Power to the investors

Bruised investors are finally calling the shots in the hedge fund market as they seek to reallocate capital. With many now demanding greater liquidity, transparency and security, more of the business is likely to migrate to managed accounts. By Peter Madigan

Hedge funds experienced a horrendous 2008. Hit by negative returns across most strategies, hedge fund managers saw record redemption requests by investors, with total industry assets under management (AUM) almost halving in the 12-month period to just $998.4 billion, according to California-based TrimTabs Investment Research.

Fund managers may have looked upon 2009 as a fresh start and an opportunity to regain their footing. The preliminary figures for hedge fund performance were certainly encouraging, with the Credit Suisse/Tremont Hedge Fund Index up 1.09% in January. The rebound was short-lived, however, with the index dropping by 0.45% in February. Despite the reversal, indications are that redemption requests from investors have slowed, falling from $77 billion in January - a month that still saw $6 billion in new investment - to an estimated $11 billion in February, based on 41% of funds reporting, according to Singapore-based data provider Eurekahedge.

However, the decision by many firms to enforce withdrawal limits, otherwise called gates, or suspend redemption requests from investors last year in the face of evaporating liquidity and distressed market prices has sent shock waves through the hedge fund universe. Investors who had been assured of regular redemption windows - whether they be weekly, monthly or quarterly - found they were no longer able to pull their money out as easily as they thought.

For dealers in the hedge fund derivatives market, the gating of redemptions has been no less severe. These banks have been big providers in recent years of options referenced to funds of funds and, to a lesser extent, single manager funds. To hedge these products, dealers must dynamically buy and sell shares in the underlying funds as the net asset value (NAV) fluctuates - typically, dealers would need to sell shares in the underlying funds as the NAV falls. However, the suspension of redemptions meant dealers were unable to hedge in some cases (Risk February 2009, pages 21-241).

Confidence in hedge funds has been dented as a result. Liquidity provision has become a key factor, while the $65 billion fraud at Bernard Madoff Investment Securities has drummed home the importance of transparency and due diligence (Risk March 2009, pages 142). Dealers claim there is still interest from institutional investors in alternative assets - but the events of 2008 are likely to push many towards managed accounts.

"It's true institutional investors have sought redemptions and exited hedge fund investments as part of a drive toward cash liquidity, but a lot are seeking to retain exposure to the asset class through different strategies within the hedge fund arena that can neutralise the risks that have appeared in the market in the past six months. Managed accounts are a means of doing that," says Tarun Nagpal, European head of fund derivatives at Deutsche Bank in London.

Managed accounts are controlled by hedge fund managers and should mirror the performance of their respective funds. However, they are separately managed accounts operating on an independent platform, and are run according to investment guidelines and risk limits set by the platform provider. The platform operator conducts independent due diligence on the manager, as well as ongoing risk monitoring. Regardless of the strategy and the asset mix of the original hedge fund, managers who are accepted to run managed accounts are usually limited to investing in liquid assets to ensure they can provide daily liquidity.

Dealers say managed accounts are seeing an increase in interest in 2009, with the biggest platform in the market, Lyxor Asset Management (the asset management arm of Societe Generale), reporting more than $600 million in new inflows in the first two months of the year.

"Today we have 108 managed accounts on hedge funds across all strategies and we should be up to 115 by the start of April," says Nathanael Benzaken, head of hedge fund research and selection at Lyxor Asset Management in Paris. "We were able to honour redemption requests without gating or paying in kind because the underlying funds are navigating for the most part in liquid instruments. Even though the hedge fund industry has seen large outflows in January and February, Lyxor saw inflows of around $600 million for the same period," he adds.

While seeing inflows so far this year, the platform experienced its own share of difficulties in 2008, along with the wider alternatives sector. It began last year with 168 managed accounts, and had established a trend of bringing 30-35 new managers a year on to the platform while retiring 15-20 accounts annually. Benzaken reveals only six new accounts were opened in the first half of 2008 and none in the second half of the year as market conditions deteriorated. At the same time, approximately 55 accounts were closed, leaving 107 managed accounts by the end of the year.

Despite the contraction, Lyxor remains bullish about its prospects for this year, citing the performance of the Lyxor Hedge Index, an investable index measuring the performance of its managed account platform, which ended 2008 down 10.13%.That compares with a fall of 23.25% for Chicago-based Hedge Fund Research's Global Hedge Fund Index.

Lyxor is not the only firm operating in the managed account space. Deutsche Bank also runs a managed account platform - in fact, it last month launched an exchange-traded fund (ETF) referenced to an index tracking hedge funds on its managed account platform. On a back-tested basis, the index (which tracks the performance of a number of strategies, including equity hedge, market neutral, credit, convertible arbitrage, systematic macro and event-driven) generated returns of -9.19% for 2008. The ETF will provide intra-day liquidity, carries an annual management fee of 0.9% and is Ucits III compliant - factors the bank hopes will attract a variety of institutional investors to the product.

Meanwhile, Credit Suisse and Barclays Capital are understood to be developing platforms of their own. JP Morgan has also confirmed it is looking into the possibility. All want to capture the cash pulled from traditional funds and funds of funds by investors looking for a more transparent home in the alternatives market.

