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Hedge Fund Outlook 2013, Part 1 of 2

Date: Thursday, December 20, 2012
Author: Parin Shah, ProHedge.co.uk

In a two-part series, PROHEDGE speaks to Phillip Chapple, Executive Director of KB Associates in the UK about the outlook for the hedge fund industry in 2013.

Phillip has over 15 years experience in the financial services industry and has held previous positions that include those of CFO/COO of Ironshield Capital Management and COO of IBIS Asset Management. Phillip has also spent a number of years in prime brokerage at Merrill Lynch where he was responsible for supporting funds across a diverse range of strategies.

What do you think about hedge fund managed accounts going into 2013?

With a managed account it’s getting the balance between the appeal of having a “leg-up” in terms of money pledged compared with the potential operational inefficiencies, and also whether it might put existing investors off. Managed accounts have been shown to work well at places like Winton where a $150m managed account allocation doesn’t pose a major problem based on the size of the fund. Where it can become an issue is a considerable investor coming into a fund with different liquidity and transparency terms to those already invested.

Are European start-ups that you’ve encountered looking closely at managed accounts?

Yes, it’s something that you’ve got to look at on a case by case basis. It’s hard to turn away money but it is important to achieve a balance of terms with existing investors. If you end up with just managed accounts there are questions surrounding how stable the business is in the long run. In reality, as an investor, if someone offers you a managed account, it is a very hard decision to say no.

Do you think the institutionalisation of the investor base is a feature of the industry that is here to stay?

Institutionalisation is here to stay; the industry has changed and it won’t change back. When I first began my career in the hedge fund industry, investors would consider half the risk to be tied up in the alpha proposition and the other half in the fact that hedge funds as relatively small entities could go out of business for whatever reason. Hedge funds were often regarded as punts and people may not have fully understood what they had bought into. This defined a culture of performance chasing by investors in the past.

Now, the majority of fund money is institutional in nature. What that means is that you often have someone like a pension fund trustee conducting the final oversight and performance isn’t their big driver, rather capital preservation. This is why considerable amounts of money is spent on due diligence in order to gain an understanding of the investment; it’s no longer a tick box procedure. The ideal for such investors is to keep money allocated for a period of 3 – 5 years. Redemptions are often seen when these investors find no longer understand a hedge fund in the context of the market. The best analogy I get told about institutional investors is that they are looking for a can of Coke, something that does what it says on the tin; if they open it up and it’s actually a Fanta, they’re going to panic.

Do you think that hedge funds benefit from an institutional asset base due to the “stickiness” of these assets?

The upsides are that assets are more sticky and we should have fewer blow ups, which is good for the industry as a whole. The downside is we do not see enough transparency on what the standards are and what is required, which is perhaps the biggest blockage. Previously where many of the investors were fund of funds, their job was to source, invest and allocate. Now most of the conduit investors job is to identify and provide due diligence. The alpha for conduit investors is due diligence which is why they are unwilling to openly disclose what their standards are. For them it is a great sales pitch to say to pension fund investors “we’ve look at these 1000 funds to get to this 100” rather than saying “we’ve looked at these 1000 funds and they were all good”. You won’t get told if you fail a due diligence process in most cases; all you’ll get told is that your fund isn’t quite right for our strategy at the moment.

Have you seen private investors coming back to the hedge fund industry?

In the last 6 months we have seen some of the older Family Offices and high net-worth individuals coming back in. They’re not any less focused on due diligence but they have slightly different wants and needs in terms of fund strategy, and have demonstrated a push towards real assets. The popularity of real estate and commodities because they represent tangible investments that are not necessarily fully correlated to underlying markets.

Of the start ups in Europe that you have seen, what are they doing well and what perhaps are they not doing as well?

There are far more people who are wanting to start up than actually can. The reason behind this is that from an investor point of view, to take that kind of small fund risk there really needs to be a reason. If you come out and look like a small version “of…” investors will more than likely go to the “of”. A risk for an investor is at its highest before launch due to the lack of tangibility, track record and infrastructure. This year I’ve seen 145 potential start ups and 18 in my view are viable compared to last year where we saw 160, 10 of which were viable. The improvement has been partly due to a widening of the investor mandate but also the fact that people who are starting up are more aware of investor concern.

Of the funds that you have deemed to be viable, is there a focus on particular strategies?

For me, 2011 was all about systematic, in being one of the few areas where you could prove alpha with liquidity. Macro was also popular in terms of looking for safe places for cash. 2012 was the year of the idiosyncratic, focusing on niche areas of expertise that you can’t necessarily get from a large fund. We’ve worked with things like real estate, carbon, oil, infrastructure and environmental and we have worked with more normal looking funds, but it is all about a defining a niche. If you’ve got an emerging market or sector expertise you’re far more marketable to investors who are trying to build up a portfolio of risks that have different drivers. On that basis, you can have bad performance as long as you deliver what you promise. We’re also seeing a push towards what I would call “β plus” products and have worked with a particularly interesting volatility neutral fund. It’s not about absolute return anymore; investors are no longer in that game. It’s all about risk-weighted return.