Services Authority (FSA), as it then was, issued two discussion papers, the first seeking to assess the risks posed by hedge funds and to identify the risk mitigation steps it would consider taking; and the second seeking views of the investment community in relation to the possibility of permitting wider retail access to hedge funds. Neither of these papers led, however, to any concrete proposals for regulation.

A range of international bodies, including IOSCO, the G8, the Bank for International Settlements, the Bank of England and the Financial Stability Forum (now the Financial Stability Board) amongst others, published pronouncements and reports commenting on the risks posed by hedge funds to financial stability and on ways potentially to mitigate those risks from 2005 onwards, both before and after the 2008 financial crisis. Somewhat surprisingly, whilst the 2008 financial crisis led to developments in fund documentation relating to gates, suspension provisions and side pockets, it did not lead to any immediate changes in regulation, perhaps because there was no evidence that the activities of hedge funds posed any systemic risk.

AIFMD introduced In an effort to head off regulation of the industry, the Hedge Fund Standards Board (HFSB) was established in 2009 by 14 leading hedge fund managers to develop practice standards to be adopted by its members, compliance with which the FSA stated would be taken into account when making supervisory judgements. This was a laudable aim but with hindsight it came too late as, by then, bureaucrats within the European Commission had already begun dreaming up what, in 2009, became the first concrete proposal to regulate the hedge fund industry, namely the proposal for an Alternative Investment Fund Managers Directive (AIFMD).

As General Counsel of AIMA I was privileged to see, and to be allowed to comment on,

early drafts of several provisions of the draft directive and subsequently to lead the AIMA working group commenting on later drafts of the directive published by the European Council, Commission and Parliament, until AIMA’s highly competent Asset Management Regulation team took over the running.

As is now all only too well known, AIFMD, which finally came into force in July 2014, has had a significant impact, and will continue to do so, on the management and marketing in the EU of alternative investment funds such as hedge funds. Most recently this has been reflected in the European Securities and Markets Authority’s advice and opinion on the possible extension of the marketing passport under AIFMD to non-EU alternative investment fund managers and/or alternative investment funds. Looking ahead, AIFMD provides that by 22 July 2017 the European Commission must commence a review of the application of the directive and, if appropriate, make proposals for amendments to it. In other words, AIFMD 2 may be upon us in the not too distant future.

This tour d’horizon would not be complete without an attempt to identify what else the future might hold for hedge funds and their managers. It seems likely that the slowdown that we have seen in the last few years in the formation of new hedge fund managers will not be reversed, at least in Europe, and that new managers will instead continue to join existing platforms. This is because not only are the costs of compliance and of the necessary operational infrastructure unlikely to reduce but also the difficulty of raising assets is unlikely to decline if the institutionalisation of the hedge fund investor base continues. It also seems likely that hedge fund managers which pursue an activist investment strategy will begin to set their sights on European companies despite the perceived difference between the legal regimes in Europe and the US where they have mostly concentrated their efforts to date.

It is also noteworthy that the Financial Stability Board recently announced that it was temporarily shelving plans to designate particular entities, such as hedge funds, as systemically important financial institutions and would instead concentrate on looking at whether certain activities that asset managers undertake are particularly risky. Hot on the heels of that announcement, however, came a statement by Mark Carney, the Governor of the Bank of England, that the Bank was now looking at whether risky activity had migrated from banks to hedge funds such that the Bank might need more power to regulate such funds!

In conclusion, it seems fair to say that, like it or not, the regulatory environment for hedge funds will continue to develop, even if the legal environment does not. •

Who can forget the senior German politician's description of hedge funds as a "swarm of locusts"?


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A global footprint requires a global vision. Follow the leader.

Wherever you are in the world, it’s vital to know your market. We have a broad and deep understanding of the assurance, tax, transaction and advisory needs of asset managers globally. So no matter where you are, we can help guide you.

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Myths about hedge funds

r e a l i t yf i c t i o nDespite plenty of evidence to the contrary, many myths have

grown up about hedge funds during the last quarter-century that still persist in the popular imagination

By Neil Wilson

Separating fiction from reality

Perhaps it is in the nature of the beast. But it is undoubtedly true that a mythology has grown up around hedge funds in the public mind — one that

bears little relation to the actual industry which tens of thousands of people work in every day.

It is in the nature of the beast, arguably, because hedge funds were historically shy of publicity and maintained a very low profile — and hence were slow to challenge the assumption that they were ‘secretive’. Hedge funds were often founded and led by entrepreneurs who felt they had developed some deeper insight into the market which gave them an ‘edge’ — a competitive advantage they were naturally reluctant to disclose.

The fact that certain hedge funds delivered exceptional performance — which made the managers very rich — only served to burnish their mystique, one that many in the industry did little to dispel. So hedge funds started to be seen both as ‘secretive’ and as ‘rich’ — even though the latter is only really true of a few in the very top echelons of the industry. Numerous surveys by recruitment consultants have shown that remuneration for the majority is akin to that of a doctor or lawyer.

There have of course been further factors that made hedge funds an object of suspicion to the wider public — such as that they could go short as well as long, which looked to some sceptics like they were trying to damage certain companies; that they were often domiciled offshore — which looked to others like they had something to hide; and that you only ever heard about them in the news on the odd occasion when there was a ‘blow-up’ or a fraud.

You almost never heard about the many hedge funds going about their jobs quietly and delivering steady, superior risk-adjusted returns. In the public mind, by contrast, hedge funds had developed a somewhat raffish image — one that some managers perhaps embraced with a certain relish, but that the great majority just did not recognise and wanted to challenge.

Over the years, many in the industry have sought to tackle these myths — either individually or collectively through organisations like AIMA — and to produce research that challenges the negative perceptions and shines a light on the many positive ways the industry operates. But it has often proven to be a frustrating task — with continuing preconceptions frequently repeated and reinforced by commentators making it difficult to get key points across to the public and politicians.

Hence the battle to improve the industry’s image has been ongoing for several years now, and with increasing intensity since the financial crisis. With many politicians still seeming to target the industry, it is far from being won yet.

As there are many myths about hedge funds, it is difficult if not impossible to put together a comprehensive or exhaustive list. But there are perhaps three main types, which are to do with:

●● Risk — centring on the accusation that hedge funds are more ‘risky’ than traditional investments, and hence ‘dangerous’ for investors and/or for the markets in general;

●● Ethics — centring on the accusation that hedge funds are ‘bad actors’ in the markets and/or in society generally; and

●● Performance — centring on the accusation that hedge fund performance either isn’t all that good or downright bad; and/or not worth the fees investors pay.

In reality, of course, none of these accusations really stack up — as the various research papers produced by AIMA and others have clearly shown. So, in the ongoing quest to help dispel them, let’s take each area in turn:

20

Common risk-related mythsMyth: Hedge funds are very risky compared to traditional investments

Reality: Hedge funds on average are not more risky either than the markets or than traditional long-only investment funds. Over time, indices show that hedge fund returns on average are higher — and, importantly, with considerably less volatility — even if one takes into account ‘survivorship bias’ (allowing for the disappearance over time of poorer-performing funds from the databases, a factor that affects all types of investment indices, not only hedge fund indices). See more on myths about hedge fund performance below.

Myth: Leverage is too high and/or investments are too illiquid

Reality: Hedge fund leverage varies enormously — depending on market conditions at any particular time and on the type of strategy. In long/short equity, one of the biggest strategy areas, it is usually modest — often varying from one to two-and-a-half times (100% — 250%) of assets under management. In fixed income strategies, it can often be a lot more — say 10-12 times — but that is usually in instruments that themselves have very low volatility (like Treasury securities) and often with a market neutral exposure (equally long and short but of different maturities for instance) rather than leveraged and directional.

The leverage among some other financial businesses such as banks, for instance, is by contrast typically a lot higher — with the size of bank balance sheets being typically 10-20 times bigger than their capital base (and often without taking into account off balance sheet instruments like derivatives).

Not many hedge fund strategies focus on illiquid instruments — which are more usually suited to longer-term investment vehicles

like private equity. Those hedge funds that do invest in such areas, such as specialists in distressed debt, tend to require longer liquidity terms for their investors too — to avoid a potential liquidity mismatch — and usually run with little or no leverage.

Myth: A lot of hedge funds ‘blow up’

Reality: A hedge fund 'blow-up' is where investors lose a substantial portion of their investment. These occur very rarely. Past blow-ups have occurred sometimes due to funds running with too much leverage, as was the case with LTCM in 1998, and/or too much concentrated exposure to positions that became illiquid, such as occurred with Peloton in 2007. But lessons have been learned from such experiences in the past, and risk management across the industry has improved as a result. While many funds may have been shut down over the years after suffering modest losses, blow-ups have become increasingly rare — and of course no hedge fund has ever been bailed out by taxpayers.

The ‘failure’ rate of hedge funds has never been inconsiderable — with up to 10% of funds trading shutting down each year, according to research from HedgeFund Intelligence prior to 2008. But most of those shutting down each year were smaller funds, where the managers were giving up because they could not raise enough assets to make them economic — not because their performance was particularly bad. The shutdown rate did spike a little during and just after the extreme conditions of the financial crisis in 2008, but has since dropped again to well below 10% a year.

Myth: Hedge funds cause systemic risk

Reality: Very few funds operate with large enough assets under management and with sufficient leverage to make their potential failure an issue of systemic concern to regulators. Since the financial crisis, studies by regulators have consistently confirmed

this. The problem of “too big to fail” does not affect hedge funds. Unlike banks, hedge funds are considered “safe to fail” by academics and many policymakers.

Common ethics-related mythsMyth: Hedge funds are self-serving and don't contribute to society

Reality: Hedge funds manage money for the public — not to bet against it. The majority of assets under management in the industry are managed on behalf of average citizens — often via their pension funds — as well as for sovereign wealth funds, endowments, foundations, family offices and other sorts of private investors. Surveys have shown for several years that well over 50% of assets in hedge funds are managed for institutional investors.

Myth: They are secretive/opaque

Reality: Many hedge funds may indeed be protective of the intellectual property which is at the basis of their returns. But most are not so secretive as may have been the case in the early days of the industry. Today, hedge funds are far from unregulated — and are indeed required to be registered and to report positions regularly in major jurisdictions (i.e. on a quarterly basis to the SEC on securities held in the United States). The vast majority of hedge funds also now routinely report their monthly returns to one or more of the industry databases.

