Funds 25 Years in AIMA's 25thanniversary A specialpublicationtomark P6 How theindustrywentmainstream over 25years Evolution ofanindustry

P20 myths fund hedge Challenging from reality Separating fiction

P38 Five yearsyonder... industry leaders Virtual roundtable of

1990 | 2015

Contributors

Contents Neil Wilson, Wilson Willis Neil 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 , 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 , The Economist and Risk magazine. He has a BA with honours in Philosophy, Politics and Economics from the . 4. 12. Introduction Timeline A global mantra The international nature of investing, trading and regulation means it has never been more necessary for the industry to have a global representative. Iain Cullen, By Jack Inglis 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 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 14. the co-editor of Hedge Funds: Law and Regulation published by Sweet & Maxwell (2001). How the landscape 6. has changed for Then and Now hedge funds Evolution of an industry The legal and regulatory environment over 25 years for hedge funds has changed beyond Niki Natarajan, In Ink recognition over the course of the Alternative investments have gone from last 25 years After writing and editing InvestHedge, a publication from HedgeFund Intelligence, for the periphery ever more towards the By Iain Cullen more than 12 years, Niki founded In Ink (), mainstream of the financial world in the a company specialising in creative content and past 25 years — and AIMA has played an communication consultancy. Niki has more than increasingly significant role along the way 20 years' experience as a financial journalist, By Neil Wilson 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 This report was prepared in collaboration with Wilson Willis Management Ltd. Wilson Willis was founded in January Money Management, all formerly publications of 2014 to provide specialised services including analysis, commentary, bespoke research and conferences for the asset 's newsletter division. management world, with a primary focus on hedge funds. A qualified NLP coach and trained yoga The views and opinions expressed do not necessarily reflect those of AIMA or the AIMA Membership. AIMA does not teacher, Niki graduated in Geography from accept responsibility for any statements herein. Reproduction of part or all of the contents of this publication is Durham University. strictly prohibited, unless prior permission is given by AIMA. © The Alternative Investment Management Association Ltd (AIMA) 2015. All rights reserved.

2 25 Years in Hedge Funds

20. 38. Separating fiction 30. Virtual roundtable from reality Accessing Five years yonder... Despite plenty of evidence to the contrary, After 25 years of rapid growth and change many myths have grown up about hedge hedge funds in hedge funds since the foundation of funds during the last quarter-century that AIMA, a group of leading players from still persist in the popular imagination How 'solutions' are the around the world give their views on the By Neil Wilson outlook ahead for markets, investors and new FoHFs the industry The roles of consultants and funds of hedge Compiled by Neil Wilson funds (FoHFs) have increasingly converged over the years, with significant ramifications for both fund managers and investors By Niki Natarajan

3,000 10,800

2,800 10,080

2,600 9,360

2,400 8,640

2,200 7,920

2,000 7,200

1,800 6,480

1,600 5,760 AuM

1,400 5,040 Funds

1,200 4,320

1,000 3,600

800 2,880

600 2,160

400 1,440

200 720

0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Assets $bn Number of funds

48. 24. Big Data Learning the The growth of the global hedge fund industry lessons of the past 34. As the hedge fund industry has evolved The next five years since 1990 it has had to learn a series of important lessons There is a wealth of research from recent By Niki Natarajan 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

3 Evolution of an industry over 25 years

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

am proud to introduce this special publication to mark the 25th Well over 1,500 corporate member firms and almost 10,000 anniversary of AIMA. Founded in Europe in 1990 by fewer than 20 individuals take advantage of AIMA membership. managers and service providers who recognised the need for It is of course our members who are the backbone of the association. mutual representation, AIMA has grown into a truly global They comprise both the largest and smallest firms around the world, Iorganisation, with offices in every region of the world and members in all contributing to important output such as responses to regulatory well over 50 countries. consultations, updates to DDQs and new industry guides. We have Most financial industry bodies are country and jurisdiction-specific, more than 70 committees and working groups globally, comprising but ‘global’ has been AIMA’s mantra. The international nature of more than 600 individuals from over 350 firms. It is that support that investing, trading and regulation means it has never been more allows us to continue to deliver all the services our members ask us necessary for the hedge fund industry to have a global representative. 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. From small European beginnings, an impressive international network encompassing Asia-Pacific, EMEA and the Americas has been We are hugely grateful to our various sponsor organisations. Our constructed. The US has the dominant market share in the industry Sponsoring Partner members continue to provide unstinting and and represents over 50% of the aggregate AUM of our global important support − Bloomberg, Clifford Chance, Dechert, Deloitte, membership; our Americas presence is further augmented by the EY, K&L Gates, KPMG, Macfarlanes, Man, Maples and Calder, Permal, existence of our National Groups in Canada and Cayman as well as our PwC, Simmons & Simmons, Societe Generale, State Street, UBS, Wells activities in Brazil. In Asia-Pacific, we have National Groups operating Fargo and Willis. in Hong Kong, , Japan and , combined under a Special thanks are also due to the sponsors of the 25th Anniversary single regionally-focused operation. Annual Conference and Dinner, whose advertisements you will see in The growth of the association in terms of membership and staff this publication − Simmons & Simmons, EY and State Street. Iain reflects the expansion of the industry. In 1990, what was then still Cullen of Simmons & Simmons, our General Counsel since inception, very much a boutique sector, managing less than $40 billion in assets, provides a wonderfully rich recent history both of the industry and was served by a part-time secretary and volunteers; in 1994 we were the association within this publication. still operating out of shared office space in . How the hedge fund industry has evolved in 25 years is obviously a As recently as 2005, by which time we had around 900 corporate theme of this publication. The sector has changed substantially in a member firms, and our head office had relocated to London, we still generation. Challenges and occasional crises as well as tremendous had only eight staff members. Today, we have a total of 38 staff; 25 in opportunities have punctuated a period marked more broadly by the London head office and a further 13 in our representative offices institutionalisation, globalisation and increased regulation. The next around the world. The industry manages around $3 trillion in assets, 25 years will doubtless see even more change. Ever present will be much of it on behalf of institutional investors such as pension funds. AIMA, the global hedge fund industry’s representative. •

4 AIMA expanded into Hong Kong in 1999 AIMA — 25 years in Hedge Funds Traders in the City of London stop for lunch in this 1991 photograph 25 Years in Hedge Funds

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

By Neil Wilson now ack in 1990, the year of AIMA’s founding, it would be safe to say that both managed futures and hedge funds Evolution of — indeed, alternative investments in Bgeneral — were regarded as somewhat peripheral to the financial markets, very an industry much on the outer fringes of the mainstream financial world. over 25 years 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 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

7 Evolution of an industry over 25 years

shocks of that decade. But by 1990, there were still a few hardy survivors of the early period left — including legendary ‘’ 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 During the 1990s, while many CTAs continued spawned a range of further top rank CTAs AIMA was early to thrive and generally make good returns including Winton Capital and Aspect Capital. to establish a (not without some volatility), they were Today, the US remains by far the biggest gradually over-shadowed by managers region for hedge funds by assets under presence on the investing instead in a long-running bull management — with New York by a long way ground in Asia — market in equities. TT International had the top single centre, alongside significant launched what was widely regarded as the clusters in other regions around the country at a time when first hedge fund managed in Europe in the in Connecticut, Massachusetts, Illinois, feelings were late 1980s. And notable early long/short Texas, California and elsewhere. equity managers who emerged in Europe still running high during the early 1990s included Crispin Odey, London has for many years been the second who launched his first hedge fund in 1992, biggest centre globally. And in the managed about hedge and John Armitage, who went live with futures space, in particular, many of the Egerton Capital in 1994. world’s operators are now based in Europe funds' perceived — and all around the Continent too, including role in the Asian The pace of development, however, was the likes of Transtrend in Rotterdam, Lynx quite slow in Europe in those early days. In in Stockholm and Capital Fund Management financial crisis. the US, by contrast, the industry was already in Paris. growing rapidly — and not just in equity- related strategies, but into other areas such as convertible , distressed debt and Sterling crisis fixed income relative value. It was in the latter strategy area that hedge funds next Arguably, the first time that hedge funds made big headlines — after the Asia and reached the public consciousness, at least in Russia crises of 1997 and 1998 was followed Europe, was in 1992 — when the Bank of by the sudden and shocking implosion of Long England was forced to give up its policy of Term Capital Management. trying to keep sterling within the European exchange rate mechanism (ERM), the The huge scale of the leverage deployed by forerunner of the euro. That was not until LTCM caused what looked like a potential after the had suffered major systemic problem — raising serious questions losses in a failed attempt to keep sterling for the first time that hedge funds were inside the ERM — and various hedge fund perhaps becoming so big that they could managers, led by Soros, famously made constitute a danger to the whole market. massive profits by betting successfully For the first time in 1998, hearings were held against it. in Washington to investigate this notion — with Congress even summoning George While there was much hot air expended by Soros to answer for the industry. critics at the time — venting about these ‘buccaneering’, ‘upstart’ hedge funds being At the time, industry representatives were allowed to humble the stately Bank of able to argue successfully that LTCM was very England — the resulting exit of sterling from much a one-off case — and that hedge funds the ERM proved a boon for the UK economy. in general were just too small and too

8 25 Years in Hedge Funds

modestly leveraged to pose a genuine AIMA was early to establish a presence on the challenging. By 1999, the ‘dotcom bubble’ systemic risk. But, over the years since, ground in Asia — starting at a time when was in full swing — making it hard for hedge regulators and legislators have continued to feelings were still running high about hedge funds, including the growing community of be pressed by sceptical or hostile public funds in many parts of the region following long/short equity managers, to stand out opinion — re-ignited whenever there has their perceived role in ‘shorting’ various from traditional long-only funds that were been any significant hedge fund-related markets during the Asia crisis. In the late riding a raging bull market. ‘blow-up’ or scandal. So 1998 turned out to 1990s, there were very few funds managed be just the first in a series of debates about from within the region itself and they were But hedge funds began to look increasingly potentially damaging new regulations that mostly focused on Japan. Over the years compelling after the dotcom bubble burst have continued all the way through to the since, while assets have waxed and waned in — during the subsequently sharp bear market present day. what have often been volatile markets, the of 2001 − 2003. While equity markets were ex-Japan markets have grown dramatically plunging 30% and more, hedge funds on — with Hong Kong and Singapore emerging as average were generally retaining their value Global reach the leading centres for managers to be based — and many individual managers, even in It was very timely, therefore, that in 1997 in the region. equity strategies, were continuing to produce gains. the managed futures-focused and still largely Meanwhile, by the late 1990s the industry in European EMFA evolved to become the Europe was also taking off in a very broader, and globally-aspiring, AIMA — significant way, with a whole new generation seeking to represent the increasing of managers being inspired to leave the The process of community of hedge funds as well as CTAs. institutions where they worked, set up on institutionalisation The importance of this development was their own and deploy the most sophisticated In the early years of the industry, hedge again probably not widely appreciated at the asset management techniques to deliver the funds and CTAs had attracted money mainly time — given what was still a nascent best risk-adjusted returns. industry driven by fiercely competitive and from wealthy individuals and clients of independent-minded individuals. The LTCM affair — given not least the private banks (which formed many of the pedigree of a management team including early funds of hedge funds), plus like-minded As a breed, hedge fund managers and CTAs Nobel laureates — had certainly been a shock family offices. Over time, more money had have of course always been entrepreneurial, when it happened. But in retrospect it looks also started to come in from investors with and fiercely competitive among themselves more like a mere blip — with funds launching tax-exempt status like endowments and — and hence by nature very hard to rally at the time finding it more difficult than they foundations, and corporate sources like together behind the same banner. had expected to raise capital, but most of companies. Yet the new AIMA was not slow to take up the them going ahead anyway. task with enthusiasm. As early as 1997, AIMA After hedge funds outperformed so clearly Those launching their first funds during that during the dotcom era, the investor base was issuing its first due diligence period — including AQR, Marshall Wace, questionnaire. In 2000, AIMA’s first started to become increasingly institutional, Viking Global and Lansdowne Partners, and with corporate and public pension funds Regulatory Forum was held. And by firms like BlueCrest that were leading a new September 2002, AIMA’s firstGuide to Sound and sovereign wealth funds becoming more wave of fixed income and macro focused and more significant allocators. Hence a Practices had been published. The players — have gone on to become some of more ‘institutional’ sort of hedge fund association was also beginning to expand the biggest names in the global hedge fund industry started to emerge — one that globally — first into Hong Kong in 1999, and industry of today. then into Australia and Japan in 2001. needed to cater to the ‘institutional Canada, Cayman, Singapore and other This was despite the fact that markets at the standards’ in money management required locations would gradually follow. time continued to be volatile and by those investors.

