From our vantage point in early 2010, we look back on the roller coaster ride of the past two years and see the tremendous change that our industry has endured. There were the heady days in late 2007 when assets under management (AUM) peaked at US$1.9 trillion, the bottom of the curve at the end of first quarter 2009 when AUM fell to US$1.3 trillion and finally the end of 2009 where AUM had recovered to a respectable US$1.6 trillion1. We are now seeing assets being re-allocated back into hedge funds and fund of hedge funds, particularly from sovereign wealth and pension fund investors, so is this resurgence here to stay?
Many of the problem issues within the industry to date have largely been stamped out, not by regulation, but by the dynamic industry itself evolving in order to continue to attract investors in the new world order. Ahead of any regulation, investors are now insisting on the existence of basic controls to protect their assets such as third party administrators, reputable auditors and independent directors. In addition, the hedge funds that have made it through the crisis, and the new ones that have emerged, have had to demonstrate the ability to manage risk, to stay within agreed strategies and loss limits, to align positions with the liquidity terms of investors, to provide transparency and to treat all investors in the same class equally.
The dynamism of the hedge fund industry ensures a continual changing of the landscape to address current demands. What has driven these changes?
The single biggest driver of change has been investor demand. For years, many institutional investors have been asking for more from managers but in the boom of the mid 2000s, managers held the reins. Many of the industry’s blue chip funds were closed to new investors with people waiting in the wings for any capacity to open up. In this environment, many institutional investors were unsuccessful in their quest for information. Some investors walked away from funds because of their unwillingness to be transparent but for the most part, if the fund had solid performance, there were new investors waiting to replace them.
With the market movements in 2008, these queues of investors dissipated and many institutional investors parked their allocations in cash to see where the markets would land. Managers became much more open to the cries of earlier years for increased transparency. Institutional investors maintain that this is not a temporary change and that recent events have cemented their position. Thanks to the resulting shrinking assets, managers of today are listening.
In the midst of this, fund administrators and their role in the operation of the fund rose to the top of the list of questions investors were asking. There was a rallying cry for North American managers to abandon their previous model of self administration and to move to the European model of independent administration. The lack of an independent administrator has become a common theme in explaining the disparity of fund failures between North America and Europe.
We have been in the fund administration space since 1992. If someone had said then that fund administrators would someday be considered one of the most important hedge fund counterparties, perhaps second only to prime brokers, would the industry have agreed? It is unlikely but TABB Group has said just that in its November 2009 research report2. Recent investor demands for more transparency and greater independent verification of existence and valuation of hedge fund assets has brought the fund administrator to the forefront of the hedge fund world.
For years, accountants have been involved behind the scenes supporting hedge fund operations. However, managers and directors often included the administrator only as an afterthought on major decisions of the fund, if it impacted the calculation of the NAV. In today’s new world, the administrator has a much larger voice in the conversations that take place with the managers and directors. Administrators are not fiduciaries to the fund and don’t make the decisions but they are more and more being asked to give their input, share their experiences and comment on what they have seen before. This increased communication between the directors, managers and administrators will benefit everyone in the industry going forward.
Many investors see the administrator as the ‘gate keeper’ of the fund as they are privy to both the investor activity and the portfolio activity. More and more investors are visiting administrators and really delving into what they are doing for the fund. As an administrator, we welcome this. It is in the best interests of everyone for the communication lines to be open and the fund to be transparent about the types of assets they invest in, the type of pricing that is available and what their service providers are doing. Where we feel that there is information that investors should know, particularly about illiquid or hard to value positions in a portfolio, we look to the fund to disclose this to investors.
Increased transparency is but one of the many changes we see on the horizon in our industry. Managed accounts have also been a widely discussed platform option since the heady high water mark days of the latter half of 2007; however, has the actual platform uptake been as voluminous as the hype?
The benefits of managed accounts have been communicated loud and clear. Managed accounts offer investors more transparent transactional reporting and a detailed breakdown of fees incurred and direct trading transactions executed. As managers and investors increase their focus on the market risk and liquidity of investment strategies, managed account platforms offer them a tailored solution. Because of the individual nature of each managed account investment, managers are able to customise fees and fee structures to suit all levels of investors and their associated investment strategies.
However, managed account platforms come at a high price which to date has managers still only tentatively dipping their toes in the water. Separate accounts, separate holdings, separate managers – separation is the overriding cost driver. Furthermore, it is plausible that the situation could arise where separate managers are placing the same equal and opposite trades within the separate accounts. A high cost indeed for a zero sum gain (plus fees of course).
The ability to gain the same managed account performance as that of the asset manager’s own fund performance is also challenging. Supply and demand for portfolio positions, along with other factors, can lead to price differentials for these positions within the different accounts, which ultimately can lead to tracking error between the managed account and the flagship fund over time.
Over the last two years administrators have been proactively positioning themselves to better accommodate the managed account platform, but as the market upturns further, will the push for managed accounts ultimately end up losing steam? No one knows for sure but just like a manager hedges his return, administrators are also hedging their bets on the future of managed accounts by ensuring that they are able to participate if the market swings in that direction.
Another issue on the horizon is proposed future regulation, causing waves in an industry that has built its foundation on the freedom to trade without the restrictions of excessive regulation. The recent surge in UCITS and QIFs is an indication of the industry hedging against regulation. Investors cannot expect to eliminate risk and continue to invest in the alternatives space; however, what investors are expecting is to be told their risks up front and to be able to make informed investment decisions with this information. Administrators play an important role in this movement with more managers moving to full administration and those that have full administration providing more disclosure on portfolio composition and the source of pricing.
This two year roller coaster ride our industry has experienced also highlights a deliverable which ultimately impacts all of us in the way we go about our business, that deliverable being quality of service. It is no longer just the fund that is operating globally; the associated service providers are also looking to global operations to keep pace with the needs of their clients. There are easy to quantify benefits to global operations, such as being able to arbitrage time zones and improve the turn-around time on deliverables. However, the challenge for all is to manage the intangibles which are often what define success or failure. Much like the manager’s quest for Alpha, the fund administrator’s quest is for quality client service. Our clients are some of the most demanding and sophisticated clients in the world. It is a delicate balance between improving efficiencies and losing the human touch.
The hedge fund industry is a relationship industry. Investors know their managers and the managers know their investors. This allows managers to predict their investor’s needs and meet their expectations. Investors are not a face in the crowd and managers want service providers that are able to understand their investors’ expectations and consistently exceed them, help identify potential issues as they arise and suggest practical solutions and provide investors comfort on controls with flexibility to implement solutions that make sense. All indications are that fund administrators who put client service first will be the ones who stand the test of time.
At the beginning of this crisis, some naysayers wondered whether hedge funds themselves would stand the test of time. Had this exclusive asset class met its match? The recent turn around in the market and the dynamic way the participants in this industry changed to adapt to new demands tell us no. This was not the end of the hedge fund industry but rather a pause for breath in an industry in a continuing growth phase. It has been an opportunity to evaluate where we stand, where we are going and how we are going to get there. Hedge funds continue to outperform the markets, even through the darkest days of 2008 and 2009. Managers have accommodated investor demands for increased controls while still producing Alpha. The industry’s resilience during what some have called the greatest financial crisis since the Great Depression leads us all to believe the hedge fund industry is here to stay.