Myth: They are run by and for only the rich

Myth: They avoid tax

Reality: Hedge funds around the world employ a significant number of people in the financial sector — over 300,000, according to AIMA research. And they are often in high-skilled jobs — which can generate significant tax revenues in jurisdictions like the US, UK, Canada, Australia, Japan, Singapore and

Dollar value of the hedge fund industry's historic returns to investors

Note The estimates contained in the above table and this report are based upon the Hedge Fund Research Database, which tracks the hedge fund industry (including funds of hedge funds). The majority of fund information in the Database is distributed to Hedge Fund Research subscribers, with permission of the fund managers. Funds that decline to be included in the distributed hedge fund database are tracked internally by Hedge Fund Research. Asset size and performance for a subset of internally-tracked funds are determined by internal company estimates and a variety of other sources. In order to arrive at the total assets and asset flows by strategy, Hedge Fund Research uses total assets from all funds contained in the Hedge Fund Research Database as well as all funds tracked internally. Funds of funds are not included in the overall Industry estimates to avoid double-counting. Funds in the Hedge Fund Research Database submit assets under management consistent with conventional reporting methods which specify investor capital under management, net performance fees.

Year Net asset flows ($bn)

Performance-based AUM change ($bn)

2005 $46.9 $85.9

2006 $126.5 $232.7

2007 $194.5 $209.4

2008 ($154.5) ($306.9)

2009 ($131.2) $324.2

2010 $55.5 $261.8

2011 $70.6 $20.1

2012 $34.4 $209.9

2013 $63.7 $312.2

2014 $76.4 $140.3

Total change since 2005 $382.9 $1,489.5

Source: Hedge Fund Research


21

Hong Kong, where many management firms are located. AIMA estimates that the total tax take for governments worldwide runs into the tens of billions each year; in the UK alone AIMA estimates annual tax revenues from hedge fund firms and professionals amount to some £4 billion ($6 billion).

As with other successful sectors that generate considerable wealth, such as technology, hedge funds have also become massive contributors to charitable causes — both individually, through foundations that they have created, and collectively through industry-wide charities.

Myth: Hedge funds have no economic value or are bad for markets and other investors

Myth: Short selling has a negative impact/‘irresponsible’ shorting causes problems in markets

Reality: Short selling is a perfectly legitimate activity. It is facilitated via the securities lending market — where owners of securities make them available to borrow (for a fee). This helps narrow bid/offer spreads and improves liquidity, making the market more efficient, less volatile and hence more attractive to all sorts of participants.

For hedge funds, the ability to go short is the main means by which they are able to hedge — to reduce the risk and volatility of their overall portfolio and to hold long positions with greater confidence — as well as to make specific bets that the prices of certain individual securities they believe are over-valued are likely to fall.

Short selling activity is unlikely to exacerbate a crisis or panic situation in the market — because, when prices are falling fast, borrowing stock becomes typically much more expensive if not very difficult or

impossible to execute. Hedge funds are only likely to profit in such a situation if they had put the short positions on long before prices started to fall.

With the ability to go short as well as long, hedge funds are in fact well placed to help the markets puncture speculative ‘bubbles’ that can and do occur, as they will tend to short securities that they believe are getting over-valued.

Similarly, when prices are declining, hedge funds with open short positons are often the only natural buyers in the market at that time — when ‘long-only’ investors are more likely to be selling — and so can effectively create a buffer against a falling market turning into a complete collapse. In practice, to realise profits on short positions, hedge funds need to be ‘buying back’ — at lower prices than they had previously sold.

Myth: Hedge funds were responsible for the financial crisis/crash

Reality: Hedge funds were not responsible for the financial crisis. The crisis was created by irresponsible lending in the banking sector, encouraged by the easy ability of banks (in the pre-crisis period) to create and then securitise ‘toxic’ loans in areas like US sub-prime mortgages. Some hedge funds were indeed among the first to identify that these loans were toxic and to go short of them, realising enormous gains. But the vast majority of hedge funds, which do not focus on the credit sector, were negatively impacted — just like most other types of businesses — when the entire banking system threatened to implode.

Certain hedge funds may have shorted certain bank stocks during the financial crisis. But hedge funds being short was not

the reason why those banks failed or had to be bailed out — that was simply due to the scale of the losses the banks had incurred.

Myth: Activist funds are just in it for themselves

Reality: Certain types of hedge funds have been singled out for causing a negative impact on markets or society — including ‘activist’ funds which encourage companies to enhance shareholder value. But plenty of research (including a 2015 report by AIMA) shows that their impact has generally been positive — on individual companies and the wider economy.

Myth: Hedge funds are not long-term investors

Reality: While some hedge fund strategies involve a large amount of short-term trading, others — including many activists and distressed debt investors — involve a much more long-term approach.

Common performance-related mythsMyth: Returns are not all they are cracked up to be/are poor or really bad

Myth: Returns are very good — but only for the rich

Myth: Assets are falling because performance isn’t good

Reality: As highlighted above, overall hedge fund performance over time has been considerably better than the returns in equity markets — and with considerably less volatility — even allowing for ‘survivorship bias’ (the disappearance over time of poorer performing funds from the databases, a factor that is also present in equity indices).

Hedge funds are not 'riskier' than traditional asset classes: Comparison of annualised volatility of hedge funds, S&P 500 and global bonds

0.0%

6.0%

4.0%

2.0%

8.0%

10.0%

16.0%

14.0%

12.0%

Annu

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3.9%

9.1%

HFRIFWC

S&P 500

BarclaysGA ex-USD

3 Year (Jan 2012− Dec 2014)

5.5%

5 Year (Jan 2010− Dec 2014)

HFRIFWC

S&P 500

BarclaysGA ex-USD

5.2%

13.0%

7.2%

10 Year (Jan 2005− Dec 2014)

HFRIFWC

S&P 500

BarclaysGA ex-USD

6.3%

14.7%

8.1%

20 Year (Jan 1995− Dec 2014)

HFRIFWC

S&P 500

BarclaysGA ex-USD

7.0%

8.2%

15.1%

Source: HFR, Barclays, AIMA research

Myths about hedge funds

22

This outperformance has been most pronounced during periods when equity markets have fallen sharply — such as during the ‘dotcom’ bust of 2000-2003 and during the financial crisis of 2008, when even though hedge funds on average may have produced negative returns they were still well ahead of the losses in equity markets.

Certain commentators have argued that net returns from hedge funds over time — after allowing for fees — have been negligible, which may have appeared to be the case for some investors immediately after the sharp drop of 2008. But such contentions have not stood up to more rigorous scrutiny.

Over shorter time frames, hedge fund performance has indeed sometimes lagged equities — most often during periods when there have been sharp rallies or strong bull market trends. Over other shortish timeframes, sometimes running to multi-year periods in gently rising markets, hedge fund return correlations have sometimes risen too — but the correlation has usually dropped whenever volatility spiked again.

There have been various sources of confusion in the debate about hedge fund returns. For one thing, the composition of the various hedge fund indices vary considerably, which can result

in them showing rather different returns over the same time series. This partly reflects the fact that hedge fund returns, even with the same strategy area, vary considerably — with considerable dispersion among the individual funds. Many of the indices focus on a simple median of the funds included — not allowing for any skew in the distribution of returns, which can often be to the high side of the median (i.e. with a significant minority outperforming by a wide margin).

Another common problem is a widespread misperception that hedge funds are an asset class — like equities or bonds — and this misleading notion has still only been partially dispelled over time. Hedge funds are not an asset class. Rather, they adopt a range of strategies with varying approaches — including the use of long and short positions and leverage — across a range of different asset classes. Hence it does not really make a great deal of sense to compare hedge fund returns in general against equity indices. It makes more sense to compare equity hedge fund returns against equities, fixed income hedge funds against bonds and so on.

For strategies which trade across a range of asset classes — such as global macro or managed futures — it probably makes more sense to compare those only against the risk-free interest rate in the relevant currency. Judged by that more appropriate yardstick, the outperformance of those funds has been considerable over many years.

It is not surprising, therefore, that hedge fund assets have risen strongly over the years — apart from the sharp drop of 2008, since when they have been rising again at a rate if more than 10% a year. Investors would not be putting so much more money in if the performance was indeed disappointing. •

0%

-200%

1000%

800%

600%

400%

200%

1173%

906%

403%

349%

1200%

1400%

HFRI Fund Weighted Composite IndexMSCI World (Local Currency TR)

S&P 500 (TR)Barclays Global Agg (TR USD UNH)

Jan-

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15Hedge funds beat the traditional asset classes: Hedge funds versus main asset class cumulative returns (1990 − 2015)

For more detailed evidence, take a look at the following reports on the AIMA website:

• Financing the Economy — The Role of Alternative Asset Managers in the Non-Bank Lending Environment — AIMA, May 2015

• Tax Paid by the UK Hedge Fund Industry at Record Levels — AIMA research, February 2015

• Unlocking Value — The Role of Activist Alternative Investment Managers — AIMA, February 2015

• The Way Ahead — Helping trustees navigate the hedge fund sector — AIMA/CAIA, January 2015

• Capital Markets and Economic Growth — Long-Term Trends and Policy Challenges — AIMA, May 2014

• Apples and Apples — How to Better Understand Hedge Fund Performance — AIMA, April 2014

• Contributing to Communities — AIMA Review of Hedge Fund Charitable Activities — May 2013

• The Value of the Hedge Fund Industry to Investors, Markets and Broader Economy — AIMA, April 2012

• The Value of the Hedge Fund Industry to Investors, Markets and Broader Economy — AIMA, April 2012

• No hedge fund today should be deemed systemically important — AIMA statement, July 2011

• Global Hedge Fund Industry employs 300,000 — AIMA research, December 2010


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Learning the lessons from

the pastAs the hedge fund industry has evolved since 1990 it has had to

learn a series of important lessons

By Niki Natarajan

Confucius said, "Study the past, if you would divine the future". If he was right, then what should we study to prepare for the future? Are there lessons the long-only world can teach the hedge fund industry as it enters a new ‘retail’ era with liquid

alternatives? What feedback can the hedge fund industry use from ‘failures’ such as Long Term Capital Management, Bear Stearns, Bernard Madoff and Amaranth Advisors, among others, as it moves forward?