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

7% Foundation Fund of hedge funds 4% 19% 4% manager Private sector 7% Endowment plan Public pension fund 8% 15% Wealth manager 9% Asset manager 15% Insurance company 12% Other

Source: Preqin, 2015

9 Evolution of an industry over 25 years

This process of institutionalisation was to hedge funds to suspend redemptions or continue over a number of years and did not ‘gate’ investors — in order to avoid realising really reach its zenith until after the massive losses in a collapsing market. At the financial crisis of 2008 — with the assets same time, many other managers were managed for institutional allocators like criticised for realising major losses — pension funds eventually coming to exceed precisely because they were obliging the amount hedge funds managed for their investors by liquidating assets in a market traditional private bank, high net worth and with no buyers. For many hedge fund family office type of clientele. managers, it was an invidious position to be in. Over the five years just before the crisis, from 2003 − 2007, there was largely a slow In the circumstances, it should have been no and steady rising market in equities, plus a surprise that the databases were showing major boom in credit markets — where an average losses of 15 − 20% for hedge funds in increasing number of hedge funds also began 2008 — although that was of course nothing to focus. These were conditions in which like as bad as equity market returns at the numbers of players and assets could grow time. Alongside the simultaneous flood of robustly — as indeed they did. In that period, redemptions, asset levels overall suddenly HFI was routinely recording well over 1,000 dropped by 30%. new hedge fund launches a year. The combined assets of AIMA’s global membership had reached the $1 trillion mark The Madoff affair as early as 2005. And the long-running Hedge There were further aggravating factors. Fund Research database put aggregate global At the depth of the crisis in December 2008, assets at a peak of almost $1.9 trillion by the wave of redemptions finally caught out 2007, though some other data providers put Bernie Madoff — who was revealed after the number even higher. HedgeFund many years to have been running a Intelligence reported assets breaching the $2 fraudulent ‘Ponzi scheme’. The smattering trillion level that year — and (albeit very of fraud cases involving (supposed) hedge briefly) even exceeding $2.5 trillion just funds which had occurred intermittently over before the financial crisis hit. the years before were mostly small and obscure cases with minimal impact. But As the industry became more institutional Madoff was truly shocking in its scale — and during this period, there was an accompanying for the fact that, although Madoff was not trend towards more consolidation too — with strictly a hedge fund manager himself, he an increasing number of managers monetising had been acting as a sub-adviser running the value of their firms through selling stakes, feeder funds or accounts for many investors such as to Petershill, a private equity vehicle in the industry. managed by , or by creating listed vehicles all the way through to The Madoff affair took a heavy toll on the full-scale IPOs. 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 The impact of the 150 FoHF groups were known to have financial crisis exposures to Madoff, and the vast majority of With assets growing so robustly, there were the money Madoff had raised had not come during the crisis, many individual funds had however mutterings among investors that via FoHFs but from direct investors, indeed continued to deliver positive returns overall performance — which had been sometimes via feeder funds or managed in 2008 — on some measures up to around strong historically — had become increasingly accounts and even some in onshore 20% — 25% of those trading at the time. tepid or lacklustre, which was indeed being structures — on all of which he was reporting reflected in the indexes of composite bogus returns. Those who made profits during the period included some huge gains from managers performance as that period wore on. But few Nevertheless, following the crisis and the investors seemed to be prepared for the sort who had called the credit crunch correctly; Madoff affair, the proportion of assets from some big macro funds; and across the of aggregate performance that came through allocated to the industry via the FoHF sector after the ‘credit crunch’ of 2007 gave way to board from CTAs — who once again began to drop — from over 50% before 2008 reaffirmed their non-correlation with the collapse of Lehman Brothers and the to around 20% — 25% today. full-blown financial crisis of 2008. average gains of 15 — 20% in 2008, with many of them up considerably more. Many of the newer investors, in particular, had been sold on the notion that hedge funds The recovery As the dust settled on the crisis, and were ‘absolute return’ products. And so, Assets started to recover quite quickly after investors began to take these sorts of facts somewhat naively perhaps, they were simply the crisis — within a year or so after the on board, asset levels began to recover — as not prepared for the eventuality that hedge equity market bottom in March 2009. That they have continued to do steadily year after fund performance in aggregate could be was after it became apparent that aggregate year since 2010. Both the HFR and HFI significantly negative — even if there was hedge fund performance had not in fact been databases now show global assets surpassing a complete meltdown of the whole all that bad during the crisis — not when you previous peaks and reaching record highs financial system. considered that global equity markets had around the $3 trillion level, including a rising plummeted 30 − 40%, more than twice as proportion in onshore structures like UCITS In the febrile, panicky conditions of late much as hedge funds on average had fallen. and 40 Act funds. 2008, the situation was made significantly worse by a virtual tidal wave of redemption Moreover, while the dispersion in returns requests hitting the industry. This led some across the industry had been enormous

10 25 Years in Hedge Funds

Increased regulation encouraging good standards in the industry getting bigger, with an increasing — to fight the industry’s corner, and to concentration of assets among the biggest Yet the image of the industry — as indeed of prevent the results from being too negative, firms of the Billion Dollar Club. According to the whole financial sector — took a battering and perhaps even destroying the industry. HFI figures, these top 400+ firms globally now during the crisis. With governments (and Extremely effective campaigns were waged account for close to $2.5 trillion of the their taxpayers) in the major economies on a variety of fronts particularly in Europe industry’s assets — well over 85% of the total. being asked to borrow hundreds of billions to and the US. bail out the banks, it provoked widespread Challenges, and risks, remain. The industry hostility to the financial sector as a whole. If The world changed in 2008/9, and with it, today is more global, more institutionalised, anything, the fact that some hedge funds had AIMA changed too. Following the crisis, the and more diverse in terms of investment correctly diagnosed the mounting problems Association built new structures and brought strategies than it has ever been, even in the financial sector only seemed to attract in new people to address the challenges allowing for the consolidation that inevitably greater opprobrium. posed by the crisis and the regulatory has occurred. It remains a source of reforms that followed. Amid a spirit of innovation and entrepreneurialism. It is Other key facts — such as the reality that constructive and proactive engagement, playing an ever increasing role in the ‘real hedge funds had not caused the crisis, or that AIMA and the industry achieved significant economy’. Its investors continue to earn many of them were badly impacted by it amendments to proposals that could have significant sums and allocate ever greater — and had never received a penny of bail-out threatened the industry’s very existence. shares of that portfolio. money — were very difficult to get across to the press, the public and the politicians. In Instead, we have an industry that has been The past 25 years have been instructive, they such a hostile atmosphere, it was inevitable growing again at a good pace of around 10% a have been incredibly difficult at times, but that pressure would mount on politicians for year or more since 2009 — though one that ultimately it has been a rewarding period. ‘something to be done’ to address what had looks very different from before. While For the new generation of hedge fund caused the crisis — and prevent it from have been managers, the next 25 years could be yet happening again. growing, the numbers of players trading has more exciting.• not — with higher barriers to entry reflected Thus, it was critically important that AIMA in a falling number of new funds coming was there — with a long record of through, especially in Europe, and the big

11 Timeline

Timeline

1990 1992 1994 1997 1998 1999 2001 2002 2003

AIMA EMFA establishes a AIMA sets up becomes presence in operations in EMFA (the AIMA; Australia Canada and forerunner first AIMA and Japan South Africa of AIMA) DDQ AIMA launches established published; CAIA AIMA Journal qualification launched with the CISDM

AIMA AIMA developments AIMA expands to Hong Kong, its first international branch

Asia financial Sterling exits Equities start crisis ERM new bull market

Mexican peso Dotcom crisis ‘bubble’ bursts

Russia crisis Market events

Dotcom ‘bubble’ starts

As greater numbers of George Soros, institutional investors seek others profit out hedge funds, the industry begins to institutionalise Amid a stock LTCM market rout, hedge Industry events collapses funds outperform

12 25 Years in Hedge Funds

2004 2005 2006 2007 2008 2009 2010 2012 2015

AIMA member AIMA assets AIMA member exceed $1tr membership assets for first time rebounds exceed $1.5tr; more than 1,500 AIMA firms AIMA creates membership Cayman Islands declines 10% branch following the crisis

AIMA establishes Singapore branch AIMA opens an office in New York

Global Markets start financial to recover Eurozone crisis; crisis start Lehman Credit collapse Major new crunch regulations for starts hedge funds Securitisation proposed in Europe drives a credit Madoff and the US in bubble fraud particular revealed

John Paulson, others call Hedge fund the crisis assets drop Global hedge correctly sharply, many Hedge fund fund assets Global shutdowns; assets, approach hedge fund but many performance $3tr assets reach hedge funds rebound $1.5tr and CTAs strongly outperform

13 How the landscape has changed for hedge funds

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

14 Hedge fund manager registration and 25 years in Hedge Funds reporting became mandatory in the US under the Dodd- Frank Act, which was enacted by Congress in the wake of the financial crisis.

ittle 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 Limagine 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

15 How the landscape has changed for hedge funds

when, in 2002, AIMA was converted from an no economic sense for them to be paying association with unlimited liability to a fees to manage their own money, began to company with limited liability. realise that such rebates constituted taxable income in the recipients’ hands. As a result, The LTCM debacle Whilst there have been substantial many funds started to create so-called developments in the regulation of hedge in 1998 was the management shares for partners, employees fund managers in the 25 years since AIMA’s and, sometimes, family and friends which catalyst which foundation, the way hedge funds are were identical in all respects to shares structured has not changed to the same led to the world's issued to investors save that no fees were extent. In the early days, it was common for payable thereon. leading regulatory separate standalone funds to be established for different types of investors, with such In terms of domicile, most offshore authorities funds investing in parallel. This gave rise to corporate funds have always been first seeking to the need to rebalance the portfolios of such established in the Cayman Islands, although parallel funds whenever investors subscribed for largely historic reasons certain managers understand what the or redeemed therefrom, leading to have established their funds in the BVI. So far hedge fund industry unnecessary operational complexity. as funds are concerned, As a result, it became common for such the majority have tended to be established was about. funds to be established as feeder funds into in Delaware although for various reasons in an offshore master fund, such that there more recent times a sizeable minority have was a single portfolio of investments to been and continue to be established in the be managed and thus no requirement Cayman Islands. for rebalancing. Whilst the dominance of the Cayman Islands Similarly, in the early days, where it was has continued, both Ireland and Luxembourg desired to offer investors the ability to have also attracted a number of hedge funds, subscribe for shares denominated in usually where the manager wished to target different currencies to reflect investors’ European institutional investors. Such preference for a particular currency investors are generally considered to prefer, exposure, separate offshore funds were and to some extent are restricted to, established with shares denominated in the investing in funds established in jurisdictions desired currencies. This resulted, however, where they are more highly regulated. in the existence of additional parallel funds Lastly, it is perhaps worth mentioning that and it was not long before separate classes of there was a time when many new funds shares in a single fund but denominated in sought a listing of their shares on the Irish different currencies began to be launched. Stock Exchange which it was thought would Around the same time, managers who had assist in marketing the fund to institutional been rebating to their partners and investors. It was also thought a listing might employees the management and give investors in an offshore fund established performance fees charged on shares held by in a more lightly regulated jurisdiction, such them in their funds, on the basis that it made as the Cayman Islands, a level of comfort

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 Cullen Partner T +44 20 7825 4422 E [email protected]

As a founding member of AIMA, Simmons & Simmons would like to congratulate AIMA on its 25th anniversary simmons-simmons.com elexica.com @SimmonsLLP