"Credit Suisse is currently evaluating the various options for the development of a sophisticated platform around managed accounts. The demand for them is definitely growing, with many existing hedge fund investors looking to migrate their holdings into account platforms. But we believe a significant share of any new money flowing into hedge funds directly will now demand these increased levels of flexibility, transparency and liquidity," says Eric van Laer, head of fund-linked products for Europe at Credit Suisse in London.

It's not just investors who are likely to be increasingly drawn to managed accounts. Dealers report hedge fund managers are proactively contacting existing and prospective managed account platforms to enquire about their eligibility and likely launch date. Benzaken says Lyxor has been in dialogue with 100 of the largest hedge funds since November, with many approaching Lyxor rather than the other way around.

This appears to be in response to investor demand, with many attracted by independent custody of assets, independent valuation, guarantees around liquidity and some level of transparency.

"Remember, lots of hedge fund clients have been in the asset class for years and even with their alternatives portfolio performing poorly in 2008, that performance may still be better than other portions of their asset allocation, so I would expect them to retain their alternatives presence," says Deutsche Bank's Nagpal. "Long-term sophisticated investors seem to be going to their fund-of-funds manager and advocating a move to managed accounts, or pulling out of funds of funds themselves and moving directly into diversified managed account portfolios."

Credit Suisse recently conducted a survey of the 100 biggest hedge funds that utilise its prime brokerage unit to ascertain interest in managed accounts. Eighty-five per cent of respondents said they had received requests from investors over the past six months asking them to look into the possibility of linking up with a managed account platform. As a result, 36% said they had become more willing to consider using managed accounts, while 28% said they were slightly more willing.

That's despite the additional work it takes to comply with the investment guidelines, and the additional scrutiny the manager can expect from the platform provider. "It is a significant additional amount of work from an administrative and logistical standpoint for a fund manager to move from an investment pool where all investors are equally invested to an account platform managing a large number of separate pools. No hedge fund likes to be constrained, but many managers are more amenable to being part of managed accounts today," says Credit Suisse's van Laer.

Dealers suspect, however, that managers may simply be acting out of self-interest. Regulators and politicians are increasingly pushing for greater regulation and supervision of the hedge fund sector. Shifting to a more transparent managed account model could allow managers to sidestep any regulatory action that seeks to clamp down on hedge funds.

"The managed account provides a level of security similar to that of the mutual fund market, such as segregation of assets from the manager, independent pricing and independent risk management, and that is why they are getting so much attention now. We expect the hedge fund market to be more regulated in the future, but managed accounts are providing an extra level of security," says Benzaken.

Managed accounts may not be the only area for new business among fund derivatives dealers. Some banks say the mutual fund derivatives market could also see a pick-up - although most of the interest is likely to come from existing investors in mutual funds that want some level of principal protection.

"Traditional equity and bond mutual funds have always been an important part of the fund-linked business, but in this environment the liquidity, transparency and regulated onshore status of those funds have attracted particular interest," says Antti Suhonen, head of fund-linked derivatives structuring at Barclays Capital in London. "Increasingly, our clients see the benefits of structured products linked to mutual funds, such as principal protection, in light of the performance of most asset classes last year. The shift we are seeing is not so much hedge fund investors moving into mutual funds, but rather mutual fund investors seeking principal-protected structures around their investments."

That would be a change from before the crisis when, because of greater liquidity of mutual funds, dealers were often willing to structure more complex products to bolster returns for investors.

"Hedge fund-linked products are much more plain vanilla in nature since dealers are primarily taking gap risk. But in mutual fund derivatives there is more liquidity, so dealers are more willing to do funkier structures - in some cases, almost akin to equity derivatives structures. So dealers are exposed to gamma, vega, correlation between different funds and more exotic risk," says Rui Fernandes, head of hedge funds structuring at JP Morgan in London. "For example, you could see a best-of trade between three different funds or a worst-of between two different funds. These kinds of themes are much more attractive for private rather than institutional clients."

The general trend towards simpler products means these types of structures are unlikely to re-emerge any time soon, suggest dealers.

While certain areas of fund-linked business - managed accounts and mutual fund derivatives - may continue to see new flows for banks, some large hedge funds are looking to cut out the middle man. In March, London-based hedge fund Brevan Howard announced the launch of its first Ucits III-compliant fixed-income bond fund, in an attempt to attract institutional investors looking for absolute returns in liquid bond markets. Dealers believe this is one of the first in what will be a series of attempts by hedge funds to bring highly regulated, liquid and transparent funds to market to broaden their investor base and assuage the concerns of wary clients and regulators alike.

Certainly, few are expecting the popularity of single-manager hedge funds to return to pre-crisis levels in the medium term. Investors are likely to shy away from those funds with long lock-ups and little transparency. Power is very much with the investor - and some reckon this could be a long-term shift.

"Former hedge fund investors are using managed accounts because they have to allocate to alternatives, but they won't invest in underlying funds directly anymore. The question is whether this trend is going to be a short-lived or a long-term structural change. We are convinced of the latter - managed accounts will definitely continue to be a sought-after model for the liquidity and transparency they provide," says Lyxor's Benzaken.

See also:

• When hedge funds attack

• Fund-linked hedging bolsters redemption requests

• Deutsche Bank launches ETF of hedge funds

• The risk of one