Regulators are working overtime trying to interpret their solutions to many of the ‘lessons’ that the various credit crunches, liquidity

mismatches and counterparty risks, to name but a few, have taught us, to make banking and investing more ‘safe’ for investors.

But might their zeal to avoid the past be creating problems in the future? Is the availability heuristic—a behavioural bias that relies on using only the most readily available information to make decisions about the future—driving decisions without considering that there might be data further back in the archives?

What are the top 10 lessons from the last 25 years, and has the industry learned them?

Learning the lessons from the past

24

25

Temple of Confucius


Lesson 1 Liquidity —

available in theory, but is it there in practice?

Selling is often harder than buying. In the past, liquidity mismatching in portfolios was too often overlooked — that was, until the aftermath of it drying up. Today, the mantra is liquidity, liquidity, liquidity, and yet precious returns can of course be lost if that liquidity is not really required.

As underlying strategies are applied to more liquid onshore structures, often via the use of derivatives, an important question to ask is: ‘In the event of needing it, will it be available?’

Roger Lowenstein, author of When Genius Failed, and of an essay in The New York Times September 2008 entitled: Long Term Capital: It’s a Short-Term Memory, has pointed out that it may not be. “The belief that one can get safely out of a ‘liquid’ market is one of the great fallacies of investing,” he wrote.

Few thought that after the crisis involving Long Term Capital Management (LTCM) in 1998, liquidity could dry up again so fast. And yet it has done time and again, resulting for instance in the near-collapse of Bear Stearns in 2008. The investment bank, which was eventually bought by JP Morgan, got caught out in a supposedly liquid market in sub-prime mortgage investments and the notice of bankruptcy of its two funds investing in these strategies may have been a catalyst for the financial crisis. Ensuring the strategy’s liquidity requirements and liquidity of the wrapper are carefully matched is what is essential, in particular as the industry heads into a new era of ‘liquid alternatives’.

Lesson 2 Derivatives — friend or foe?

One operative word linking LTCM and Bear Stearns is derivatives. Derivatives enable users to find new ways to re-package old structures, such as debt and mortgages, to provide ‘solutions’ to challenges that clients present.

When looking closely at how a sudden loss of liquidity hit both LTCM and Bear Stearns, it is important to highlight that the issue was less the assets they traded, but their reliance on off-balance sheet derivatives as a way to trade them.

Today there are two industry shifts that are likely to see the increased use of derivatives. The first is the UCITS revolution that allows hedge fund strategies to fit into a liquid wrapper — where, in many cases, derivatives are being used to achieve this. And the second is the regulators’ recent and ongoing moves to deleverage the system.

New regulations such as Basel III are forcing banks to be more parsimonious with their exposures both on and off balance sheet — and hence be more selective as to which hedge funds they finance. Hedge funds that cannot get financing through the traditional channels may have to look at new synthetic financing via derivatives to structure their trades.

The lesson of previous crises is that derivatives of course cannot really remove risk, but rather allow for the transformation of where risk resides. Investors need to pay attention to where the risk really is.

Lesson 3 Leverage — Hedge funds may have to get by with less

Leverage was one of the factors allowing hedge funds to post outsized returns in the past. Regulation and low interest rates have now conspired to reduce leverage and credit to support such trading strategies of the past.

Bubbles occur when credit is easy to obtain — so regulators globally are now on a mission to make sure that banks and hedge funds are more constrained in terms of their borrowing. In the short term, the new regulations they have been pushing through are likely to stymie returns from some hedge fund strategies. But in the long term it is more than likely that savvy hedge funds will find alternative sources of funding, such as through so-called shadow banking or synthetic financing.

Again investors need to ask: Will the next set of financing innovations potentially bring with them a new set of unintended consequences?

26

Lesson 4 Transparency — now you have it, but do you understand it?

Thanks to a number of factors including the institutionalisation of the industry and even the Madoff affair, the hedge fund industry has recognised the importance of transparency. For many investors today, third party managed account platforms are no longer a luxury item but an essential business tool.

Few now buy hedge funds without knowing that they get plenty of transparency on what is in the portfolio, but answering questions like: ‘what information do you want?’; ‘how often do you need it?’; ‘what format would you like it in?’; and ’how do you intend to use it?’ is a different story.

One of the greatest liabilities an investor has today is having the transparency but not doing anything with it — or not really knowing what to do with it.

Lesson 5 Diversification — how correlated are you still?

In the early 1990s, more investors moved from balanced to specialist investing, and in doing so they ‘diversified’ into Japan, emerging markets, US and other ‘exotic’ markets — mainly or all through equities. So when the global stock markets crashed in 1997 in the aftermath of the Asian crisis, many discovered they were not so diversified after all.

A similar thing happened during the financial crisis. Many investors that thought they were diversified because of their hedge fund holdings only to discover too late that those holdings had become highly correlated during panic selling of all stocks in the stressed market.

Whether it is avoiding an over-concentration in stocks from banks and financial institutions, as many investors had going into the financial crisis, or not being simply in one hedge fund into which all the ‘alternatives’ allocation was investing in, genuine diversification across asset classes and across providers continues to be one of the most important investment lessons to remember.

The crisis highlighted that diversification alone cannot save a portfolio. Low correlation between assets held is key to capital preservation.

Lesson 6 Key allocator risk — don’t forget consultant risk

Hedge funds have always known about the importance of diversifying their client base. Indeed there are more than one or two managers who will remember their single largest investor pulling their allocation, resulting in their fund’s closure.

Few, however, will have made this connection with consultants. This is a lesson that any hedge fund manager that has been removed from a consultant's buy list can attest to.

When a consultant takes a hedge fund off its buy list, rapid inflows can turn to rapid outflows almost overnight. As the hedge fund industry becomes reliant on the consulting community for institutional inflows, increasingly consultant risk is a lesson in waiting.


27

Lesson 7 Ongoing due diligence — never skimp on it

From an investor point of view, due diligence is like the right fuel for a car, essential to get right all the time. Without it, or with the wrong kind, the car won’t run.

In the hedge fund space, where alpha is mercurial and profitable traders thrive on loopholes, a park-and-play attitude to investing can land investors in hot water. A number of funds of funds and one consultant found this out the hard way in the case of Amaranth Advisors: Rocaton Investment Advisors, an investment consultant, ended up paying $2.75 million to San Diego County Employees’ Retirement Association for recommending Amaranth.

Diversification across hedge funds helped those FoHFs with exposure on a performance basis, but not necessarily on a reputational basis. As more and more allocators buy hedge funds directly, and in many cases put lots of eggs in one basket, ongoing due diligence is going to be key to avoid investment-related mishaps.

Lesson 8 Risk management — is it more than just risk reporting?

“The market can stay irrational longer than you can stay solvent” — as said John Maynard Keynes. Risk management is about knowing when to cut positions (or add to them), it is not about avoiding risk.

Investors need to know that the risk management function inside a hedge fund is second to none, and to know the information is right, and that often means having experience of the markets the hedge fund is trading. How a manager stops positions and cuts losses, who is ultimately responsible for risk oversight, and how many counterparties a hedge fund has are all facets of the risk management role. Risk management is far more complicated than simply risk reporting.

Amaranth was an example of a natural gas trade that grew bigger than the regulators knew, because of the ‘Enron loophole’. Despite the NYMEX exchange forcing Amaranth to reduce its positions in natural gas, further trades were executed elsewhere such as on the Intercontinental Exchange.

The reason Amaranth is held up as an example for so many of this lesson is that it was not a fraud but an investment related risk — one that rigorous, active and knowledgeable risk management both internal and external could have helped investors avoid.

Lesson 9 Regulated wrappers

won’t stop frauds

In the new age of liquid alternatives, a potentially new type of investor might start to access hedge funds. It is very easy for the novice investor to be lulled into a false sense of security when they see the words ‘onshore’ and ‘regulated’. But it is important to remember that a UCITS wrapper will not stop frauds.

Manager selection, due diligence, risk management and diversification are arguably even more important for the underlying portfolios when they are wrapped in a new onshore structure such as UCITS because old track records do not count and new managers are able to enter the market.


28

Lesson 10 Counterparty risk — can history repeat itself?

When Rick Sopher of LCF Rothschild first agreed to host a discussion on counterparty risk it was a topic he felt passionate about — as he could foresee problems that few seemed to be taking seriously.

When the agenda was set six months previously, few even knew that the word ‘re-hypothecation’ even existed, let alone what it could mean to them. But by the time Sopher took to the stage at the British Museum to discuss it on 23rd September 2008, Lehman Brothers had collapsed and there was standing room only in the session.

At the time many hedge funds had only one prime broker, custodian and administrator, and much less thought was given generally by managers and investors to the quality of counterparties than the rest of the business. After Lehman all of this changed of course — and some investors will only invest in a fund now if it has more than one counterparty and, depending on the size of the fund and its complexity, multiple counterparties may be required.

Few believe that this issue could raise its head again as multiple counterparties has often become a non-negotiable element of doing business. The impact of Basel III on limiting bank balance sheets, however, means that smaller hedge funds or those that are not active traders are finding themselves being turned away by counterparties. Some hedge funds are finding they have no choice but to consolidate their activity with a single counterparty to avoid hefty charges. •

Final thought: Learning the importance of an industry bodyEvery hedge fund and every allocator will have learned something on their journey. Making sure the lessons, these or others, are firmly engrained as they step towards a new and in many cases more liquid and retail future will stand them in good stead to become the ‘go to’ tool for investors as they manage their assets more optimally.

One last thought — courtesy of Ian Morley, founding chairman of AIMA 25 years ago, who reminds us how standing together with AIMA makes the industry more solid than going solo. “You would not readily think of trade unions and hedge funds as natural soul mates. Yet several years ago I watched a trade union speaker make a point. He asked a member of the audience to break a pencil. They did so easily. He then asked them to try and break twenty pencils all at once. They couldn’t.

“A group is stronger than any individual. A group that speaks with a single voice to represent the collective interest will be heard in the corridors of power in a way that no single person can achieve alone. The trade unions have known this for over 100 years; the hedge fund world for 25 years, when AIMA was formed to be the only global trade association that allows them to lobby as a collective forcing people to listen. As they chant at the Kop in Liverpool: ‘You will never walk alone’.”