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. How the landscape has changed for hedge funds

that some body (albeit not a regulatory one this was quietly dropped; indeed, very few early drafts of several provisions of the draft as such) would have an ongoing oversight role people now recall its existence. directive and subsequently to lead the AIMA in relation to the fund’s activities under the working group commenting on later drafts of Later the same year, the French Autorité des stock exchange’s continuing obligation rules. the directive published by the European marchés financiers (AMF) worked with AIMA In more recent years, however, the number Council, Commission and Parliament, until and the French fund managers’ association of such listings has substantially decreased. AIMA’s highly competent Asset Management on the development of the AMF’s new Regulation team took over the running. Although the structure of hedge funds may regulations for French domestic hedge funds, not have changed much, there have been in particular with respect to their As is now all only too well known, AIFMD, many changes in the way hedge funds are relationships with prime brokers. which finally came into force in July 2014, operated, driven frequently by the demands Approximately one year later, in June 2005, has had a significant impact, and will of an increasingly sophisticated investor base the UK Financial Services Authority (FSA), continue to do so, on the management and rather than by regulation. These include the as it then was, issued two discussion marketing in the EU of alternative appointment of administrators, unaffiliated papers, the first seeking to assess the risks investment funds such as hedge funds. Most with the manager, to provide an independent posed by hedge funds and to identify the recently this has been reflected in the valuation of a fund’s assets, though in this risk mitigation steps it would consider European Securities and Markets Authority’s regard the EU Alternative Investment Fund taking; and the second seeking views of advice and opinion on the possible extension Managers Directive has to some extent the investment community in relation to of the marketing passport under AIFMD to turned the clock back as it places the the possibility of permitting wider retail non-EU alternative investment fund responsibility for valuation on the manager. access to hedge funds. Neither of these managers and/or alternative investment Another change has been an increased focus papers led, however, to any concrete funds. Looking ahead, AIFMD provides that on corporate governance which has led proposals for regulation. by 22 July 2017 the European Commission increasingly to the appointment to the must commence a review of the application boards of funds of a majority of independent of the directive and, if appropriate, make directors who are unaffiliated with the Who can forget proposals for amendments to it. In other manager or the fund’s service providers. words, AIFMD 2 may be upon us in the not the senior German too distant future. politician's description This tour d’horizon would not be complete LTCM debacle without an attempt to identify what else the AIMA’s industry views were not always sought of hedge funds as a future might hold for hedge funds and their or welcomed in the early days by regulators, "swarm of locusts"? managers. It seems likely that the slowdown politicians or the press. It was the LTCM that we have seen in the last few years in the debacle in 1998 that was the catalyst which formation of new hedge fund managers will led to the world’s leading regulatory A range of international bodies, including not be reversed, at least in Europe, and that authorities first seeking to understand what IOSCO, the G8, the Bank for International new managers will instead continue to join the hedge fund industry was all about. That Settlements, the Bank of England and the existing platforms. This is because not only the willingness to listen to AIMA’s views and Financial Stability Forum (now the Financial are the costs of compliance and of the those of its membership changed, at least so Stability Board) amongst others, published necessary operational infrastructure unlikely far as the regulators are concerned, is pronouncements and reports commenting on to reduce but also the difficulty of raising demonstrated by the willing participation of the risks posed by hedge funds to financial assets is unlikely to decline if the regulators from the US and Europe at AIMA’s stability and on ways potentially to mitigate institutionalisation of the hedge fund first International Regulatory Forum in 2000. those risks from 2005 onwards, both before investor base continues. It also seems likely Despite serious concerns about the potential and after the 2008 financial crisis. that hedge fund managers which pursue an of hedge funds to cause systemic risk, the Somewhat surprisingly, whilst the 2008 activist investment strategy will begin to main consequence of LTCM was that prime financial crisis led to developments in fund set their sights on European companies brokers began to demand greater portfolio documentation relating to gates, suspension despite the perceived difference between transparency from their clients. provisions and side pockets, it did not lead the legal regimes in Europe and the US where In the years leading up to 2005 when to any immediate changes in regulation, they have mostly concentrated their efforts politicians (who can forget the senior perhaps because there was no evidence that to date. the activities of hedge funds posed any German politician’s description of hedge It is also noteworthy that the Financial systemic risk. funds as a “swarm of locusts”?), journalists, Stability Board recently announced that it central bankers, academics and company was temporarily shelving plans to designate managements first began to comment on the particular entities, such as hedge funds, as need for increased regulation of hedge funds, AIFMD introduced systemically important financial institutions AIMA actively pursued, in line with its In an effort to head off regulation of the and would instead concentrate on looking at objectives, an agenda which involved: industry, the Hedge Fund Standards Board whether certain activities that asset educating its members on the benefits of (HFSB) was established in 2009 by 14 leading managers undertake are particularly risky. sound practices; publishing its first DDQ in hedge fund managers to develop practice Hot on the heels of that announcement, 1997; the first edition of itsGuide to Sound standards to be adopted by its members, however, came a statement by Mark Carney, Practices for Hedge Fund Managers in compliance with which the FSA stated would the Governor of the Bank of England, that the September 2002; and in 2005 the first be taken into account when making Bank was now looking at whether risky editions of its Offshore Alternative Fund supervisory judgements. This was a laudable activity had migrated from banks to hedge Directors’ Guide and of its Guide to Sound aim but with hindsight it came too late as, by funds such that the Bank might need more Practices for Hedge Fund Valuation. then, bureaucrats within the European power to regulate such funds! Commission had already begun dreaming up The first occasion when regulation was what, in 2009, became the first concrete In conclusion, it seems fair to say that, like it actually mooted was in January 2004 when proposal to regulate the hedge fund industry, or not, the regulatory environment for hedge the European Parliament submitted to the namely the proposal for an Alternative funds will continue to develop, even if the European Commission a proposal for a Investment Fund Managers Directive (AIFMD). legal environment does not. • directive introducing the concept of a sophisticated alternative investment vehicle As General Counsel of AIMA I was privileged (the so-called “Purvis Report”). Subsequently to see, and to be allowed to comment on,

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© 2014 Ernst All© 2014 Rights & Young LLP. Reserved. ED None. 19 Myths about hedge funds

Separating fiction from reality fictionreali t y Despite 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

erhaps it is in the nature of the beast. There have of course been further factors Hence the battle to improve the industry’s But it is undoubtedly true that a that made hedge funds an object of suspicion image has been ongoing for several years mythology has grown up around hedge to the wider public — such as that they could now, and with increasing intensity since the funds in the public mind — one that go short as well as long, which looked to financial crisis. With many politicians still Pbears little relation to the actual industry some sceptics like they were trying to seeming to target the industry, it is far from which tens of thousands of people work in damage certain companies; that they were being won yet. every day. often domiciled offshore — which looked to As there are many myths about hedge funds, others like they had something to hide; and it is difficult if not impossible to put together It is in the nature of the beast, arguably, that you only ever heard about them in the a comprehensive or exhaustive list. But there because hedge funds were historically shy of news on the odd occasion when there was a are perhaps three main types, which are to publicity and maintained a very low profile ‘blow-up’ or a fraud. — and hence were slow to challenge the do with: assumption that they were ‘secretive’. You almost never heard about the many Hedge funds were often founded and led by hedge funds going about their jobs quietly ●● Risk — centring on the accusation that entrepreneurs who felt they had developed and delivering steady, superior risk-adjusted hedge funds are more ‘risky’ than some deeper insight into the market which returns. In the public mind, by contrast, traditional investments, and hence gave them an ‘edge’ — a competitive hedge funds had developed a somewhat ‘dangerous’ for investors and/or for the advantage they were naturally reluctant raffish image — one that some managers markets in general; to disclose. perhaps embraced with a certain relish, but ●● Ethics — centring on the accusation that that the great majority just did not recognise hedge funds are ‘bad actors’ in the The fact that certain hedge funds delivered and wanted to challenge. exceptional performance — which made the markets and/or in society generally; and managers very rich — only served to burnish Over the years, many in the industry have ●● Performance — centring on the their mystique, one that many in the industry sought to tackle these myths — either accusation that hedge fund performance did little to dispel. So hedge funds started to individually or collectively through either isn’t all that good or downright be seen both as ‘secretive’ and as ‘rich’ organisations like AIMA — and to produce bad; and/or not worth the fees — even though the latter is only really true of research that challenges the negative investors pay. a few in the very top echelons of the perceptions and shines a light on the many industry. Numerous surveys by recruitment positive ways the industry operates. But it In reality, of course, none of these consultants have shown that remuneration has often proven to be a frustrating task accusations really stack up — as the various for the majority is akin to that of a doctor — with continuing preconceptions frequently research papers produced by AIMA and others or lawyer. repeated and reinforced by commentators have clearly shown. So, in the ongoing quest making it difficult to get key points across to to help dispel them, let’s take each area the public and politicians. in turn:

20 25 Years in Hedge Funds

like private equity. Those hedge funds that this. The problem of “too big to fail” does Common do invest in such areas, such as specialists in not affect hedge funds. Unlike banks, hedge risk-related myths distressed debt, tend to require longer funds are considered “safe to fail” by Myth: Hedge funds are very risky compared liquidity terms for their investors too — to academics and many policymakers. to traditional investments avoid a potential liquidity mismatch — and usually run with little or no leverage. Reality: Hedge funds on average are not Common more risky either than the markets or than Myth: A lot of hedge funds ‘blow up’ traditional long-only investment funds. Over Reality: A hedge fund 'blow-up' is where ethics-related myths time, indices show that hedge fund returns investors lose a substantial portion of their Myth: Hedge funds are self-serving and don't on average are higher — and, importantly, investment. These occur very rarely. Past contribute to society with considerably less volatility — even if one blow-ups have occurred sometimes due to Reality: Hedge funds manage money for the takes into account ‘survivorship bias’ funds running with too much leverage, as was public — not to bet against it. The majority of (allowing for the disappearance over time of the case with LTCM in 1998, and/or too much assets under management in the industry are poorer-performing funds from the databases, concentrated exposure to positions that managed on behalf of average citizens a factor that affects all types of investment became illiquid, such as occurred with — often via their pension funds — as well as indices, not only hedge fund indices). See Peloton in 2007. But lessons have been for sovereign wealth funds, endowments, more on myths about hedge fund learned from such experiences in the past, foundations, family offices and other sorts of performance below. and risk management across the industry has private investors. Surveys have shown for Myth: Leverage is too high and/or improved as a result. While many funds may several years that well over 50% of assets in investments are too illiquid have been shut down over the years after hedge funds are managed for institutional Reality: Hedge fund leverage varies suffering modest losses, blow-ups have investors. become increasingly rare — and of course no enormously — depending on market Myth: They are secretive/opaque conditions at any particular time and on the hedge fund has ever been bailed out by type of strategy. In long/short equity, one of taxpayers. Reality: Many hedge funds may indeed be the biggest strategy areas, it is usually The ‘failure’ rate of hedge funds has never protective of the intellectual property which modest — often varying from one to two-and- been inconsiderable — with up to 10% of is at the basis of their returns. But most are a-half times (100% — 250%) of assets under funds trading shutting down each year, not so secretive as may have been the case in management. In fixed income strategies, it according to research from HedgeFund the early days of the industry. Today, hedge can often be a lot more — say 10-12 times Intelligence prior to 2008. But most of those funds are far from unregulated — and are — but that is usually in instruments that shutting down each year were smaller funds, indeed required to be registered and to themselves have very low volatility (like where the managers were giving up because report positions regularly in major Treasury securities) and often with a market they could not raise enough assets to make jurisdictions (i.e. on a quarterly basis to the neutral exposure (equally long and short but them economic — not because their SEC on securities held in the United States). of different maturities for instance) rather performance was particularly bad. The The vast majority of hedge funds also now than leveraged and directional. shutdown rate did spike a little during and routinely report their monthly returns to one just after the extreme conditions of the or more of the industry databases. The leverage among some other financial financial crisis in 2008, but has since dropped Myth: They are run by and for only the rich businesses such as banks, for instance, is by again to well below 10% a year. contrast typically a lot higher — with the size Myth: They avoid tax of bank balance sheets being typically 10-20 Myth: Hedge funds cause systemic risk Reality: Hedge funds around the world times bigger than their capital base (and Reality: Very few funds operate with large employ a significant number of people in the often without taking into account off balance enough assets under management and with financial sector — over 300,000, according to sheet instruments like derivatives). sufficient leverage to make their potential AIMA research. And they are often in high- Not many hedge fund strategies focus on failure an issue of systemic concern to skilled jobs — which can generate significant illiquid instruments — which are more usually regulators. Since the financial crisis, studies tax revenues in jurisdictions like the US, UK, suited to longer-term investment vehicles by regulators have consistently confirmed Canada, Australia, Japan, Singapore and

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

Year Net asset flows Performance-based ($bn) AUM change ($bn)

2005 $46.9 $85.9 2006 $126.5 $232.7 Note 2007 $194.5 $209.4 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 2008 ($154.5) ($306.9) funds of hedge funds). The majority of fund information in the Database is 2009 ($131.2) $324.2 distributed to Hedge Fund Research subscribers, with permission of the fund managers. Funds that decline to be included in the distributed hedge fund 2010 $55.5 $261.8 database are tracked internally by Hedge Fund Research. Asset size and 2011 $70.6 $20.1 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 2012 $34.4 $209.9 assets and asset flows by strategy, Hedge Fund Research uses total assets from all 2013 $63.7 $312.2 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 2014 $76.4 $140.3 avoid double-counting. Funds in the Hedge Fund Research Database submit assets under management Total change $382.9 $1,489.5 consistent with conventional reporting methods which specify investor capital since 2005 under management, net performance fees.

