The hedge fund industry has been through two dramatic changes since the credit crisis erupted, but what has really changed in this sector? Karen Tan of Deutsche Bank takes a look.

Summary: In 2010, hedge fund managers are judged beyond trust and are assessed for investment performance, risk management, and philosophy, writes Karen Tan, director of the hedge fund group at Deutsche Bank Private Wealth Management.

As we ended 2008, it would appear that the hedge fund industry could do no right and many industry watchers were predicting the demise of the industry. The industry faced its version of a bank run with its first liquidity squeeze in 18 years, since HFR [Chicago-based Hedge Fund Research] begun tracking asset flow data since 1990.

Fast forward 18 months, according to the Q2 HFR Inc’s industry report, the hedge fund industry’s assets as of June 2010 were just 3 per cent shy of its October 2007 peak, ending the quarter with $1.65 trillion in assets, a result of both inflows going back into the industry and credible performance over the 6 quarters following a dismal 2008.

If one was to only look at the asset flows, then it would be entirely reasonable to miss the changes that have started taking place in the industry and be misled into thinking that nothing has changed in the interest of investors.

Deutsche Bank’s Hedge Fund Capital Group has been conducting an Alternative Investment Survey for the past 8 years, polling a wide spectrum of institutional hedge fund investors ranging from pension funds to industry consultants to family offices. The results of the latest survey for 2010 reflected a sign of the times and provided an insight into some of the pressing issues for the hedge fund industry.

In 2003 and 2004, the three most important factors for investors when evaluating a hedge fund was the investment philosophy, manager pedigree and investment performance. 

In the 2010 survey, investment performance ranked significantly higher at the top, followed by risk management and investment philosophy respectively.

To this end, structural changes have begun to take place in the hedge fund industry in response to investors’ push on liquidity, transparency and regulations. Potentially, hedge funds have started embracing two possible solutions – managed accounts and UCITS III wrappers.

What are managed accounts?
Managed accounts are segregated portfolios of securities whereby ownership of the underlying assets is with the owner of the managed accounts as opposed to the hedge fund. The assets in the managed accounts are still managed by the hedge fund manager, typically pari passu alongside the main hedge fund.

In this case, the idea would be for an investor to open an account with a prime broker and authorize the hedge fund manager to trade the assets of the account using an agreed strategy and specified parameters.

To debate the pros and cons of a managed account would take too much time. We would simply say that in all practicality, such a route would only be feasible for institutional investors such as Fund-of-Funds or pension funds for cost, size and liability reasons.

As a compromise, managed account platforms provide other investors a possible means of accessing the managed account route. In this case, a platform provider sets up multiple managed accounts and authorizes individually hedge fund managers to trade a single managed account each, according to their respective investment strategies but subject to risk parameters, liquidity and trading guidelines of the platform provider. Examples of platform operators include Deutsche Bank’s X-markets and Societe Generale’s Lyxor.

In this case, ownership of the underlying securities lies with the platform providers. Typically these platforms may provide equal or better liquidity terms to end investors compared to the hedge fund that they are meant to be cloning.

On the other spectrum, managed accounts would ensure that assets are independently valued and risk monitoring is also done independently from the hedge fund manager, potentially resolving concerns over fraud and other operational risks.

However, one would caution that managed accounts on a platform are usually still packaged in the form of a fund to an end investor for structural reasons.

The other response that the industry has embraced is that of the UCITS III wrapped hedge funds.

UCITS III and what it means for investors?

UCITS III stands for Undertaking for Collective Investments in Transferable Securities. Simplistically, it’s the regulation in the European Union which specifies the range of financial instruments that a Fund may invest in for both investment and hedging purposes subject to investment guidelines on portfolio diversification and limits on leverage.

In addition, it potentially aims to ensure investor protection by providing behavior guidelines for asset management companies with respect to ensuring investors with worst case 14 days redemption liquidity at NAV, adequate disclosures and strict risk monitoring.

UCITS III is not a new phenomenon. The original UCITS regulation was first introduced in 1985 primarily with the aim of allowing asset management firms to do cross border marketing in an efficient manner subject to a common set of rules. UCITS III which was put in place in 2001 was a follow up to the original regulation.

There are 2 versions to the UCITS III funds: Non – Sophisticated and Sophisticated UCITS III.

Non-Sophisticated UCITS are really the typical long-only mutual funds which are widely sold to the mass market. These funds are termed “Non-Sophisticated” only because they use derivates solely for hedge purposes and not investment purposes.

Sophisticated UCITS are termed such because they are allowed to employ derivatives for investment purposes; they may employ shorting strategies via derivatives as well and have to use a Value-at-Risk methodology for risk monitoring. Hence, many hedge funds which trade fairly liquid strategies are finding it feasible for them to employ their hedge fund trading strategy within a mutual fund structure.

Interest in the UCITS III structure has been gaining strength rapidly in recent times. Albourne Partners estimates that there are about 240 UCITS III funds employing hedge fund strategies with more than $70 billion in assets (as of end March 2010).

While the UCITS III hedge funds industry is still in its infancy stage, by virtue of its structure being mutual fund-like from an investor standpoint, we would expect the UCITS III to gain increasing momentum amongst a broader base of investors (especially in Europe), as they gain comfort from a clear and reliable redemption policy, regulatory oversight and transparency standpoint.

The regulatory requirements of a UCITS III structure, nevertheless, bring with it a different set of challenges for hedge fund managers which investors should be aware of.

The infrastructure and administration demands of a UCITS III structure would be significantly higher than that for a traditional hedge fund. Hence, a hedge fund manager seeking to set up a “clone” in a UCITS III needs to ensure that the firm’s infrastructure is sufficiently robust.
 
Many of the new UCITS III hedge funds would typically be clones of or an extraction of a sub-strategy from their traditional hedge funds. However, restrictions on leverage, investment instruments and risk diversification rules may result in tracking errors between the clones and the traditional hedge funds.

The same guiding principles on liquidity for UCITS III also limits hedge fund managers in less liquid asset class and/or strategies such as distressed investing from accessing this structure. Hence, investors may have a smaller range of strategy choice within the UCITS III structure.

A third solution that has also emerged which we believe will become a mainstay as investors become more familiar with them are ETFs (Exchange Traded Funds) on Hedge Fund strategies. There are a few HF ETFs which are either HF Replication indices or created by managed account platform providers using actual hedge fund manager returns. An example of the latter would be the db Hedge Fund Index ETF. Such ETFs are usually traded like a stock.

We expect the hedge fund industry to continue evolving and adapting itself to investor needs. While we welcome these structural changes in the industry and the comfort that some of these changes bring (be it from managed accounts or UCITS III), we do recognize that they will not be the perfect answer and that there is still no substitute for good old fashion due diligence work in searching for the right manager, be it in the traditional hedge fund world, amongst the managed account platforms or the world of UCITS III hedge funds.