29

Consolidation and ever greater concentration of assets among a small group of the biggest players has been an ongoing story in the funds of hedge funds world ever since the financial crisis of 2008. During the crisis, there was a rapid shrinkage in the

FoHF sector, and there has since been a recovery of sorts – though much more muted than in the underlying hedge fund industry itself.

The result has been that FoHFs have accounted for a declining proportion of the industry’s assets, though by most measures they still today represent more than 20% of the total. Over the same period, the number of bigger FoHF groups that manage hedge fund assets of $1 billion or more – the InvestHedge Billion Dollar Club – has declined from about 150 separate firms to under 100 following a long series of mergers and acquisitions as well as the disappearance of a number of groups.

The fund of funds world has been continuing to concentrate, with more than 40% of its assets now in the hands of just the 10 largest players – no less than three of which also happen to be investment consultants, according to the 2014 InvestHedge multi-manager survey. This has created a situation that has many in the traditional FoHF community up in arms – because of what they see as potential conflicts of interest that arise (despite whatever Chinese walls are in place) when the consultant is also the provider of the solution, as so often happens in implemented consulting or fiduciary management.

The roles of consultants and funds of hedge funds (FoHFs) have increasingly converged over the years, with significant ramifications

for both fund managers and investors

By Niki Natarajan

ccessing hedge funds:

how ‘solutions’ are the new FoHFs


While implemented consulting and fiduciary management services are likely to be offered across all asset classes, not just hedge funds, the KPMG 2014 Fiduciary Management Survey highlighted some statistics that are likely to be relevant when applied to the selection of hedge funds. The first is the 44% growth in the number of full delegation of fiduciary mandates over the year, a number that is likely to include assets to hedge funds. The second is that of the 92 new mandates, 75% of them were won on an uncontested basis — in other words: in eight out of 10 cases a quote was only provided by the ultimate mandate winner.

This raises the question: How many pension funds are hiring hedge advisers or allocators without the appropriate tender process?

Without a competitive tender process, trustees risk not getting the delegation solution that best matches their needs, KPMG states — an issue that is likely to also be reflected in the selection of hedge funds. The KPMG survey also highlights the absence of investment performance in the fiduciary management industry. In a similar fashion, there is no transparent standardised measurement of the performance of bespoke and customised portfolios, which makes assessing the skills of providers that do not have a commingled track record to show, much harder.

30

The long term damage to the global FoHF industry of not having audited performance for customised and bespoke portfolio included in the indices is that, as more assets flow into the customised solutions, the worse the performance of FoHF indices become, thereby perpetuating the notion that funds of hedge funds are just ‘funds of fees’ with no inherent added value.

Offering bespoke and customised solutions is a relatively new phenomenon in the 45 year timeline of funds of hedge funds. But a couple of firms — Pacific Alternative Asset Management Company, with heritage is in the consulting world, and the former EIM, now Gottex Fund Management — have offered this form of tailoring since their inception. In fact one of the synergies between Gottex and EIM was the product centric focus of Gottex and bespoke forte of EIM that combined with EIM’s Luma managed account platform — now giving the firm a full set of services to offer clients.

This new age of transparency, liquidity and control means that managed account infrastructures allow investors access to a wide variety of hedge funds that would once not be seen dead on a platform. In turn, this has helped the change in how hedge funds have been defined over the last six or seven years, as they have moved away from being seen as an asset class and towards being used as more of a tool for better overall portfolio management.

In the UK, the Cornwall Pension Fund gave FRM a $180 million hedge fund mandate to manage via its managed account platform. Meanwhile, the advisory services that come with many of the platforms allow investors like California State Teachers’ Employee Retirement System, which uses the Lyxor Asset Management platform, to go direct but with a little assistance if required.

Just by looking at the performance dispersion across the 1,414 FoHFs run by 404 management companies in the InvestHedge database it is clear to see that not all FoHFs are the same. Despite the poor perception of FoHFs in the mainstream media, the industry has a role in the hedge fund allocation food chain. This conclusion is supported by the fact assets grew by 8% in 2014, according to InvestHedge, driven more by inflows than

performance as investors looked for more yield in low interest rate environments and protection from the inevitable but

unpredictable likelihood of a spike in volatility.

While the composition of who is winning the race for hedge fund assets may be changing with the entrance of consultants as viable providers, the need for professional hedge fund allocation services is clearly not in question.

Collectively the top three investment consultants now manage some $100 billion in hedge fund assets, making up 13% of the total $767 billion in the InvestHedge multi-manager survey. And while not all three of the investment consultants offer commingled funds, the phenomenon is not new — Russell Investments and Stamford Associates were among the first to do so.

Whether the multi-manager fund is onshore, offshore, a fund of UCITS funds or managed by the independent arm of a major pension fund such as ABP’s New Holland Capital, is a different question. But the demise of the humble commingled product has been exaggerated for the simple reason that a single multi-manager vehicle is a far more cost effective way to manage hedge fund assets than the many and varied bespoke portfolios

with lots of moving parts and objectives. The irony, however, is that as consultants move towards offering commingled funds, FoHFs are expanding their advisory and consulting remit in a bid to retain clients and win new ones. For many FoHFs offering advice is the main areas of business growth and for others it is already the biggest part of their business. While it is well known that advisory fees are low, many FoHFs have employed this strategy to make their mark as — due to their depth and breadth of resources — most FoHFs are well placed to offer solid advice on manager selection based on an existing track record.

Offering low-fee advisory services put Blackstone Alternative Asset Management on the institutional hedge fund map back in 2003 when it won the advisory mandate for California Public Employees’ Retirement

System’s hedge fund portfolio — one that is now being wound down more than a decade later. But with more than $60 billion in assets that make up 8.2% of the entire universe of multi-manager assets, many look at Blackstone’s solution-based model as one to emulate, offering: commingled hedge fund portfolios in all flavours; best ideas funds; a range of liquidity spectrums from illiquid opportunities funds to liquid alternatives; portfolio advisory; and a host of other ways to make sure that client needs are taken care of.

Solution providers Solving problems is the new FoHF because the real challenge facing the industry is not who offers what hedge fund product, but who can offer clients what they need. A current example of this is K2 Advisors, which started as a pure FoHF. Since it was bought by Franklin Templeton, a successful long-only mutual fund giant, it has become a solutions provider offering access to hedge funds, other asset classes and beta strategies, all in a wrapper to suit the client.

The winners are going to be groups that can translate the needs of the clients into solutions that work. On top of the consultant offering implemented consulting, a new threat to the traditional FoHF may come from the long-only asset management brand that has the client base and an army of client relations people but not yet enough alternative products.

An example of this may be seen in the 2015 acquisition of Arden Asset Management by Aberdeen Asset Management. Aberdeen has the clients and the support infrastructure, what it needed was bigger footprint in the US and a deeper hedge fund team. The fact that Arden is adviser to the $6 billion hedge fund

portfolio at Massachusetts Pension Reserves Investment Management and that it has more than $1 billion in liquid alternative assets from Fidelity made it a desirable ‘catch’.

With hedge funds and FoHFs also looking for exit strategies — selling their business or stakes in it — deals such as the one between Texas Teachers’ and Bridgewater are also going be potentially attractive options for investors wanting to access alternatives. Teaming up with a US mutual fund group is the quickest way for a FoHF willing to enter the liquid alternatives space to help stabilise its business with new asset flows and a new client base. M&A in the FoHF space is likely to continue to access skills, distribution or assets and while the FoHF industry is likely to continue to shrink in number of groups it will grow in assets as the solutions mind-set that started in the wake of gating, suspensions,

The irony is that as consultants move towards offering commingled funds, FoHFs are expanding their advisory and consulting remit.

The winners are going to be groups that translate the needs of clients into solutions that work.


31

frauds and general lacklustre performance in the hedge fund industry, continues.

How investors access hedge funds' return streams is changing. As investors look for solutions to enhance returns and protect portfolios, in a regulatory environment that challenges fees and makes the cost of capital expensive, even hedge funds themselves are under threat by the cheaper replicators, alternative betas, risk premia, factor models, investable indices and in fact

anything that purports to offer hedge fund-like returns, cheaply.

The asset manager, hedge fund, fund of funds, or long-only player that can mix and match all the options so the investor gets what they need in a single cost-effective way will be the winner in terms of assets under management. All of this is not to say that the multi-manager culture is dead. Indeed, far from it.

As hedge fund investing enters the ‘retail’ space with liquid alternatives, access to diversified hedge fund strategies will be key. Players in this space such as K2, Arden and Blackstone are those that can access mutual funds distribution channels and offer the solutions in ‘plain English’ language. Hence, to succeed in raising assets with a

liquid alternatives brand will become increasingly important.

In addition to liquid alternatives, access to new alpha and talent in the form of smaller managers is another way FoHFs are distinguishing themselves from the consultants. The latter have typically, but not exclusively, allocated to the larger better known brands. The downside of size is that big allocators can only allocate to big funds to make a difference, leaving the smaller manager market to smaller investors and family offices where performance is more important than anything else. Tages Capital, Larch Lane Advisors and Aurora Investment Management are among the FoHFs that actively seed new managers, while others such as ABS Investment Management are enthusiastic day one investors.

While much of what can be called hedge fund alternative return streams are not proven in dire markets, the real challenge for investors

today is to make sure they know who has fiduciary responsibility for their hedge fund allocations when the markets turn sour or a fraud rears its ugly head.

As the multi-manager industry moves beyond product-driven commingled funds to solution-driven alternatives businesses, investors need to start asking:

●● “Who is in charge of lining up the hedge fund advisers if the consultants are now also the potential provider?”

●● “How do you measure the performance of ‘bespoke’ solutions?” and:

●● “Who is responsible for my hedge fund allocation during times of market stress?”

FoHFs were once deemed 'fast money' by some hedge funds. But one of the greatest lessons hedge funds can learn from the long-only world is that consultant concentration risk can be just as dangerous. •


Source: Preqin

Mean allocation to hedge funds by investor type, 2011 — 2014

As hedge fund investing enters the 'retail' space with liquid alternatives, access to diversified hedge fund strategies will be key.