Source: Hedge Fund Research

21 Myths about hedge funds

Hong Kong, where many management firms impossible to execute. Hedge funds are only the reason why those banks failed or had to are located. AIMA estimates that the total tax likely to profit in such a situation if they had be bailed out — that was simply due to the take for governments worldwide runs into put the short positions on long before prices scale of the losses the banks had incurred. the tens of billions each year; in the UK alone started to fall. AIMA estimates annual tax revenues from Myth: Activist funds are just in it for With the ability to go short as well as long, hedge fund firms and professionals amount to themselves hedge funds are in fact well placed to help some £4 billion ($6 billion). Reality: Certain types of hedge funds have the markets puncture speculative ‘bubbles’ been singled out for causing a negative As with other successful sectors that that can and do occur, as they will tend to impact on markets or society — including generate considerable wealth, such as short securities that they believe are getting ‘activist’ funds which encourage companies technology, hedge funds have also become over-valued. to enhance shareholder value. But plenty of massive contributors to charitable causes research (including a 2015 report by AIMA) — both individually, through foundations that Similarly, when prices are declining, hedge shows that their impact has generally been they have created, and collectively through funds with open short positons are often the positive — on individual companies and the industry-wide charities. only natural buyers in the market at that time — when ‘long-only’ investors are more wider economy. Myth: Hedge funds have no economic value likely to be selling — and so can effectively Myth: Hedge funds are not long-term or are bad for markets and other investors create a buffer against a falling market investors turning into a complete collapse. In practice, Myth: Short selling has a negative Reality: While some hedge fund strategies to realise profits on short positions, hedge impact/‘irresponsible’ shorting causes involve a large amount of short-term trading, funds need to be ‘buying back’ — at lower problems in markets others — including many activists and prices than they had previously sold. Reality: Short selling is a perfectly legitimate distressed debt investors — involve a much activity. It is facilitated via the securities Myth: Hedge funds were responsible for the more long-term approach. lending market — where owners of securities financial crisis/crash make them available to borrow (for a fee). Reality: Hedge funds were not responsible This helps narrow bid/offer spreads and Common performance- for the financial crisis. The crisis was created improves liquidity, making the market more by irresponsible lending in the banking efficient, less volatile and hence more related myths sector, encouraged by the easy ability of attractive to all sorts of participants. Myth: Returns are not all they are cracked banks (in the pre-crisis period) to create and up to be/are poor or really bad For hedge funds, the ability to go short is the then securitise ‘toxic’ loans in areas like US Myth: Returns are very good — but only for main means by which they are able to hedge sub-prime mortgages. Some hedge funds — to reduce the risk and volatility of their were indeed among the first to identify that the rich overall portfolio and to hold long positions these loans were toxic and to go short of Myth: Assets are falling because with greater confidence — as well as to make them, realising enormous gains. But the vast performance isn’t good specific bets that the prices of certain majority of hedge funds, which do not focus Reality: As highlighted above, overall hedge individual securities they believe are on the credit sector, were negatively fund performance over time has been over-valued are likely to fall. impacted — just like most other types of considerably better than the returns in Short selling activity is unlikely to exacerbate businesses — when the entire banking system equity markets — and with considerably less a crisis or panic situation in the market threatened to implode. volatility — even allowing for ‘survivorship — because, when prices are falling fast, Certain hedge funds may have shorted bias’ (the disappearance over time of poorer borrowing stock becomes typically much certain bank stocks during the financial performing funds from the databases, a more expensive if not very difficult or crisis. But hedge funds being short was not 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

16.0% 15.1% 14.7% 14.0% 13.0%

12.0%

10.0% 9.1% 8.1% 8.2% 8.0% 7.2% 7.0% 6.3% Annualised volatility 6.0% 5.5% 5.2%

4.0% 3.9%

2.0%

0.0% HFRI S&P Barclays HFRI S&P Barclays HFRI S&P Barclays HFRI S&P Barclays FWC 500 GA ex-USD FWC 500 GA ex-USD FWC 500 GA ex-USD FWC 500 GA ex-USD 3 Year (Jan 2012− Dec 2014) 5 Year (Jan 2010− Dec 2014) 10 Year (Jan 2005− Dec 2014) 20 Year (Jan 1995− Dec 2014)

Source: HFR, Barclays, AIMA research

22 25 Years in Hedge Funds

This outperformance has been most in them showing rather different returns over pronounced during periods when equity the same time series. This partly reflects the For more detailed evidence, take a look at markets have fallen sharply — such as during fact that hedge fund returns, even with the the following reports on the AIMA website: the ‘dotcom’ bust of 2000-2003 and during same strategy area, vary considerably — with • Financing the Economy — The Role of the financial crisis of 2008, when even though considerable dispersion among the individual Alternative Asset Managers in the hedge funds on average may have produced funds. Many of the indices focus on a simple Non-Bank Lending Environment — AIMA, negative returns they were still well ahead of median of the funds included — not allowing for May 2015 the losses in equity markets. any skew in the distribution of returns, which can often be to the high side of the median • Tax Paid by the UK Hedge Fund Industry (i.e. with a significant minority outperforming at Record Levels — AIMA research, by a wide margin). February 2015 Another common problem is a widespread • Unlocking Value — The Role of Activist misperception that hedge funds are an asset Alternative Investment Managers — AIMA, class — like equities or bonds — and this February 2015 misleading notion has still only been partially • The Way Ahead — Helping trustees dispelled over time. Hedge funds are not an navigate the hedge fund sector — AIMA/ asset class. Rather, they adopt a range of CAIA, January 2015 strategies with varying approaches — • Capital Markets and Economic Growth including the use of long and short positions — Long-Term Trends and Policy and leverage — across a range of different Challenges — AIMA, May 2014 Certain commentators have argued that net asset classes. Hence it does not really make a returns from hedge funds over time — after great deal of sense to compare hedge fund • Apples and Apples — How to Better allowing for fees — have been negligible, returns in general against equity indices. It Understand Hedge Fund Performance which may have appeared to be the case for makes more sense to compare equity hedge — AIMA, April 2014 some investors immediately after the sharp fund returns against equities, fixed income • Contributing to Communities — AIMA drop of 2008. But such contentions have not hedge funds against bonds and so on. Review of Hedge Fund Charitable stood up to more rigorous scrutiny. Activities — May 2013 For strategies which trade across a range of Over shorter time frames, hedge fund asset classes — such as global macro or • The Value of the Hedge Fund Industry to performance has indeed sometimes lagged managed futures — it probably makes more Investors, Markets and Broader Economy equities — most often during periods when sense to compare those only against the — AIMA, April 2012 there have been sharp rallies or strong bull risk-free interest rate in the relevant • The Value of the Hedge Fund Industry to market trends. Over other shortish currency. Judged by that more appropriate Investors, Markets and Broader Economy timeframes, sometimes running to multi-year yardstick, the outperformance of those funds — AIMA, April 2012 has been considerable over many years. periods in gently rising markets, hedge fund • No hedge fund today should be deemed return correlations have sometimes risen too It is not surprising, therefore, that hedge systemically important — AIMA — but the correlation has usually dropped fund assets have risen strongly over the years statement, July 2011 whenever volatility spiked again. — apart from the sharp drop of 2008, since • Global Hedge Fund Industry employs There have been various sources of confusion in when they have been rising again at a rate if 300,000 — AIMA research, December 2010 the debate about hedge fund returns. For one more than 10% a year. Investors would not be thing, the composition of the various hedge putting so much more money in if the fund indices vary considerably, which can result performance was indeed disappointing. •

Hedge funds beat the traditional asset classes: Hedge funds versus main asset class cumulative returns (1990 − 2015) 1400%

1173% 1200%

1000% 906%

800%

600%

403% 400% 349% 200%

0%

-200%

Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 HFRI Fund Weighted Composite Index S&P 500 (TR) MSCI World (Local Currency TR) Barclays Global Agg (TR USD UNH)

23 Learning the lessons from the past

Learning the lessons from the past

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

By Niki Natarajan

onfucius said, "Study the past, if you would divine the future". mismatches and counterparty risks, to name but a few, have taught If he was right, then what should we study to prepare for the us, to make banking and investing more ‘safe’ for investors. future? Are there lessons the long-only world can teach the But might their zeal to avoid the past be creating problems in the hedge fund industry as it enters a new ‘retail’ era with liquid future? Is the availability heuristic—a behavioural bias that relies on Calternatives? What feedback can the hedge fund industry use from using only the most readily available information to make decisions ‘failures’ such as Long Term Capital Management, Bear Stearns, about the future—driving decisions without considering that there Bernard Madoff and Amaranth Advisors, among others, as it might be data further back in the archives? moves forward? What are the top 10 lessons from the last 25 years, and has the Regulators are working overtime trying to interpret their solutions to industry learned them? many of the ‘lessons’ that the various credit crunches, liquidity

24 Temple of Confucius

25 Learning the lessons from the past

Lesson 1 Lesson 2 Lesson 3 Liquidity — Derivatives Leverage — available in theory, but — friend or foe? Hedge funds may have

is it there in practice? One operative word linking LTCM and Bear to get by with less Stearns is derivatives. Derivatives enable Selling is often harder than buying. In the users to find new ways to re-package old Leverage was one of the factors allowing past, liquidity mismatching in portfolios was structures, such as debt and mortgages, hedge funds to post outsized returns in the too often overlooked — that was, until the to provide ‘solutions’ to challenges that past. Regulation and low interest rates have aftermath of it drying up. Today, the mantra clients present. now conspired to reduce leverage and credit is liquidity, liquidity, liquidity, and yet to support such trading strategies of precious returns can of course be lost if that When looking closely at how a sudden loss of the past. liquidity is not really required. liquidity hit both LTCM and Bear Stearns, it is important to highlight that the issue was less Bubbles occur when credit is easy to obtain As underlying strategies are applied to more the assets they traded, but their reliance on — so regulators globally are now on a mission liquid onshore structures, often via the use of off-balance sheet derivatives as a way to to make sure that banks and hedge funds are derivatives, an important question to ask is: trade them. more constrained in terms of their ‘In the event of needing it, will it borrowing. In the short term, the new be available?’ Today there are two industry shifts that are regulations they have been pushing through likely to see the increased use of derivatives. are likely to stymie returns from some hedge Roger Lowenstein, author of When Genius The first is the UCITS revolution that allows fund strategies. But in the long term it is Failed, and of an essay in The New York hedge fund strategies to fit into a liquid more than likely that savvy hedge funds will Times September 2008 entitled: Long Term wrapper — where, in many cases, derivatives find alternative sources of funding, such as Capital: It’s a Short-Term Memory, has are being used to achieve this. And the through so-called shadow banking or pointed out that it may not be. “The belief second is the regulators’ recent and ongoing synthetic financing. that one can get safely out of a ‘liquid’ moves to deleverage the system. market is one of the great fallacies of Again investors need to ask: Will the next investing,” he wrote. New regulations such as Basel III are forcing set of financing innovations potentially banks to be more parsimonious with their bring with them a new set of unintended Few thought that after the crisis involving exposures both on and off balance sheet consequences? Long Term Capital Management (LTCM) in — and hence be more selective as to which 1998, liquidity could dry up again so fast. And hedge funds they finance. Hedge funds that yet it has done time and again, resulting for cannot get financing through the traditional instance in the near-collapse of Bear Stearns channels may have to look at new synthetic in 2008. The investment bank, which was financing via derivatives to structure eventually bought by JP Morgan, got caught their trades. out in a supposedly liquid market in sub- prime mortgage investments and the notice The lesson of previous crises is that of bankruptcy of its two funds investing in derivatives of course cannot really remove these strategies may have been a catalyst for risk, but rather allow for the transformation the financial crisis. Ensuring the strategy’s of where risk resides. Investors need to liquidity requirements and liquidity of the pay attention to where the risk really is. wrapper are carefully matched is what is essential, in particular as the industry heads into a new era of ‘liquid alternatives’.

