Obstacles remain for hedge funds as they enter 2011

Fluctuat nec mergitur

leader-duck

No matter how upbeat managers and investors may be for 2011, there are still quite a few challenges as well as some potential catastrophes that could upset the trend.

But first, the reasons to pop open the bubbly. Assets are finally flowing back into the industry and could top $2 trillion for the first time ever next year. Investors still seem stuck in panic mode (possibly with good reason), continuing to pump money only into the largest hedge funds.

Smaller fund managers should not despair. There are encouraging signs that the mid-sized managers may be getting more attention in 2011, as long as they have sufficient operational infrastructure and risk reporting mechanism in place.

This middle-tier could also benefit from a bit of a backlash from investors not keen to pay high fees and worried about the concentration of portfolios and less diversification. Increasingly surveys are showing that investors are looking at the smaller managers (between $100-$500 million AUM).

(Whatever your size, however, be prepared. The industry has to be grown up now. The one man in the back room is not going to cut it in future with investors, particularly institutional money.)

Smaller managers as well as the big boys are also finding managed accounts or segregated structures could be the future if they want to attract money from some investor groups. The largest pension funds in Europe are quietly but determinedly moving to close out their existing fund of hedge funds  (FoHFs) accounts and allocate directly to managers.

This may be bad news for FoHFs but should not be a major cause of worry. In Europe there are only a handful of pension funds large, experienced enough and financially able to build and take on the burden of their own managed account platform.

FoHFs will continue to evolve and reports of their demise are grossly exaggerated as well as unfounded. The future for them seems to be moving into less product and much more bespoke portfolio construction. A role as overall investment advisor is looking likely for some.

Actually, there has been a lot of exaggerated reporting going on in 2010. Investors are not rushing into managed account structures (cost, lack of experience and manpower as well as operational issues are curtailing the initial enthusiasm) although managed account platforms are becoming more attractive and numerous. This trend is likely to continue and pick up speed in 2011.

There has certainly been a lot of hype (at least in Europe) over Ucits hedge funds this year. Now that the dust has almost settled over the controversial alternative investment fund managers (AIFM) legislation from the European Union (EU), the question now is whether fund managers will really want to shackle themselves in a Ucits wrapper or opt for much more flexible and strategy-friendly onshore structures on offer in various EU jurisdictions.

In the short term at least Ucits is likely to remain popular with institutional investors keen to get exposure to higher performance hedge funds within a regulated structure. Educating this new class of investor about the onshore fund structures will probably take a while. The Ucits brand should continue well into the next decade as long as there are no big blow-ups – something that many still fear could upset the structure, particularly as more inexperienced managers and more complex strategies try their hands at the wrapper.

While some anxiety over proposed legislation on both sides of the Atlantic have melted away, the regulatory environment is not fully clear. The AIFM ended up in a far less awful state than it began but it still packs a wallop. How FoHFs are going to cope with multiple-country based managers in a portfolio will be interesting to see. There are widespread concerns over the depositary clauses. It will take a couple of years to sort out the details.

In fact whichever way hedge funds look, impending regulatory reform continues to disrupt business and will eventually raise costs. The EU, now that it has discovered hedge funds, is unlikely to stop ­harassing them.

Short-selling regulation and over-the-counter clearing reform could seriously affect the industry, particularly if it is unable to start effective lobbying of the many-headed Brussels machinery. Several other initiatives could offer opportunity or possible disaster.

In the US the enactment of the Dodd-Frank Act should take a less tortuous path and is likely to be more business friendly than anything coming out of the EU.

If regulation does not sink hedge funds, the general economic chaos might. The eurozone now resembles the lead in an opera who, although clearly fatally stabbed, just keeps on singing.

Whatever 2011 holds, however, there seems little doubt that the hedge fund industry is riding on the crest of a positive wave. Investors will continue to want higher performance options and are becoming more adventurous with their allocations. Every survey predicts rising allocations into the industry. As more emerging market institutional investors come onto the scene, the amount should continue to climb.

While market volatility will probably continue in equities, bonds and commodities, this should mean opportunity for hedge funds rather than disappointment. Most managers are predicting the strategies to watch for 2011 include emerging markets, event driven, distressed and credit as well as, perhaps ­surprisingly, equities.

Emerging markets should continue to drive growth as the seemingly inexorable shift eastwards continues and the Brics (Brazil, Russia, India and China) continue to outperform the developed West. China in particular should be even more interesting than usual to watch in 2011 as it gains in confidence both politically and economically. How it deals with more economic liberalisation and the inevitability of a fully convertible currency will make the old adage “we live in interesting times” even more apt.

Overall, 2011 should prove an interesting and highly profitable year for the hedge funds industry.

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