0

5

10

15

25

20

Mea

n al

loca

tion

%

2012 2013 2014*

Family office

17%

20% 20%

Private sectorpension fund

9%10%

11%

Sovereignwealth fund

7% 7% 7%

Insurancecompany

2% 2%3%

Foundation

17%18% 18%

Endowment

19% 19% 19%

Publicpension fund

7%8% 8%

32

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years

The

next

five

Since the founding of AIMA 25 years ago, we have already seen how hedge funds have become an increasingly mainstream feature of the financial world. But what kind of role will they play in the asset management world of the future? A veritable wealth of

research and analysis, including regular surveys and reports, point towards a range of likely developments over the next few years.

Among the various developments widely anticipated are: a continuing robust rate of growth in industry assets; a continuing rise in the influence of investors in how the industry operates; and a whole range of challenges for managers to overcome if they want to meet those investor requirements — and benefit from that likely asset growth.

Interesting and important surveys and reports include ones conducted regularly by each of the major consulting firms — Deloitte, EY, KPMG and PwC. Not surprisingly, there are a number of similarities among their conclusions, but there are also some interesting differences — in what they anticipate and in what they highlight as the most important challenges for the future.

KPMG International partnered with AIMA and the MFA to produce a report in March 2015 entitled Growing Up — A New Environment for Hedge Funds.1 Among the key things it highlighted were developments on the investor side — and how these were changing the approach of hedge fund managers.

The report, which was based on global research involving over 100 hedge fund firms representing over $440 billion in assets, found that a majority of hedge fund managers expect a significant shift in their primary sources of capital toward pension funds over the next five years. Public sector pension and sovereign wealth funds will be increasingly important over the next five years through 2020, the report found. And institutional investors, it predicted, will continue to eclipse high net worth investors as primary sources of investment.

It also found:

●● Almost 70% of managers say they offer, or plan to offer, customised investment solutions;

●● More than two-thirds anticipate using specialised fee structures to attract allocations, including a significant minority planning more UCITS funds;

●● More than four in 10 expect to change the mix of countries where they invest — with more than a third shifting their focus more towards emerging and frontier markets; and:

●● Regulation is being seen as the biggest threat to growth — as cited by more than 75% of managers.

Some of the same themes and conclusions were also reached in the EY global hedge fund and investor survey entitled Shifting Strategies: Winning Investor Assets in a Competitive Landscape,2 published in November 2014. But this report also highlighted some different things — in areas such as new products, expenses, outsourcing and cyber security — and also suggested that new allocations from institutional investors in North America and Europe that are already big allocators to hedge funds would likely be slowing in the years ahead.

This EY survey was also based on interviews with over 100 hedge fund managers, representing $956 billion in assets, plus 65 interviews with institutional investors representing $1.3 trillion of assets ($220 billion of which being allocated to hedge funds). It found that larger managers, with over $10 billion of assets under management, were continually launching new products, including separately managed accounts, liquid alternatives and long-only funds, where investor appetite appeared to be strong. However, it said many of these sorts of products had generally lower fee structures, that many managers were under-estimating the costs — and that this was affecting margins.

1 www.aima.org/download.cfm/docid/365F6A57-DB56-4430-9683CC34571D9F022 response.ey.com/CSG3/2014/1407/1407-1284479/HFsurvey14/GHF14.html?Shortcut=HFsurvey14

There is a wealth of research from recent surveys and studies looking to the future — and how hedge funds are likely to continue to grow, but are also grappling with various complex challenges ahead

By Neil Wilson


35

The next five years

According to the EY survey, nearly one in four managers that had launched a new product in the previous three years said it had had a negative impact on margins. The effect was particularly marked on those offering sub-advisory arrangements, with 43% of them saying it had had a negative impact. Other key things highlighted in the EY survey included:

●● Regulatory reporting expenses are creating an added drag on margins and creating a barrier to entry;

●● Smaller funds are having trouble raising capital to develop new products;

●● Expense ratios had “declined modestly” over the previous three years — perhaps reflecting a rising pressure on managers to reduce fees — but that about three-quarters of investors still took “no issue” with the expense ratios on their funds;

●● Outsourcing is continuing — while internal headcount, especially in the back office, is continuing to decline;

●● Cloud computing and cyber security are becoming key themes for the industry — with only a minority of investors saying they were “confident” in their managers’ cyber-security policies, and a vast majority of managers intending to make additional investments in that area.

Cloud computing and cyber security are becoming key themes for the industry.

Cyber security also turned out to be one of the major themes of the latest Deloitte report, its 2015 Alternative Investment Outlook,3 put together by almost a dozen partners and other senior personnel at the Deloitte Center for Financial Services. The report highlighted three main focus areas in the current year:

Globalisation — both in terms of new investment markets that managers in the US (historically dominant in hedge funds) cannot afford to ignore; and in terms of new investors in parts of the world many managers may not have raised money before, but which will become increasingly important. Management firms would therefore need to work out how best to be set up to cope with the regulatory, tax and operational challenges to tackle this increasingly globalised world.

Monetisation — with an increasing number of managers looking at either selling stakes in their business to institutional investors all the way through to potential IPOs. This was being driven by a number of factors — from the pressure for succession planning to the need to raise more capital and ally with strong external partners in order to raise capital for expansion.

Strategic brand management — the need to plan for and cope with any “risk event” such as a valuation error, conflict of interest or potential data breach. Given the rising risk of cyber attacks in particular — which had already caused major impacts in other industries — managers would need key building blocks in place: on governance, standardised risk reporting and what the report called “risk sensing”. The latter, it said, involved developing “the ability to identify emerging risks and trends quickly

and thus allow for a more nimble and effective response to risk” — what it said was “a critical skill in today’s complex financial environment”.

Other key predictions of the Deloitte report included:

●● Larger managers will continue to get bigger, while smaller managers will compete by focusing on niche sectors;

●● Alternative managers in general will increasingly engage the retail investor;

●● The importance of data will grow, but also become more challenging;

●● More managers will improve oversight of external risks, increase use of risk-based reporting models and offer customised reporting.

3 www2.deloitte.com/content/dam/Deloitte/us/Documents/financial-services/us-fsi-2015-alternative-investment-outlook-123114.pdf4 www.pwc.com/gx/en/asset-management/publications/pdfs/alternative-asset-management-2020.pdf

36

Some of these themes, together with other points, were also highlighted and amplified in a PwC report, Alternative Asset Management in 2020,4 published in January 2015.

In its report, PwC envisaged that the principal focus for many firms will shift toward creating a broader asset class and product mix and to the opening of new distribution channels. It also envisaged a shift in focus and investment of more time and resources into business strategy, operational design and “data-informed decision-making”.

Factors like these will help to propel alternative managers towards centre stage of the wider asset management world over the next five years, PwC predicted, with total assets under management in alternatives reaching somewhere between $13.6 trillion and $15.3 trillion including private equity and real assets as well as hedge funds. Within

that, it predicted that hedge fund assets (including the fund of fund sector) would grow from around $2.9 trillion at the time of the report to about $4.6 trillion − $5 trillion in 2020.

In this developing new environment for asset management, PwC highlighted six areas where managers will face challenges and have to make key decisions. These were described as:

●● Choose your channels: With managers needing to decide which segments of a varied investor base to target — from sovereign wealth and pension funds to emerging markets to retail — and hence what they need to put in place to tap those market segments successfully.

●● Build, buy or borrow: Whether to add new products to an existing platform or to grow in other ways such as via acquisitions.

●● More standardisation, more customisation: How to cope best with the rising demand both for more bespoke ‘made-to-order’ products, but also for simple and cheaper products like liquid alternatives.

●● From institutional quality to industrial strength: How to cope with the demand from investors for ever higher standards in key functions like compliance, tax and investor servicing.

●● The right resources in the right places: How to use the rising trend toward more data-informed decision-making to arrive at successful “right-sourcing” strategies for when and where to deploy in-house capabilities or to outsource.

●● It’s not only about the data: How to best use the rising trend towards data-centric analytics and solutions to better measure and enhance operational strength and key operational processes.

Each of these reports brings to light some different things, and likely scenarios for the future. But all of them predict an industry that looks like it will continue to grow and change a great deal over the next five years — though also with significant issues that individual firms will need to tackle. •

16

14

12

AuM

($t

r)

10

8

6

4

2

01.0

1.0

26.5%

28.5%

17.0%

37.9%

6.6%

9.5%

6.3%

6.9%

8.9%

8.8%

2.5

5.3

7.9

13.6

15.3

2004

Private Equity

2007 2013 2020(Base case)

2020(High case)

0.5 2.5

2.0

0.8

3.6

2.9

1.46.5

4.6

2.5

7.4

5.0

2.9

6.9%

8.1% 9.9%

Real Assets Hedge Funds & FoHF CAGR

Projected growth in alternative assets, 2015 — 2020

Source: PwC Market Research Centre analysis based on Preqin, HFR and Lipper data.

Hedge fund assets are predicted to grow to between $4.6 trillion and $5 trillion by 2020, says PwC.


37

Virtual roundtable:Five years yonder…

After 25 years of rapid growth and change in hedge funds since the foundation of AIMA, a group of leading players from around the world give their views on the outlook ahead for markets,

investors and the industry Compiled by Neil Wilson

James G. Dinan, York Capital ManagementJamie founded York Capital Management in September 1991 and is the Chairman, Chief Executive Officer and a Managing Partner of the Firm. Jamie is a Co-Portfolio Manager of the York Multi-Strategy, York Credit Opportunities, York Event-Driven UCITS funds, York Sub-Advised ’40 Act Strategy, and Portfolio Manager of the York Total Return funds and is the Chair of the Firm’s Executive Committee.

From 1985 to 1991, he worked at Kellner, DiLeo & Co., where he became a General Partner and was responsible for investing in risk arbitrage and special situation investments. From 1981 to 1983, Jamie was a member of the investment banking group at Donaldson, Lufkin & Jenrette, Inc.

Jamie is currently the Chairman of the Board of Trustees of the Museum of the City of New York, and a member of the Board of Directors of the Hospital for Special Surgery, the Board of Directors of the Lincoln Center for the Performing Arts, Harvard Business School’s Board of Dean’s Advisors, the Board of Trustees of the University of Pennsylvania and The Wharton Board of Overseers at the University of Pennsylvania. Jamie received a B.S. in Economics from The Wharton School of the University of Pennsylvania and an M.B.A. from Harvard Business School.