26 25 Years in Hedge Funds

Lesson 4 Lesson 5 Lesson 6 Transparency — Diversification — Key allocator risk — now you have it, but how correlated are don’t forget do you understand it? you still? consultant risk Thanks to a number of factors including the In the early 1990s, more investors moved Hedge funds have always known about the institutionalisation of the industry and even from balanced to specialist investing, and in importance of diversifying their client base. the Madoff affair, the hedge fund industry doing so they ‘diversified’ into Japan, Indeed there are more than one or two has recognised the importance of emerging markets, US and other ‘exotic’ managers who will remember their single transparency. For many investors today, markets — mainly or all through equities. largest investor pulling their allocation, third party managed account platforms are So when the global stock markets crashed in resulting in their fund’s closure. no longer a luxury item but an essential 1997 in the aftermath of the Asian crisis, Few, however, will have made this business tool. many discovered they were not so diversified connection with consultants. This is a lesson after all. Few now buy hedge funds without knowing that any hedge fund manager that has been that they get plenty of transparency on what A similar thing happened during the financial removed from a consultant's buy list can is in the portfolio, but answering questions crisis. Many investors that thought they were attest to. like: ‘what information do you want?’; ‘how diversified because of their hedge fund When a consultant takes a hedge fund off often do you need it?’; ‘what format would holdings only to discover too late that its buy list, rapid inflows can turn to rapid you like it in?’; and ’how do you intend to use those holdings had become highly correlated outflows almost overnight. As the hedge it?’ is a different story. during panic selling of all stocks in the fund industry becomes reliant on the stressed market. One of the greatest liabilities an investor has consulting community for institutional today is having the transparency but not Whether it is avoiding an over-concentration inflows, increasingly consultant risk is a doing anything with it — or not really knowing in stocks from banks and financial lesson in waiting. what to do with it. 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.

27 Learning the lessons from the past

Lesson 7 Lesson 8 Lesson 9 Ongoing due diligence Risk management — is Regulated wrappers — never skimp on it it more than just risk won’t stop frauds

From an investor point of view, due diligence reporting? In the new age of liquid alternatives, a is like the right fuel for a car, essential to get potentially new type of investor might start right all the time. Without it, or with the “The market can stay irrational longer than to access hedge funds. It is very easy for the wrong kind, the car won’t run. you can stay solvent” — as said John Maynard Keynes. Risk management is about knowing novice investor to be lulled into a false sense In the hedge fund space, where is when to cut positions (or add to them), it is of security when they see the words mercurial and profitable traders thrive on not about avoiding risk. ‘onshore’ and ‘regulated’. But it is important loopholes, a park-and-play attitude to to remember that a UCITS wrapper will not investing can land investors in hot water. A Investors need to know that the risk stop frauds. number of funds of funds and one consultant management function inside a hedge fund is Manager selection, due diligence, risk found this out the hard way in the case of second to none, and to know the information management and diversification are arguably Amaranth Advisors: Rocaton Investment is right, and that often means having even more important for the underlying Advisors, an investment consultant, ended experience of the markets the hedge fund is portfolios when they are wrapped in a new up paying $2.75 million to San Diego County trading. How a manager stops positions and onshore structure such as UCITS because old Employees’ Retirement Association for cuts losses, who is ultimately responsible for track records do not count and new managers recommending Amaranth. risk oversight, and how many counterparties a hedge fund has are all facets of the risk are able to enter the market. Diversification across hedge funds helped management role. Risk management is far those FoHFs with exposure on a performance more complicated than simply risk reporting. basis, but not necessarily on a reputational basis. As more and more allocators buy hedge Amaranth was an example of a natural gas funds directly, and in many cases put lots of trade that grew bigger than the regulators eggs in one basket, ongoing due diligence knew, because of the ‘Enron loophole’. is going to be key to avoid investment- Despite the NYMEX exchange forcing related mishaps. 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.

28 25 Years in Hedge Funds

Lesson 10 Final thought: Learning the importance of an Counterparty risk — industry body can history repeat Every hedge fund and every allocator will have learned something on their journey. Making itself? 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 When Rick Sopher of LCF Rothschild first to’ tool for investors as they manage their assets more optimally. agreed to host a discussion on counterparty One last thought — courtesy of Ian Morley, founding chairman of AIMA 25 years ago, who risk it was a topic he felt passionate about reminds us how standing together with AIMA makes the industry more solid than going solo. — as he could foresee problems that few “You would not readily think of trade unions and hedge funds as natural soul mates. Yet seemed to be taking seriously. several years ago I watched a trade union speaker make a point. He asked a member of the When the agenda was set six months audience to break a pencil. They did so easily. He then asked them to try and break twenty previously, few even knew that the word pencils all at once. They couldn’t. ‘re-hypothecation’ even existed, let alone “A group is stronger than any individual. A group that speaks with a single voice to what it could mean to them. But by the time represent the collective interest will be heard in the corridors of power in a way that no Sopher took to the stage at the British single person can achieve alone. The trade unions have known this for over 100 years; Museum to discuss it on 23rd September the hedge fund world for 25 years, when AIMA was formed to be the only global trade 2008, Lehman Brothers had collapsed and association that allows them to lobby as a collective forcing people to listen. As they chant there was standing room only in the session. at the Kop in Liverpool: ‘You will never walk alone’.” 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. •

29 Accessing hedge funds

ccessing 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

onsolidation and ever greater concentration of assets among a While implemented consulting and fiduciary management services are small group of the biggest players has been an ongoing story in likely to be offered across all asset classes, not just hedge funds, the the funds of hedge funds world ever since the financial crisis KPMG 2014 Fiduciary Management Survey highlighted some statistics of 2008. During the crisis, there was a rapid shrinkage in the that are likely to be relevant when applied to the selection of hedge CFoHF sector, and there has since been a recovery of sorts – though funds. The first is the 44% growth in the number of full delegation of much more muted than in the underlying hedge fund industry itself. 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, The result has been that FoHFs have accounted for a declining 75% of them were won on an uncontested basis — in other words: in proportion of the industry’s assets, though by most measures they eight out of 10 cases a quote was only provided by the ultimate still today represent more than 20% of the total. Over the same mandate winner. period, the number of bigger FoHF groups that manage hedge fund assets of $1 billion or more – the InvestHedge Billion Dollar Club – has This raises the question: How many pension funds are hiring hedge declined from about 150 separate firms to under 100 following a long advisers or allocators without the appropriate tender process? series of as well as the disappearance of a Without a competitive tender process, trustees risk not getting the number of groups. delegation solution that best matches their needs, KPMG states — an The world has been continuing to concentrate, with issue that is likely to also be reflected in the selection of hedge funds. more than 40% of its assets now in the hands of just the 10 largest The KPMG survey also highlights the absence of investment players – no less than three of which also happen to be investment performance in the fiduciary management industry. In a similar consultants, according to the 2014 InvestHedge multi-manager fashion, there is no transparent standardised measurement of the survey. This has created a situation that has many in the traditional performance of bespoke and customised portfolios, which makes FoHF community up in arms – because of what they see as potential assessing the skills of providers that do not have a commingled track conflicts of interest that arise (despite whatever Chinese walls are in record to show, much harder. place) when the consultant is also the provider of the solution, as so often happens in implemented consulting or fiduciary management.

30 25 Years in Hedge Funds

The long term damage to the global FoHF performance as investors looked for more yield System’s hedge fund portfolio — one that is industry of not having audited performance in low interest rate environments and now being wound down more than a decade for customised and bespoke portfolio protection from the inevitable but later. But with more than $60 billion in assets included in the indices is that, as more assets that make up 8.2% of the entire universe of flow into the customised solutions, the worse multi-manager assets, many look at the performance of FoHF indices become, Blackstone’s solution-based model as one to thereby perpetuating the notion that funds The irony is that as emulate, offering: commingled hedge fund of hedge funds are just ‘funds of fees’ with consultants move portfolios in all flavours; best ideas funds; a no inherent added value. range of liquidity spectrums from illiquid towards offering opportunities funds to liquid alternatives; Offering bespoke and customised solutions is portfolio advisory; and a host of other ways a relatively new phenomenon in the 45 year commingled funds, to make sure that client needs are taken timeline of funds of hedge funds. But a care of. couple of firms — Pacific Alternative Asset FoHFs are expanding Management Company, with heritage is in the their advisory and consulting world, and the former EIM, now Gottex Fund Management — have offered this consulting remit. Solution providers form of tailoring since their inception. In fact Solving problems is the new FoHF because one of the synergies between Gottex and EIM the real challenge facing the industry is not was the product centric focus of Gottex and unpredictable likelihood of a spike in volatility. who offers what hedge fund product, but bespoke forte of EIM that combined with who can offer clients what they need. A While the composition of who is winning the EIM’s Luma managed account platform current example of this is K2 Advisors, which race for hedge fund assets may be changing — now giving the firm a full set of services started as a pure FoHF. Since it was bought by with the entrance of consultants as viable to offer clients. Franklin Templeton, a successful long-only providers, the need for professional hedge fund mutual fund giant, it has become a solutions This new age of transparency, liquidity and allocation services is clearly not in question. provider offering access to hedge funds, control means that managed account Collectively the top three investment other asset classes and strategies, all in infrastructures allow investors access to a consultants now manage some $100 billion in a wrapper to suit the client. wide variety of hedge funds that would hedge fund assets, making up 13% of the total once not be seen dead on a platform. The winners are going to be groups that can $767 billion in the InvestHedge multi-manager In turn, this has helped the change in how translate the needs of the clients into survey. And while not all three of the solutions that work. On top of the consultant hedge funds have been defined over the last investment consultants offer commingled six or seven years, as they have moved away offering implemented consulting, a new funds, the phenomenon is not new — Russell threat to the traditional FoHF may come from being seen as an asset class and towards Investments and Stamford Associates were from the long-only asset management brand being used as more of a tool for better overall among the first to do so. portfolio management. that has the client base and an army of client Whether the multi-manager fund is onshore, relations people but not yet enough offshore, a fund of UCITS funds or managed by alternative products. the independent arm of a major pension fund An example of this may be seen in the 2015 such as ABP’s New Holland Capital, is a acquisition of Arden Asset Management by different question. But the demise of the Aberdeen Asset Management. Aberdeen has humble commingled product has been the clients and the support infrastructure, exaggerated for the simple reason that a single what it needed was bigger footprint in the US multi-manager vehicle is a far more cost effective way to manage hedge fund assets and a deeper hedge fund team. The fact that than the many and varied bespoke portfolios Arden is adviser to the $6 billion hedge fund