Luke Ellis, Man Group plcLuke Ellis is President of Man Group plc (‘Man’), based in London, and a member of the Man Group Executive Committee — as President of Man, Luke is responsible for managing Man’s four investment units, Man AHL (‘AHL’), Man GLG (‘GLG’), Man Numeric (‘Numeric’) and Man FRM (‘FRM’). Prior to assuming his current role, Luke was Head and CIO of Man’s Multi-Manager Business.

Before joining Man in 2010, he was Non-Executive Chairman of GLG’s Multi-Manager activities and manager of the GLG Multi-Strategy Fund from April 2009. Prior to this, he was Managing Director of FRM from 1998 to 2008 and one of two partners running the business.

Before joining FRM, he was a Managing Director at JPMorgan in London, and as Global Head was responsible for building the firm’s Global Equity Derivatives and Equity Proprietary trading business. Luke holds a BSc Hons. in Mathematics and Economics from Bristol University.

Loïc Fery, Chenavari Investment ManagersLoïc Fery is Chief Executive and co-Chief Investment Officer of Chenavari Investment Managers (www.chenavari.com), a group of regulated asset management companies (London, Luxembourg, Hong Kong, Sydney) focused on credit, debt and structured finance public and private markets.

Loïc created Chenavari Investment Managers at the end of 2007. Since then, Chenavari Investment Managers established as one of the leading alternative credit managers globally; with approx. $5.5 billion assets under management (as of July 31st 2015) and over 100 investment professionals, it is one of the largest independent non-US credit hedge fund managers.

Chenavari Investment Managers’ clients include institutional investors, pension funds, sovereign wealth funds and family offices globally. Chenavari credit funds steady performance was recently acknowledged with several industry awards, such as Institutional Investors, Eurohedge and Hedge Fund Magazine.

Prior to setting up Chenavari, Loïc was Managing Director, Global Head of Credit Markets of the investment bank of Credit Agricole. He was responsible globally for Credit, Structured Credit & High Yield activities of the bank, including Trading, Structuring and Sales activities. In 2005, he became the youngest Managing Director appointed to the “Cercle des Dirigeants” of Credit Agricole Group.

Loïc Fery graduated from the French business school HEC and started his career in credit markets in Hong Kong − where he lived for 4 years − while running the Asian Credit Trading desk for Societe Generale. Loïc is often mentioned as one of the market participants who pioneered the development of European credit markets and one of the only independent asset managers who started in Europe since 2007. He co-authored several books on credit derivatives and securitisation topics, focusing on the convergence of credit markets activities and funds/private equity activities. He is also an occasional lecturer on alternative asset management at industry conference and business schools.

Loïc, 41, lives in London and is married with 3 children. As a personal interest, he is the owner of FC Lorient (www.fclweb.fr), a French Premier League football club.

Participants


39

Participants

Sir Michael Hintze, AM, CQSSir Michael is the Founder, Chief Executive and Senior Investment Officer of CQS, one of Europe’s leading credit-focused multi-strategy asset management firms. He is also a Senior Portfolio Manager.

Prior to establishing CQS in 1999, Michael held a number of senior roles at CSFB and Goldman Sachs. He began his career in finance in 1982 with Salomon Brothers, New York, after working as an Electrical Design Engineer for Civil and Civic Pty Ltd in Australia, where he had also served in the Australian Regular Army in the Royal Australian Electrical and Mechanical Engineers, latterly as a Captain.

Michael has significant and wide-ranging philanthropic interests and to consolidate these, the Hintze Family Charitable Foundation was established in 2005. Since inception, over 200 charities have received funding from the Foundation. Major donations have, amongst others, provided funding to Trinity Hospice in south London, the Royal Naval and Royal Marines Charity, established the chair of International Security at the University of Sydney and enabled the restoration of Michelangelo’s frescoes in the Pauline Chapel at the Vatican. The beneficial impact of the Foundation on cultural organisations in the UK include the Natural History Museum, the University of Oxford Centre for Astrophysical Surveys, sponsorship of the Sculpture and Medieval and Renaissance galleries at the Victoria & Albert Museum and the provision of vital funding to the Old Vic Theatre in London, where Michael is co-Chairman of the Old Vic Endowment Trust.

Michael is a Trustee of the National Gallery, the Institute of Economic Affairs and the University of Sydney UK Trust. Michael was made a Knight Commander of the Order of St. Gregory in 2005, subsequently Knight Grand Cross, and in January 2008 he was honoured as “Australian of the Year” in the UK. In November 2009, Michael and his wife Dorothy received the Prince of Wales Award for Arts Philanthropy. In January 2013, he was made a Member of the Order of Australia for services to the community through philanthropic contributions supporting the arts, health and education. In June 2013, Michael was awarded a knighthood in the Queen’s Birthday Honours for his philanthropic services to the arts.

Michael is a fluent Russian speaker. He holds a BSc in Physics and Pure Mathematics and a BEng in Electrical Engineering both from the University of Sydney. He also holds an MSc in Acoustics from the University of New South Wales, an MBA from Harvard Business School and received a Doctor of Business and an Honoris Causa from the University of New South Wales.

Omar Kodmani, Permal GroupOmar Kodmani was appointed Chief Executive of Permal Group in 2014, having previously been its President. Prior to this appointment, he was Senior Executive Officer, responsible for monitoring Permal's international investment activities as well as asset gathering initiatives. Mr. Kodmani is also Director of Permal Investment Management Services Limited and Permal Group Ltd.

Before joining Permal in 2000, Mr. Kodmani spent seven years with Scudder Investments in London and New York where he developed the firm's international mutual fund business. Prior to Scudder, Mr. Kodmani worked for four years at Equitable Capital (now part of Alliance Bernstein). He is a CFA® Charterholder and serves on the Advisory Board of the CFA® (UK). He holds an M.B.A. in Finance (Beta Gamma Sigma) from New York University Stern School of Business, a B.A. in Economics from Columbia University and a G.C. Certificate from the London School of Economics.

Virtual roundtable

40

George W. Long, LIM Advisors LimitedGeorge is the Founder, Chairman and Chief Investment Officer of LIM Advisors Limited; he brings 30 years of financial industry experience to the firm. Before he established LIM in 1995, George set up and ran the Asian division of what became Barclays Global Investors (BGI) in 1990, where he served on the Executive Committee for Barclays Group Asia and the Global Investment Committee in London.

Prior to joining Barclays, George was the Managing Director and Chief Investment Officer of Gartmore Asia, and before that head of Korean operations for Indosuez W.I. Carr Securities. He also worked in New York and Asia for Manufacturers Hanover Trust Company (now part of JP Morgan) as an international banking officer.

George is a former governor of The CFA Institute. He also established the Hong Kong Society of Financial Analysts in 1992 and was its president for 8 years. He also set up the Hong Kong/China Chapter of the Alternative Investment Management Association in 2002 and was its chairman for 5 years. He received the Thomas L. Hansberger Leadership in Global Investing Award for his contributions to the practice of global investment management. George holds an MBA in Finance and an MA in Asian Studies from the University of Washington in Seattle and is a CFA Charterholder.

Mark McCombe, BlackRockMark, Senior Managing Director, is Global Head of BlackRock's Institutional Client Business, Chairman and Co-Head of BlackRock Alternative Investors. Mr. McCombe is responsible for driving the growth of BlackRock's institutional business and alternatives presence globally. He is a member of BlackRock's Global Executive Committee and Global Operating Committee.

Mr. McCombe has had an international career in finance spanning more than 20 years. Before joining BlackRock, he served as Chief Executive Officer in Hong Kong, for HSBC. He was also a Non-Executive Director of Hang Seng Bank Ltd, and Chairman of HSBC Global Asset Management (HK) Ltd. Prior to that, he was based in London where he was Chief Executive of HSBC Global Asset Management.

Mr. McCombe has served on a number of finance industry bodies during his career. He was a member of the Risk Management Committee of the Hong Kong Exchanges and Clearing Limited, a member of the Banking Advisory Committee of the Hong Kong Monetary Authority, a committee member of the Hong Kong Association of Banks, and a council member of the Financial Services Development Council (FSDC), an advisory body established by the Hong Kong Special Administrative Region.


41

Virtual roundtable

Summary of responses

Question Over the next 5 years: Sir Michael Hintze

Omar Kodmani Mark McCombe

Jamie Dinan

Luke Ellis

George Long

Loic Fery

1 Do you think that the hedge fund industry will continue to grow at 10% or more per year?

Yes Yes Yes Yes Yes Yes No

2a Do you expect hedge funds to outperform equities?

Only on risk adjusted basis

Yes No No Yes/No Yes Yes

2b Do you expect hedge funds to outperform bonds?

Yes Yes Yes Yes Yes Yes Yes

3 Which strategy/region/asset class do you think offers the most opportunity?

Various Macro/global/ multi-asset

Direct Lending & EMs

Japanese Equities

Quant Strategies

Various − inc Credit, Commodities, Macro

European Illiquid Credit/EMs

4 Which segment of the investor base do you expect to see fastest growth in allocating to funds?

Pension funds, SWFs, Insurers, Endowments

Insurers Pension funds Insurers SWFs/Insurers Pension funds PFs/Insurers/Family offices

5 Do you expect fund of funds to represent 20% or more of industry assets in five years time?

No Yes No No Yes No No

6 Which type of fund structure do you expect to show the fastest growth over next five years?

UCITS and segregated/bespoke accounts

AIFM 40 Act Mutual funds

40 Act Mutual funds

Depends on regulations

Managed accounts and Co-Investments

Managed accounts and UCITS

7 Do you expect hedge fund management fees to drop over next five years?

Yes/No No No No Yes − gradually

No No

8 What is the biggest issue facing the hedge fund industry today?

Hasty regulations

Insufficient Risk

Investors attitude

Size constraints

Quality portfolio managers

Excessive regulations

Regulatory requirements

9 What weighting should investors have of hedge funds in their portfolio?

10 − 20% 20 − 30% Depends 20 − 30% 20 − 30% 10 − 20% 20 − 30%

10 Will hedge funds have a stronger reputation in five years?

Yes Yes Yes Yes Yes Yes Yes

Table page 42.indd 1 21/10/2015 16:35

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The hedge fund industry has been growing at approximately 10% a year in recent years. Do you think it will continue to grow at this pace over the next five years?