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

with lots of moving parts and objectives. portfolio at Massachusetts Pension Reserves In the UK, the Cornwall Pension Fund gave Investment Management and that it has more The irony, however, is that as consultants move FRM a $180 million hedge fund mandate to than $1 billion in liquid alternative assets towards offering commingled funds, FoHFs are manage via its managed account platform. from Fidelity made it a desirable ‘catch’. expanding their advisory and consulting remit Meanwhile, the advisory services that come in a bid to retain clients and win new ones. For With hedge funds and FoHFs also looking for with many of the platforms allow investors many FoHFs offering advice is the main areas of exit strategies — selling their business or like California State Teachers’ Employee business growth and for others it is already the stakes in it — deals such as the one between Retirement System, which uses the Lyxor Asset biggest part of their business. While it is well Texas Teachers’ and Bridgewater are also Management platform, to go direct but with a known that advisory fees are low, many FoHFs going be potentially attractive options for little assistance if required. have employed this strategy to make their investors wanting to access alternatives. Just by looking at the performance dispersion mark as — due to their depth and breadth of Teaming up with a US mutual fund group is the across the 1,414 FoHFs run by 404 resources — most FoHFs are well placed to quickest way for a FoHF willing to enter the management companies in the InvestHedge offer solid advice on manager selection based liquid alternatives space to help stabilise its database it is clear to see that not all FoHFs on an existing track record. business with new asset flows and a new client are the same. Despite the poor perception of base. M&A in the FoHF space is likely to FoHFs in the mainstream media, the industry Offering low-fee advisory services put continue to access skills, distribution or assets has a role in the hedge fund allocation food Blackstone Alternative Asset Management on and while the FoHF industry is likely to chain. This conclusion is supported by the fact the institutional hedge fund map back in continue to shrink in number of groups it will assets grew by 8% in 2014, according to 2003 when it won the advisory mandate for grow in assets as the solutions mind-set that InvestHedge, driven more by inflows than California Public Employees’ Retirement started in the wake of gating, suspensions,

31 Accessing hedge funds

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

As hedge fund investing enters the 'retail' space with liquid alternatives, access to diversified hedge fund liquid alternatives brand will become today is to make sure they know who has strategies will be key. increasingly important. fiduciary responsibility for their hedge fund allocations when the markets turn sour or a In addition to liquid alternatives, access to fraud rears its ugly head. new alpha and talent in the form of smaller anything that purports to offer hedge managers is another way FoHFs are As the multi-manager industry moves beyond fund-like returns, cheaply. distinguishing themselves from the product-driven commingled funds to solution- consultants. The latter have typically, but not driven alternatives businesses, investors need The asset manager, hedge fund, fund of funds, exclusively, allocated to the larger better to start asking: or long-only player that can mix and match all known brands. The downside of size is that big the options so the investor gets what they allocators can only allocate to big funds to ●● “Who is in charge of lining up the hedge need in a single cost-effective way will be the make a difference, leaving the smaller fund advisers if the consultants are now winner in terms of assets under management. manager market to smaller investors and also the potential provider?” All of this is not to say that the multi-manager family offices where performance is more ●● “How do you measure the performance of culture is dead. Indeed, far from it. important than anything else. Tages Capital, ‘bespoke’ solutions?” and: Larch Lane Advisors and Aurora Investment As hedge fund investing enters the ‘retail’ Management are among the FoHFs that ●● “Who is responsible for my hedge fund space with liquid alternatives, access to actively seed new managers, while others allocation during times of market stress?” diversified hedge fund strategies will be key. such as ABS Investment Management are Players in this space such as K2, Arden and FoHFs were once deemed 'fast money' by some enthusiastic day one investors. Blackstone are those that can access mutual hedge funds. But one of the greatest lessons funds distribution channels and offer the While much of what can be called hedge fund hedge funds can learn from the long-only solutions in ‘plain English’ language. alternative return streams are not proven in world is that consultant concentration risk Hence, to succeed in raising assets with a dire markets, the real challenge for investors can be just as dangerous. •

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

25

20% 20% 20 19% 19% 19% 18% 18% 17% 17% 15

11% 10% 10 9% 8% 8%

Mean allocation % 7% 7% 7% 7% 5 3% 2% 2% 0 Endowment Family office Foundation Insurance Private sector Public Sovereign company pension fund pension fund wealth fund 2012 2013 2014*

Source: Preqin

32 A successful fund is about more than investing. Strong operating models, advanced reporting tools and systems are critical. Hedge, private equity and real estate funds globally rely on our skills. Infrastructure? They depend on our tools. We’ve Got And our scalable systems help us evolve with your business. You Covered

www.statestreet.com 33

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five

next

The 25 Years in Hedge Funds

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

ince the founding of AIMA 25 years ago, we have already seen how It also found: hedge funds have become an increasingly mainstream feature of ●● Almost 70% of managers say they offer, or plan to offer, customised the financial world. But what kind of role will they play in the asset management world of the future? A veritable wealth of investment solutions; Sresearch and analysis, including regular surveys and reports, point ●● More than two-thirds anticipate using specialised fee structures to towards a range of likely developments over the next few years. attract allocations, including a significant minority planning more UCITS funds; Among the various developments widely anticipated are: a continuing robust rate of growth in industry assets; a continuing rise in the ●● More than four in 10 expect to change the mix of countries where influence of investors in how the industry operates; and a whole range they invest — with more than a third shifting their focus more of challenges for managers to overcome if they want to meet those towards emerging and frontier markets; and: investor requirements — and benefit from that likely asset growth. ●● Regulation is being seen as the biggest threat to growth — as cited Interesting and important surveys and reports include ones conducted by more than 75% of managers. regularly by each of the major consulting firms — Deloitte, EY, KPMG Some of the same themes and conclusions were also reached in the EY and PwC. Not surprisingly, there are a number of similarities among global hedge fund and investor survey entitled Shifting Strategies: their conclusions, but there are also some interesting differences — in Winning Investor Assets in a Competitive Landscape,2 published in what they anticipate and in what they highlight as the most important November 2014. But this report also highlighted some different things challenges for the future. — in areas such as new products, expenses, outsourcing and cyber security — and also suggested that new allocations from institutional KPMG International partnered with AIMA and the MFA to produce a investors in North America and Europe that are already big allocators report in March 2015 entitled Growing Up — A New Environment for to hedge funds would likely be slowing in the years ahead. Hedge Funds.1 Among the key things it highlighted were developments on the investor side — and how these were changing the approach of This EY survey was also based on interviews with over 100 hedge fund hedge fund managers. managers, representing $956 billion in assets, plus 65 interviews with institutional investors representing $1.3 trillion of assets ($220 billion The report, which was based on global research involving over 100 of which being allocated to hedge funds). It found that larger hedge fund firms representing over $440 billion in assets, found that a managers, with over $10 billion of assets under management, were majority of hedge fund managers expect a significant shift in their continually launching new products, including separately managed primary sources of capital toward pension funds over the next five accounts, liquid alternatives and long-only funds, where investor years. Public sector pension and sovereign wealth funds will be appetite appeared to be strong. However, it said many of these increasingly important over the next five years through 2020, the sorts of products had generally lower fee structures, that many report found. And institutional investors, it predicted, will continue managers were under-estimating the costs — and that this was to eclipse high net worth investors as primary sources of investment. affecting margins.

1 www.aima.org/download.cfm/docid/365F6A57-DB56-4430-9683CC34571D9F02 2 response.ey.com/CSG3/2014/1407/1407-1284479/HFsurvey14/GHF14.html?Shortcut=HFsurvey14

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 Monetisation — with an increasing number of and thus allow for a more nimble and partners and other senior personnel at the managers looking at either selling stakes in effective response to risk” — what it said was Deloitte Center for Financial Services. The their business to institutional investors all “a critical skill in today’s complex financial report highlighted three main focus areas in the way through to potential IPOs. This was environment”. the current year: being driven by a number of factors — from Other key predictions of the Deloitte report the pressure for succession planning to the Globalisation — both in terms of new included: investment markets that managers in the US need to raise more capital and ally with (historically dominant in hedge funds) cannot strong external partners in order to raise ●● Larger managers will continue to get afford to ignore; and in terms of new capital for expansion. bigger, while smaller managers will compete by focusing on niche sectors; investors in parts of the world many Strategic brand management — the need to managers may not have raised money before, plan for and cope with any “risk event” such ●● Alternative managers in general will but which will become increasingly as a valuation error, conflict of interest or increasingly engage the retail investor; important. Management firms would potential data breach. Given the rising risk of therefore need to work out how best to be cyber attacks in particular — which had ●● The importance of data will grow, but set up to cope with the regulatory, tax and already caused major impacts in other also become more challenging; operational challenges to tackle this industries — managers would need key ●● More managers will improve oversight increasingly globalised world. building blocks in place: on governance, of external risks, increase use of risk- standardised risk reporting and what the based reporting models and offer report called “risk sensing”. The latter, it customised reporting. said, involved developing “the ability to identify emerging risks and trends quickly

3 www2.deloitte.com/content/dam/Deloitte/us/Documents/financial-services/us-fsi-2015-alternative-investment-outlook-123114.pdf 4 www.pwc.com/gx/en/asset-management/publications/pdfs/alternative-asset-management-2020.pdf

36 25 Years in Hedge Funds

Some of these themes, together with other that, it predicted that hedge fund assets ●● The right resources in the right places: points, were also highlighted and amplified in (including the fund of fund sector) would How to use the rising trend toward more a PwC report, Alternative Asset Management grow from around $2.9 trillion at the time of data-informed decision-making to arrive in 2020,4 published in January 2015. the report to about $4.6 trillion − $5 trillion at successful “right-sourcing” strategies in 2020. for when and where to deploy in-house In its report, PwC envisaged that the capabilities or to outsource. principal focus for many firms will shift In this developing new environment for asset toward creating a broader asset class and management, PwC highlighted six areas ●● It’s not only about the data: How to best product mix and to the opening of new where managers will face challenges and use the rising trend towards data-centric distribution channels. It also envisaged a have to make key decisions. These were analytics and solutions to better measure shift in focus and investment of more time described as: and enhance operational strength and key and resources into business strategy, operational processes. operational design and “data-informed ●● Choose your channels: With managers Each of these reports brings to light some decision-making”. needing to decide which segments of a varied investor base to target — from different things, and likely scenarios for the sovereign wealth and pension funds to future. But all of them predict an industry emerging markets to retail — and hence that looks like it will continue to grow and Hedge fund assets are what they need to put in place to tap change a great deal over the next five years those market segments successfully. — though also with significant issues that predicted to grow to individual firms will need to tackle.• between $4.6 trillion ●● Build, buy or borrow: Whether to add new products to an existing platform and $5 trillion by 2020, or to grow in other ways such as says PwC. via acquisitions. ●● More standardisation, more customisation: How to cope best with the rising demand both for more bespoke ‘made-to-order’ products, but also Factors like these will help to propel for simple and cheaper products like alternative managers towards centre stage of liquid alternatives. the wider asset management world over the next five years, PwC predicted, with total ●● From institutional quality to industrial assets under management in alternatives strength: How to cope with the demand reaching somewhere between $13.6 trillion from investors for ever higher standards in and $15.3 trillion including private equity key functions like compliance, tax and and real assets as well as hedge funds. Within investor servicing.