JAMIE DINAN: Yes – demand for alternatives will continue to grow.

LUKE ELLIS: Recent growth has been achieved despite a very significant and almost continuous bull market in both bonds and equities. For an alpha driven industry to grow while beta is as strong as that gives me confidence that growth can be sustained in the years ahead where it is my view that beta returns are likely to be materially lower.

LOIC FERY: I believe the industry will keep on growing over the next few years. But not at 10% a year, probably more like 3% to 5%.

SIR MICHAEL HINTZE: Yes, however, it is more nuanced that that. As always it is a competitive landscape. Funds that can demonstrate risk-adjusted performance and that are able to meet exacting institutional standards will prevail.

Market returns overall are likely to be more modest, favouring strategies that can be both long and short. There will be a continuation of allocations to assets that can provide diversification, good risk-adjusted returns and demonstrate low correlations to traditional markets.

OMAR KODMANI: Hedge funds provide the best chance to meet future liabilities. Institutions remain still under-allocated to this space; while retail will experience a further surge.

GEORGE LONG: Once investors realise that both long-only equities (especially passive index funds) and long government bonds have limitations, I believe there will be renewed appreciation of absolute return strategies. As we enter a period of greater volatility across all asset classes, I expect the demand for absolute return and diversification to remain strong.

MARK McCOMBE: Yes, we believe the adoption rate of hedge funds by institutions will continue at a similar pace. Hedge funds continue to provide an attractive investment option given their strong risk-adjusted return profile.

Hedge fund strategies have greater flexibility as compared to traditional investments with a much wider range of investment strategies and fewer structural and capacity limitations. We believe investors that do not have exposure will adopt hedge fund allocations and those with allocations may look to increase exposure within their active management budgets.

Do you expect hedge funds to outperform equities/bonds over the next five years (on an absolute as well as risk-adjusted basis)?

JAMIE DINAN: Hedge funds may not outperform equities but will outperform bonds. But I think hedge funds will outperform both on a risk-adjusted basis.

LUKE ELLIS: Performance relative to equities is not really an appropriate way to look at hedge fund returns. Put simply, if we continue to have a bull market then hedge funds are likely to underperform. But if we get a bear market then hedge funds are likely to outperform. So relative or even risk-adjusted relative performance is essentially a prediction on equity performance. For what it’s worth, it seems to me doubtful that the next five years we won’t see a sell-off in equities at some point − at which point hedge fund compounding is likely to deliver attractive performance.

Performance relative to bonds is a more valid way to assess hedge funds and in this regard I think it is highly likely that hedge funds will outperform. Over five years the only return you can earn from buying five-year investment grade bonds today is the current yield − which, based on five-year US treasuries, is about 1.5% and I think we would all hope hedge funds will outperform that!

LOIC FERY: Over a five-year period, I believe so. But not all hedge funds will.

SIR MICHAEL HINTZE: The risk lies with the risk-free rate benefitting shorter duration, floating rates securities, equity and equity-linked strategies. The next stage of market cycle should favour stock and credit pickers. The ability to short securities should generate a greater return than over the last few years.

OMAR KODMANI: History shows that equities at current valuations (CAPE − cyclically adjusted price earnings) will not return more than +2% p.a. for next five years; and bonds with current starting yields will be hard pressed to do better. The bar is set very low for hedge funds.

GEORGE LONG: Both bonds and equities are over-priced. I expect we will see a period of greater dispersion within equity and bond markets which will provide a suitable environment for a number of hedge fund strategies.

MARK McCOMBE: It is difficult to predict the absolute performance of hedge funds relative to equity and bond markets over the next five years particularly given the level of volatility in the markets driven by a variety of factors including uncertainty around interest rate hikes by the Fed, the steady but slow growth of the US economy coupled with the uncertainty of prominent geopolitical events (Greece, Puerto Rico and China).

Notwithstanding this, we believe hedge funds will outperform both stocks and bonds on a risk-adjusted basis, but there is a possibility stocks will outperform on an absolute basis, with higher volatility.


43

Which strategy/region/asset class do you think offers the most opportunity over the next five years?JAMIE DINAN: Japanese equities − because corporate governance reforms coupled with share buybacks and monetary easing create an amazing technical backdrop.

LUKE ELLIS: My personal view is that, generally the market environment is likely to favour quantitative strategies over discretionary ones. There is likely to be lower liquidity in markets going forward as banks continue to withdraw market-making capital. This is likely to result in two key outcomes. Firstly, there may be more room for short-term equity strategies and secondly, macro trends may tend to be extended. To take advantage, I think managers would need to construct complex portfolios with a large number of positions to get the diversification needed and quant strategies tend to be better at constructing complex portfolios and managing the risks they generate.

LOIC FERY: European illiquid credit opportunities and emerging markets will be among the most interesting areas − with a stressed energy market, plus European stressed and distressed corporate credits.

SIR MICHAEL HINTZE: Longer-lock strategies that are able to take advantage of bank disintermediation and regulatory distortions.

Plus: Shorter duration, floating rates securities, equity and equity-linked strategies such as convertibles.

And: Strategies that are able to identify and trade idiosyncratic risk such as credit and equity long/short.

OMAR KODMANI: Macro/global/multi-asset − these strategies are the most flexible, most liquid, most agnostic; and best positioned for sideways markets in bonds and stocks.

GEORGE LONG: High yield and distressed credit will become very interesting as China slows and global growth contracts. Currency volatility will cause problems for countries and companies that will lead to more high-yield and distressed opportunities.

Special situations (such as private convertibles, mezzanine financing, etc) should see a lot of opportunities as markets get more stressed and traditional bank capital becomes more scarce.

Commodities and the mining sector will become very cheap as we see the impact of a slowing China on the major commodity producers and the ending of the commodity super cycle.

Macro trading should see opportunities around currency volatility.

MARK McCOMBE: The large-scale withdrawal by banks from markets and investment-related activities, driven by both regulatory and financial constraints, continues to change the investment marketplace. As a result, lending activity has become more segmented and certain market activities have been disrupted. This has created opportunities to take advantage of prominent price inefficiencies and liquidity premiums for those able to effectively operate in these affected markets. Additionally, capital intensive industries are in need of more flexible capital solutions given balance sheet constraints and large capital expenditure needs. The resultant void of capital has produced very attractive economics for investors able to provide creative capital solutions. Similarly the liberalisation of the financial systems of select emerging markets are creating investment opportunities that skilled investors can capitalise on.

Which segment of the investor base (e.g. pension funds, sovereign wealth funds, insurers, endowments, family offices etc.) do you expect to see the fastest growth in terms of allocations to hedge funds over the next five years?

JAMIE DINAN: Insurers − because they can no longer just hold low-return bonds in their investment portfolios.

LUKE ELLIS: In volume terms, I think we will see the highest growth into the sector from sovereign wealth funds as it is the fastest growing sector with huge assets under management. In percentage terms I think we will see the highest growth from insurers as they are currently significantly underweight.

LOIC FERY: Pension funds, insurers and family offices − due to mismatch of assets and liabilities, particularly in pension funds, and the need for alpha.

SIR MICHAEL HINTZE: Pension funds, SWFs, insurance companies and endowments − seeking yield and good risk-adjusted returns, they also need to meet long-term liabilities and obligations to beneficiaries. Many still have relatively low allocations to hedge funds.

OMAR KODMANI: Insurers − an extremely large investor base with very low starting allocations to hedge funds and significant need for uncorrelated return streams.

GEORGE LONG: Pension funds − as they are also relatively underinvested in hedge funds; and from their continued desire to diversify return streams, particularly with the general de-risking required to manage the assets of imminently retiring baby-boomers.

MARK McCOMBE: Pension funds and defined contribution plans.

Hedge funds have proven to be a valuable tool for investors. While many pension plans have adopted hedge funds, their overall allocations remain smaller than endowments and foundations, family offices and some sovereign wealth funds. We expect continued growth in this segment as they seek attractive investment options that will help them meet their pension liabilities and obligations.

Also, as the industry moves toward modelling Defined Contribution (DC) plans after Defined Benefit (DB) plans, we have observed an increased interest in alternative investments by DC plans. As such, we believe that DC plan assets may serve as an area of growth for hedge funds in the next five years as well.

Virtual roundtable

44

Assets in funds of funds represent roughly 20% of total hedge fund industry assets. Do you expect funds of funds to represent 20% or more of industry assets in five years’ time?

JAMIE DINAN: No − I see further disintermediation taking place.

LUKE ELLIS: The real question is what does one mean by a fund of funds? The vast majority of hedge fund investments are part of portfolios of hedge funds which are in the end a fund of hedge funds. The question, then, is what percentage of clients require support in order to implement their portfolio? In my view most clients need help, certainly more than 20%. And then the question is how much is done by funds of hedge funds and how much by consultants… but really these two are barely distinguishable in many cases.

LOIC FERY: No − [because of the] increasing sophistication of institutional investors who tend to increasingly invest directly into hedge funds.

SIR MICHAEL HINTZE: Direct investment is a growing trend. Larger more successful FoFs are continuing to grow due to their business models that continue to capture institutional flows.

OMAR KODMANI: Direct programs and consultant-led allocations will underperform funds of funds, while the appetite for professional funds of funds guidance from new and existing investors in hedge funds will re-grow.

GEORGE LONG: Not directly, as historical returns have shown that many funds of funds have struggled to prove that they can add value, which is impacting their popularity. Also many institutional investors are building up more capability to manage hedge fund investing in-house. However, as funds of funds transition to a more advisory business, I expect that more direct hedge fund investments will be advised by funds of funds groups.

MARK McCOMBE: We expect the growth rate of direct hedge funds to be faster than the growth rate of funds of funds. Although funds of funds will continue to see growth through customised opportunities and co-investment opportunities developed for investors.

Which type of fund structure (e.g. offshore, UCITS, 40 Act, managed accounts etc.) do you expect to show the fastest growth over the next five years?

JAMIE DINAN: 40 Act funds − that’s where there is the biggest unexploited investor base.