Projected growth in alternative assets, 2015 — 2020

16 15.3

14 13.6 8.1% 9.9% 5.0 12 6.9% 4.6 28.5% 10

2.9 8 7.9 2.5 26.5% 6.6% 6.9% AuM ($tr) 2.9 6 17.0% 5.3 9.5% 8.9%

2.0 1.4 4 7.4 37.9% 6.3% 8.8% 6.5 2.5 0.8 2 1.0 3.6 0.5 2.5 1.0 0 2004 2007 2013 2020 2020 (Base case) (High case) Private Equity Real Assets Hedge Funds & FoHF CAGR

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

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 25 Years in Hedge Funds

Participants

James G. Dinan, York Capital Management Loïc Fery, Chenavari Investment Managers Jamie founded York Capital Management in September 1991 and is Loïc Fery is Chief Executive and co-Chief Investment Officer of the Chairman, Chief Executive Officer and a Managing Partner of Chenavari Investment Managers (www.chenavari.com), a group of the Firm. Jamie is a Co- of the York Multi-Strategy, regulated asset management companies (London, Luxembourg, York Credit Opportunities, York Event-Driven UCITS funds, York Sub- Hong Kong, Sydney) focused on credit, debt and Advised ’40 Act Strategy, and Portfolio Manager of the York Total public and private markets. Return funds and is the Chair of the Firm’s Executive Committee. Loïc created Chenavari Investment Managers at the end of 2007. From 1985 to 1991, he worked at Kellner, DiLeo & Co., where he Since then, Chenavari Investment Managers established as one of became a General Partner and was responsible for investing in risk the leading alternative credit managers globally; with approx. $5.5 arbitrage and investments. From 1981 to 1983, billion assets under management (as of July 31st 2015) and over 100 Jamie was a member of the group at Donaldson, investment professionals, it is one of the largest independent non- Lufkin & Jenrette, Inc. US credit hedge fund managers. Jamie is currently the Chairman of the Board of Trustees of the Chenavari Investment Managers’ clients include institutional Museum of the City of New York, and a member of the Board of investors, pension funds, sovereign wealth funds and family offices Directors of the Hospital for Special Surgery, the Board of Directors globally. Chenavari credit funds steady performance was recently of the Lincoln Center for the Performing Arts, Harvard Business acknowledged with several industry awards, such as Institutional School’s Board of Dean’s Advisors, the Board of Trustees of the Investors, Eurohedge and Hedge Fund Magazine. University of Pennsylvania and The Wharton Board of Overseers at Prior to setting up Chenavari, Loïc was Managing Director, Global the University of Pennsylvania. Jamie received a B.S. in Economics Head of Credit Markets of the investment bank of Credit Agricole. from The Wharton School of the University of Pennsylvania and an He was responsible globally for Credit, Structured Credit & High M.B.A. from Harvard Business School. 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 Luke Ellis, Man Group plc and securitisation topics, focusing on the convergence of credit markets activities and funds/private equity activities. He is also an Luke Ellis is President of Man Group plc (‘Man’), based in London, occasional lecturer on alternative asset management at industry and a member of the Man Group Executive Committee — as conference and business schools. President of Man, Luke is responsible for managing Man’s four Loïc, 41, lives in London and is married with 3 children. As a investment units, Man AHL (‘AHL’), Man GLG (‘GLG’), Man Numeric personal interest, he is the owner of FC Lorient (www.fclweb.fr), a (‘Numeric’) and Man FRM (‘FRM’). Prior to assuming his current role, French Premier League football club. 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 business. Luke holds a BSc Hons. in Mathematics and Economics from Bristol University.

39 Virtual roundtable

Participants

Sir Michael Hintze, AM, CQS Omar Kodmani, Permal Group Sir Michael is the Founder, Chief Executive and Senior Omar Kodmani was appointed Chief Executive of Permal Group Investment Officer of CQS, one of Europe’s leading credit- in 2014, having previously been its President. Prior to this focused multi-strategy asset management firms. He is also a appointment, he was Senior Executive Officer, responsible for Senior Portfolio Manager. monitoring Permal's international investment activities as well as Prior to establishing CQS in 1999, Michael held a number of senior asset gathering initiatives. Mr. Kodmani is also Director of Permal roles at CSFB and Goldman Sachs. He began his career in finance Investment Management Services Limited and Permal Group Ltd. in 1982 with Salomon Brothers, New York, after working as an Before joining Permal in 2000, Mr. Kodmani spent seven years with Electrical Design Engineer for Civil and Civic Pty Ltd in Australia, Scudder Investments in London and New York where he developed where he had also served in the Australian Regular Army in the the firm's international mutual fund business. Prior to Scudder, Mr. Royal Australian Electrical and Mechanical Engineers, latterly as Kodmani worked for four years at Equitable Capital (now part of a Captain. Alliance Bernstein). He is a CFA® Charterholder and serves on the Michael has significant and wide-ranging philanthropic interests Advisory Board of the CFA® (UK). He holds an M.B.A. in Finance and to consolidate these, the Hintze Family Charitable Foundation (Beta Gamma Sigma) from New York University Stern School of was established in 2005. Since inception, over 200 charities have Business, a B.A. in Economics from Columbia University and a G.C. received funding from the Foundation. Major donations have, Certificate from the London School of Economics. 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 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 , 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.

40 25 Years in Hedge Funds

George W. Long, LIM Advisors Limited Mark McCombe, BlackRock George is the Founder, Chairman and Chief Investment Officer Mark, Senior Managing Director, is Global Head of BlackRock's of LIM Advisors Limited; he brings 30 years of financial industry Institutional Client Business, Chairman and Co-Head of BlackRock experience to the firm. Before he established LIM in 1995, Alternative Investors. Mr. McCombe is responsible for driving George set up and ran the Asian division of what became Barclays the growth of BlackRock's institutional business and alternatives Global Investors (BGI) in 1990, where he served on the Executive presence globally. He is a member of BlackRock's Global Executive Committee for Barclays Group Asia and the Global Investment Committee and Global Operating Committee. Committee in London. Mr. McCombe has had an international career in finance spanning Prior to joining Barclays, George was the Managing Director and more than 20 years. Before joining BlackRock, he served as Chief Investment Officer of Gartmore Asia, and before that head of Chief Executive Officer in Hong Kong, for HSBC. He was also a Korean operations for Indosuez W.I. Carr Securities. He also worked Non-Executive Director of Hang Seng Bank Ltd, and Chairman of in New York and Asia for Manufacturers Hanover Trust Company HSBC Global Asset Management (HK) Ltd. Prior to that, he was (now part of JP Morgan) as an international banking officer. based in London where he was Chief Executive of HSBC Global George is a former governor of The CFA Institute. He also Asset Management. established the Hong Kong Society of Financial Analysts in 1992 and Mr. McCombe has served on a number of finance industry bodies was its president for 8 years. He also set up the Hong Kong/China during his career. He was a member of the Risk Management Chapter of the Alternative Investment Management Association in Committee of the Hong Kong Exchanges and Clearing Limited, 2002 and was its chairman for 5 years. He received the Thomas a member of the Banking Advisory Committee of the Hong Kong L. Hansberger Leadership in Global Investing Award for his Monetary Authority, a committee member of the Hong Kong contributions to the practice of global investment management. Association of Banks, and a council member of the Financial George holds an MBA in Finance and an MA in Asian Studies from the Services Development Council (FSDC), an advisory body established University of Washington in Seattle and is a CFA Charterholder. by the Hong Kong Special Administrative Region.

41 Virtual roundtable

Summary of responses

Question Over the next 5 years: Sir Michael Omar Kodmani Mark Jamie Luke George Loic Hintze McCombe Dinan Ellis Long Fery

1 Do you think that the Yes Yes Yes Yes Yes Yes No hedge fund industry will continue to grow at 10% or more per year?

2a Do you expect hedge Only on risk Yes No No Yes/No Yes Yes funds to outperform adjusted basis equities?

2b Do you expect hedge Yes Yes Yes Yes Yes Yes Yes funds to outperform bonds?

3 Which strategy/ Various Macro/global/ Direct Lending Japanese Quant Various − inc European region/asset class do multi-asset & EMs Equities Strategies Credit, Illiquid you think offers the Commodities, Credit/EMs most opportunity? Macro

4 Which segment of the Pension funds, Insurers Pension funds Insurers SWFs/Insurers Pension funds PFs/Insurers/ investor base do you SWFs, Family offices expect to see fastest Insurers, growth in allocating to Endowments funds?

5 Do you expect fund of No Yes No No Yes No No funds to represent 20% or more of industry assets in five years time?

6 Which type of fund UCITS and AIFM 40 Act Mutual 40 Act Mutual Depends on Managed Managed structure do you segregated/ funds funds regulations accounts and accounts and expect to show the bespoke Co- UCITS fastest growth over accounts Investments next five years?

7 Do you expect hedge Yes/No No No No Yes − No No fund management gradually fees to drop over next five years?

8 What is the biggest Hasty Insufficient Investors Size Quality Excessive Regulatory issue facing the hedge regulations Risk attitude constraints portfolio regulations requirements fund industry today? managers

9 What weighting 10 − 20% 20 − 30% Depends 20 − 30% 20 − 30% 10 − 20% 20 − 30% should investors have of hedge funds in their portfolio?

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

42

Table page 42.indd 1 21/10/2015 16:35 25 Years in Hedge Funds

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 Do you expect hedge funds to SIR MICHAEL HINTZE: The risk lies with the modest, favouring strategies that can be risk-free rate benefitting shorter duration, both long and short. There will be a outperform equities/bonds floating rates securities, equity and equity- continuation of allocations to assets that can over the next five years (on linked strategies. The next stage of market provide diversification, good risk-adjusted an absolute as well as risk- cycle should favour stock and credit pickers. returns and demonstrate low correlations to adjusted basis)? The ability to short securities should traditional markets. generate a greater return than over the last few years. OMAR KODMANI: Hedge funds provide the JAMIE DINAN: Hedge funds may not best chance to meet future liabilities. outperform equities but will outperform OMAR KODMANI: History shows that equities Institutions remain still under-allocated to bonds. But I think hedge funds will at current valuations (CAPE − cyclically this space; while retail will experience a outperform both on a risk-adjusted basis. adjusted price earnings) will not return more further surge. LUKE ELLIS: Performance relative to equities than +2% p.a. for next five years; and bonds with current starting yields will be hard GEORGE LONG: Once investors realise that is not really an appropriate way to look at hedge fund returns. Put simply, if we pressed to do better. The bar is set very low both long-only equities (especially passive for hedge funds. index funds) and long government bonds continue to have a bull market then hedge have limitations, I believe there will be funds are likely to underperform. But if we GEORGE LONG: Both bonds and equities renewed appreciation of absolute return get a bear market then hedge funds are likely are over-priced. I expect we will see a strategies. As we enter a period of greater to outperform. So relative or even risk- period of greater dispersion within equity volatility across all asset classes, I expect the adjusted relative performance is essentially and bond markets which will provide a demand for absolute return and a prediction on equity performance. For suitable environment for a number of hedge diversification to remain strong. what it’s worth, it seems to me doubtful that fund strategies. the next five years we won’t see a sell-off in MARK McCOMBE: Yes, we believe the equities at some point − at which point hedge MARK McCOMBE: It is difficult to predict the adoption rate of hedge funds by institutions fund compounding is likely to deliver absolute performance of hedge funds will continue at a similar pace. Hedge funds attractive performance. relative to equity and bond markets over the continue to provide an attractive investment next five years particularly given the level of option given their strong risk-adjusted Performance relative to bonds is a more valid volatility in the markets driven by a variety return profile. way to assess hedge funds and in this regard I of factors including uncertainty around think it is highly likely that hedge funds will interest rate hikes by the Fed, the steady but Hedge fund strategies have greater flexibility outperform. Over five years the only return slow growth of the US economy coupled with as compared to traditional investments with you can earn from buying five-year the uncertainty of prominent geopolitical a much wider range of investment strategies investment grade bonds today is the current events (Greece, Puerto Rico and China). and fewer structural and capacity yield − which, based on five-year US limitations. We believe investors that do not treasuries, is about 1.5% and I think we would Notwithstanding this, we believe hedge funds have exposure will adopt hedge fund all hope hedge funds will outperform that! will outperform both stocks and bonds on a allocations and those with allocations may risk-adjusted basis, but there is a possibility look to increase exposure within their active LOIC FERY: Over a five-year period, I believe stocks will outperform on an absolute basis, management budgets. so. But not all hedge funds will. with higher volatility.