LUKE ELLIS: This depends entirely on how regulations develop.

SIR MICHAEL HINTZE: For co-mingled structures − UCITS, due to regulatory trends. For larger, more sophisticated investors − segregated and bespoke accounts, with growth to be driven by larger institutions’ desire for tailored investment solutions that meet their risk, return and volatility criteria.

OMAR KODMANI: The trend toward regulated structures is irreversible.

GEORGE LONG: Managed accounts and co-investment vehicles – because hedge fund returns have often not been that attractive and hedge fund fee structures have often been excessive.

MARK McCOMBE: 40 Act mutual funds. The state of retail investments in hedge funds remains young with 3% of US and European retail investors investing today. However, exposure to these investment options is growing rapidly within the retail market and the diversification benefits of hedge funds is fuelling demand. This, coupled with growth in product development and distribution, will result in meaningful growth over the next five years.

25 years in Hedge Funds

45

Virtual roundtable

Do you expect hedge fund management fees to fall materially over the next five years?

JAMIE DINAN: No – because people will continue to pay for quality.

LUKE ELLIS: I think it is most likely that hedge fund fees will fall but in a very gradual way. All financial industry fees are and will remain under pressure − this is a secular and fundamental change. Within the financial services sector, hedge funds continue to provide what we believe to be a very valuable option − alpha is very valuable and very scarce, so the fees will remain supported by the scarcity.

LOIC FERY: No. Managers delivering consistent returns should not see their fees dropping.

SIR MICHAEL HINTZE: Fees have already seen a decline across the industry so do not expect a further material drop. However, it is more about alignment.

Regulation is driving up costs. [But] investors will continue to pay a premium for managers who deliver superior risk-adjusted returns and are able to provide investment solutions.

OMAR KODMANI: A normalised interest rate environment will alleviate fee pressures. The genuine alpha producers will still command higher fees and increased hedge fund returns will help.

GEORGE LONG: Despite a lot of public discussion of hedge fund fees following the global financial crisis, the actual impact on fees has been minimal. Hedge fund talent is still hard to find and generally investors are still willing to pay. However, as managed accounts grow in popularity, we could see some industry pressure from large investors on fees as their ability to negotiate managed accounts is greater than on commingled funds.

MARK McCOMBE: The resources required to run an institutional-quality hedge fund continue to grow more demanding each year, particularly with the increased level of regulation and associated compliance requirements. For this reason, we do not expect fund management fees to decrease dramatically over the next five years for the most competitive managers.

What is the biggest issue facing the hedge fund industry today – and how should it be addressed?JAMIE DINAN: The biggest issue is the size of the best investment managers. Those managers need to broaden their investment offerings.

LUKE ELLIS: The biggest issue is the supply of high-quality, well-trained portfolio managers. The first phase of the hedge fund industry was based on the best people from banks and long-only managers switching to running hedge funds so the industry was a big beneficiary of the training provided in the past at banks and long-only institutions. As we look forward, though, it is clear that this supply has shrunk significantly and it will become extremely important for the hedge fund industry to both hire younger people and provide them with the training and instruction required.

LOIC FERY: Regulation requirements with increasing convexity. AIMA is part of the way to address this.

SIR MICHAEL HINTZE: Hastily legislated regulation, and increased cost – limiting competition.

OMAR KODMANI: Not taking enough risk. The industry needs to re-educate investors that flexibility − including tolerance for drawdowns – is a major part of alpha generation.

GEORGE LONG: Excessive regulations and 1) its indirect impact on hedge fund manager expenses and the ability to start a new fund;

and 2) its indirect impact on the ability to undertake some strategies.

MARK McCOMBE: On the heels of a three-year equity bull market (with relatively muted volatility), the biggest issue facing the hedge fund industry is the view regarding absolute performance. With this backdrop, certain investors have expressed concerns over the level of absolute performance of hedge funds relative to what they have achieved with equity investments. However, we believe this is mitigated when taken in the context of risk-adjusted performance. Furthermore, we believe hedge fund strategies are particularly well-positioned to take advantage of opportunities that may arise from market volatility discussed previously.

While not completely immune to price volatility as markets adjust, a diversified hedge fund portfolio can help mitigate the gyrations experienced in traditional beta-driven markets. Relative value strategies may be able to take advantage of the disequilibria and inconsistent pricing driven by panicked sellers and heavy cash flows across markets.

Distressed and direct sourcing strategies may provide bespoke solutions to help stressed firms strengthen or rebuild their balance sheets, transition through restructurings, or improve underperforming assets. Long/short managers may be able to anticipate and take advantage of dispersion between companies whose competitive positions shift as rates rise, or find attractive entry points for well-run companies whose securities have been indiscriminately sold. Regional specialists may have the intimate local knowledge necessary to identify potential investments with asymmetric risk profiles, particularly where there may be less competition from mainstream investors.

46

What weighting should investors have of hedge funds in their portfolios?JAMIE DINAN: 20 − 30%.

LUKE ELLIS: This depends on the specific investor’s investment strategy and goals but I would think generally 20 − 30%.

LOIC FERY: 20 − 30%.

SIR MICHAEL HINTZE: 10 − 20% − [though] depending on investor risk profile.

OMAR KODMANI: 20 − 30%.

GEORGE LONG: 10 − 20%.

MARK McCOMBE: The optimal allocation to hedge funds is highly dependent on the specific client and their risk, return and liquidity tolerances.

Will hedge funds have a stronger reputation in five years’ time and be widely accepted as a valuable component of the modern investment landscape?

JAMIE DINAN: Reputations follow talent − and hedge funds will continue to attract and retain the best talent.

LUKE ELLIS: Any weakness in the current reputation of hedge funds come from the ‘relative’ performance of bonds/equities − but we have had an unprecedented period of bull markets in both bonds and equities created by central banks making money ‘free’ and driving down future returns. In the next five years the benefit of alpha in a portfolio should become much clearer as beta is likely to disappoint.

LOIC FERY: The frontier between asset managers and hedge fund managers is [already] narrower today. Hedge funds are [increasingly] commodified.

SIR MICHAEL HINTZE: Yes − due to the ability to provide investors with solutions and returns, plus increased transparency and institutional acceptability.

OMAR KODMANI: Yes − they will be validated by an improved risk/return proposition versus traditional assets as well as a better liquidity proposition compared to other asset classes.

GEORGE LONG: In a period where markets have been largely impacted by central bank actions, it has been tough for many hedge fund strategies to outperform simple directional equity and fixed income strategies. The next five years are unlikely to be the same, and a period of relative hedge fund outperformance is more probable.

MARK McCOMBE: The reputation of hedge funds has continued to grow over the last five years and we expect similar growth in the next five years through continued adoption of hedge funds as a valued diversification tool within a total portfolio context.


47

The growth of the hedge fund industry

3,000

2,800

2,000

2,200

2,400

2,600

1,800

1,600

1,400

1,200

1,000

AuM

Fund

s

800

600

400

200

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

10,800

7,920

8,640

9,360

10,080

7,200

6,480

5,760

5,040

4,320

3,600

2,880

2,160

1,440

720

0


Growth in assets and funds globally

Big Data: The growth of the hedge fund industry

1,000

650

600

700

750

800

850

900

950

500

550

450

400

350

300

250

200

150

50

100

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Assets $bn Number of funds (De-duplicated for multiple share classes. No data available for 2000-2001).

0

200

130

120

140

150

160

170

180

190

100

110

90

80

AuM

Fund

s

70

60

50

40

30

10

20

0

Growth of the industry in Asia

Source: HFR

Source: HedgeFund Intelligence

48

1,800

1,700

1,000

1,100

1,200

1,300

1,400

1,500

1,600

900

800

700

600

500

400

300

200

100

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

720

680

400

440

480

520

560

600

640

360

320

280

240

200

160

AuM

Fund

s

120

80

40

0

Assets $bn Number of funds (De-duplicated for multiple share classes. Excluding standalone UCITS funds).

Growth of the industry in Europe

6,400

6,000

3,200

3,600

4,000

4,400

4,800

5,200

5,600

2,800

2,400

2,000

1,600

1,200

800

400

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

1,600

1,500

800

900

1,000

1,100

1,200

1,300

1,400

700

600

500

AuM

Fund

s

400

300

200

100

0


Growth of the industry in North America

Source: Eurekahedge

Source: HedgeFund Intelligence


49

800

450

500

550

600

650

AuM

700

750

400

350

300

250

200

150

50

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

Growth in FoHFs, 1990 − 2014

Source: HFR

200

180

160

140

120

AuM 100

80

60

40

20

0

40.86

2008

84.90

2009

125.28

2010

127.13

2011

131.97

2012 2013

158.44

2014

177.36

Q2 2015

181.63

Growth in UCITS funds, 2008 − 2015

Source: HFR (Q2 2015)

The growth of the hedge fund industry

50

AcknowledgementsWe would like to take this opportunity to offer our thanks and gratitude to our past and present Chairs − Ian Morley, Jean-Francois Conil-Lacoste, Sohail Jaffer, Hans-Willem Baron Van Tuyll Van Serooskerken, Christopher Fawcett, Todd Groome and Kathleen Casey − to our former CEOs, Florence Lombard and Andrew Baker, and our present CEO, Jack Inglis. A further special word of thanks to our General Counsel since inception, Iain Cullen.

About AIMAThe Alternative Investment Management Association (AIMA) is the global hedge fund industry association, with over 1,500 corporate members (and over 9,000 individual contacts) in over 50 countries. Members include hedge fund managers, fund of hedge funds managers, prime brokers, legal and accounting firms, investors, fund administrators and independent fund directors. AIMA’s manager members collectively manage more than $1.5 trillion in assets. All AIMA members benefit from AIMA’s active influence in policy development, its leadership in industry initiatives, including education and sound practice manuals, and its excellent reputation with regulators worldwide. AIMA is a dynamic organisation that reflects its members’ interests and provides them with a vibrant global network. AIMA is committed to developing industry skills and education standards and is a co-founder of the Chartered Alternative Investment Analyst designation (CAIA) – the industry’s first and only specialised educational standard for alternative investment specialists.

For further information, please visit AIMA’s website, www.aima.org


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Sponsoring Partners of AIMA

AIMA Alternative Investment Management Association

www.aima.org

19

90

| 2

01

5