43 Virtual roundtable

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. Which strategy/region/asset class GEORGE LONG: High yield and distressed credit will become very interesting as China SIR MICHAEL HINTZE: Pension funds, SWFs, do you think offers the most slows and global growth contracts. Currency insurance companies and endowments opportunity over the next volatility will cause problems for countries and − seeking yield and good risk-adjusted five years? companies that will lead to more high-yield returns, they also need to meet long-term and distressed opportunities. liabilities and obligations to beneficiaries. JAMIE DINAN: Japanese equities − because Many still have relatively low allocations to corporate governance reforms coupled with Special situations (such as private hedge funds. share buybacks and monetary easing create an convertibles, mezzanine financing, etc) should amazing technical backdrop. see a lot of opportunities as markets get more OMAR KODMANI: Insurers − an extremely stressed and traditional bank capital becomes large investor base with very low starting LUKE ELLIS: My personal view is that, more scarce. allocations to hedge funds and significant generally the market environment is likely to need for uncorrelated return streams. favour quantitative strategies over Commodities and the mining sector will discretionary ones. There is likely to be lower become very cheap as we see the impact of a GEORGE LONG: Pension funds − as they are liquidity in markets going forward as banks slowing China on the major commodity also relatively underinvested in hedge funds; continue to withdraw market-making capital. producers and the ending of the commodity and from their continued desire to diversify This is likely to result in two key outcomes. super cycle. return streams, particularly with the general Firstly, there may be more room for short-term de-risking required to manage the assets of Macro trading should see opportunities around imminently retiring baby-boomers. equity strategies and secondly, macro trends currency volatility. may tend to be extended. To take advantage, I MARK McCOMBE: Pension funds and defined think managers would need to construct MARK McCOMBE: The large-scale withdrawal contribution plans. complex portfolios with a large number of by banks from markets and investment-related positions to get the diversification needed and activities, driven by both regulatory and Hedge funds have proven to be a valuable quant strategies tend to be better at financial constraints, continues to change the tool for investors. While many pension plans constructing complex portfolios and managing investment marketplace. As a result, lending have adopted hedge funds, their overall the risks they generate. activity has become more segmented and allocations remain smaller than endowments certain market activities have been disrupted. and foundations, family offices and some LOIC FERY: European illiquid credit This has created opportunities to take sovereign wealth funds. We expect continued opportunities and emerging markets will be advantage of prominent price inefficiencies growth in this segment as they seek among the most interesting areas − with a and liquidity premiums for those able to attractive investment options that will help stressed energy market, plus European effectively operate in these affected markets. them meet their pension liabilities and stressed and distressed corporate credits. Additionally, capital intensive industries are in obligations. SIR MICHAEL HINTZE: Longer-lock strategies need of more flexible capital solutions given Also, as the industry moves toward modelling that are able to take advantage of bank balance sheet constraints and large capital Defined Contribution (DC) plans after Defined disintermediation and regulatory distortions. expenditure needs. The resultant void of Benefit (DB) plans, we have observed an capital has produced very attractive Plus: Shorter duration, floating rates increased interest in alternative investments economics for investors able to provide by DC plans. As such, we believe that DC plan securities, equity and equity-linked strategies creative capital solutions. Similarly the such as convertibles. assets may serve as an area of growth for liberalisation of the financial systems of select hedge funds in the next five years as well. And: Strategies that are able to identify and emerging markets are creating investment trade idiosyncratic risk such as credit and opportunities that skilled investors can equity long/short. capitalise on. 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.

44 25 years in Hedge Funds

Assets in funds of funds Which type of fund structure represent roughly 20% of total (e.g. offshore, UCITS, 40 Act, hedge fund industry assets. managed accounts etc.) do Do you expect funds of funds you expect to show the fastest to represent 20% or more of growth over the next five years? industry assets in five JAMIE DINAN: 40 Act funds − that’s years’ time? where there is the biggest unexploited investor base. JAMIE DINAN: No − I see further disintermediation taking place. LUKE ELLIS: This depends entirely on how regulations develop. LUKE ELLIS: The real question is what does one mean by a fund of funds? The vast SIR MICHAEL HINTZE: For co-mingled majority of hedge fund investments are part structures − UCITS, due to regulatory trends. of portfolios of hedge funds which are in the For larger, more sophisticated investors end a fund of hedge funds. The question, − segregated and bespoke accounts, with then, is what percentage of clients require growth to be driven by larger institutions’ support in order to implement their desire for tailored investment solutions that portfolio? In my view most clients need help, meet their risk, return and volatility criteria. certainly more than 20%. And then the OMAR KODMANI: The trend toward regulated question is how much is done by funds of structures is irreversible. hedge funds and how much by consultants… but really these two are barely GEORGE LONG: Managed accounts and distinguishable in many cases. co-investment vehicles – because hedge fund returns have often not been that attractive LOIC FERY: No − [because of the] increasing and hedge fund fee structures have often sophistication of institutional investors who been excessive. tend to increasingly invest directly into hedge funds. MARK McCOMBE: 40 Act mutual funds. The state of retail investments in hedge funds SIR MICHAEL HINTZE: Direct investment is remains young with 3% of US and European a growing trend. Larger more successful retail investors investing today. However, FoFs are continuing to grow due to their exposure to these investment options is business models that continue to capture growing rapidly within the retail market and institutional flows. the diversification benefits of hedge funds is OMAR KODMANI: Direct programs and fuelling demand. This, coupled with growth consultant-led allocations will underperform in product development and distribution, will funds of funds, while the appetite for result in meaningful growth over the next professional funds of funds guidance from five years. 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.

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 and 2) its indirect impact on the ability to will continue to pay a premium for managers What is the biggest issue facing undertake some strategies. who deliver superior risk-adjusted returns and the hedge fund industry today are able to provide investment solutions. – and how should it be addressed? MARK McCOMBE: On the heels of a three- year equity bull market (with relatively A normalised interest rate OMAR KODMANI: JAMIE DINAN: The biggest issue is the size of muted volatility), the biggest issue facing the environment will alleviate fee pressures. The the best investment managers. Those hedge fund industry is the view regarding genuine alpha producers will still command managers need to broaden their investment absolute performance. With this backdrop, higher fees and increased hedge fund returns offerings. certain investors have expressed concerns will help. over the level of absolute performance of LUKE ELLIS: The biggest issue is the supply of hedge funds relative to what they have GEORGE LONG: Despite a lot of public high-quality, well-trained portfolio achieved with equity investments. However, discussion of hedge fund fees following the managers. The first phase of the hedge fund we believe this is mitigated when taken in global financial crisis, the actual impact on industry was based on the best people from the context of risk-adjusted performance. fees has been minimal. Hedge fund talent is banks and long-only managers switching to Furthermore, we believe hedge fund still hard to find and generally investors are running hedge funds so the industry was a big strategies are particularly well-positioned to still willing to pay. However, as managed beneficiary of the training provided in the take advantage of opportunities that may accounts grow in popularity, we could see past at banks and long-only institutions. As arise from market volatility discussed some industry pressure from large investors we look forward, though, it is clear that this previously. on fees as their ability to negotiate supply has shrunk significantly and it will managed accounts is greater than on become extremely important for the hedge While not completely immune to price commingled funds. fund industry to both hire younger people volatility as markets adjust, a diversified MARK McCOMBE: The resources required to and provide them with the training and hedge fund portfolio can help mitigate the run an institutional-quality hedge fund instruction required. gyrations experienced in traditional beta- driven markets. Relative value strategies continue to grow more demanding each year, LOIC FERY: Regulation requirements with may be able to take advantage of the particularly with the increased level of increasing convexity. AIMA is part of the way disequilibria and inconsistent pricing driven regulation and associated compliance to address this. requirements. For this reason, we do not by panicked sellers and heavy cash flows expect fund management fees to decrease SIR MICHAEL HINTZE: Hastily legislated across markets. dramatically over the next five years for the regulation, and increased cost – limiting Distressed and direct sourcing strategies may most competitive managers. competition. provide bespoke solutions to help stressed OMAR KODMANI: Not taking enough risk. The firms strengthen or rebuild their balance industry needs to re-educate investors that sheets, transition through restructurings, or flexibility − including tolerance for improve underperforming assets. Long/short drawdowns – is a major part of alpha managers may be able to anticipate and take generation. advantage of dispersion between companies whose competitive positions shift as rates GEORGE LONG: Excessive regulations and 1) rise, or find attractive entry points for its indirect impact on hedge fund manager well-run companies whose securities have expenses and the ability to start a new fund; 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 25 Years in Hedge Funds

What weighting should Will hedge funds have a stronger investors have of hedge funds reputation in five years’ time in their portfolios? and be widely accepted as a JAMIE DINAN: 20 − 30%. valuable component of the modern investment landscape? LUKE ELLIS: This depends on the specific investor’s investment strategy and goals but I JAMIE DINAN: Reputations follow talent would think generally 20 − 30%. − and hedge funds will continue to attract LOIC FERY: 20 − 30%. and retain the best talent. SIR MICHAEL HINTZE: 10 − 20% − [though] LUKE ELLIS: Any weakness in the current depending on investor risk profile. reputation of hedge funds come from the ‘relative’ performance of bonds/equities OMAR KODMANI: 20 − 30%. − but we have had an unprecedented period GEORGE LONG: 10 − 20%. of bull markets in both bonds and equities created by central banks making money MARK McCOMBE: The optimal allocation to ‘free’ and driving down future returns. In the hedge funds is highly dependent on the next five years the benefit of alpha in a specific client and their risk, return and portfolio should become much clearer as liquidity tolerances. 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

Big Data: The growth of the hedge fund industry

Growth in assets and funds globally

3,000 10,800

2,800 10,080

2,600 9,360

2,400 8,640

2,200 7,920

2,000 7,200

1,800 6,480

1,600 5,760 AuM

1,400 5,040 Funds

1,200 4,320

1,000 3,600

800 2,880

600 2,160

400 1,440

200 720

0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Assets $bn Number of funds

Source: HFR

Growth of the industry in Asia

200 1,000 190 950 180 900 170 850 160 800 150 750 140 700 130 650 120 600 110 550 100 500 AuM 90 450 Funds 80 400 70 350 60 300 50 250 40 200 30 150 20 100 10 50 0 0 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).

Source: HedgeFund Intelligence

48 25 Years in Hedge Funds

Growth of the industry in Europe

720 1,800 680 1,700 640 1,600 600 1,500 560 1,400 520 1,300 480 1,200 440 1,100 400 1,000 s 360 900 Au M Fund 320 800 280 700 240 600 200 500 160 400 120 300 80 200 40 100 0 0 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. Excluding standalone UCITS funds).

Source: HedgeFund Intelligence

Growth of the industry in North America

1,600 6,400

1,500 6,000

1,400 5,600

1,300 5,200

1,200 4,800

1,100 4,400

1,000 4,000

900 3,600

800 3,200 AuM Funds 700 2,800

600 2,400

500 2,000

400 1,600

300 1,200

200 800

100 400

0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Assets $bn Number of funds

Source: Eurekahedge

49 The growth of the hedge fund industry

Growth in FoHFs, 1990 − 2014

800

750

700

650

600

550

500

450

400 AuM

350

300

250

200

150

50

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Source: HFR

Growth in UCITS funds, 2008 − 2015

200

181.63 180 177.36

160 158.44

140 131.97 125.28 127.13 120

100 AuM 84.90 80

60

40.86 40

20

0 2008 2009 2010 2011 2012 2013 2014 Q2 2015

Source: HFR (Q2 2015)

50 25 Years in Hedge Funds

Acknowledgements About AIMA We would like to take this opportunity to offer our thanks and The Alternative Investment Management Association (AIMA) is the gratitude to our past and present Chairs − Ian Morley, Jean-Francois global hedge fund industry association, with over 1,500 corporate Conil-Lacoste, Sohail Jaffer, Hans-Willem Baron Van Tuyll Van members (and over 9,000 individual contacts) in over 50 countries. Serooskerken, Christopher Fawcett, Todd Groome and Kathleen Casey Members include hedge fund managers, fund of hedge funds − to our former CEOs, Florence Lombard and Andrew Baker, and our managers, prime brokers, legal and accounting firms, investors, fund present CEO, Jack Inglis. A further special word of thanks to our administrators and independent fund directors. AIMA’s manager General Counsel since inception, Iain Cullen. 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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