Investors Dig These Hedge Funds. So Why Don’t Firms Start More?

  • Liquid alternatives beat hedge funds in net capital raising
  • But managers are slow to warm up to the regulated pools

Europe’s hedge fund industry may be facing a liquidity mismatch of a different kind.

Investors in the region have been flocking to funds like Marshall Wace’s Liquid Alpha, a regulated hedge fund that increased assets almost 13-fold last year to $1.7 billion, according to a person familiar with the matter. Schroder GAIA Two Sigma Diversified fund, another such vehicle, has attracted $700 million since it was started about five months ago.

Both are so-called UCITS funds, set up under a European directive that’s been in place for more than three decades. Over the past six years, alternative investment strategies offered through such vehicles received almost 17 times as much net new money as traditional hedge funds in Europe. Investors like them because they’re more transparent, less risky and don’t lock up clients’ money for long periods. In most cases, they’re also cheaper.

Yet what makes them attractive for clients is rendering them less appealing to some hedge fund managers, who keep favoring the more lucrative traditional funds. In every year since at least 2008, firms have started more traditional hedge funds in Europe than UCITS funds, according to data compiled by Eurekahedge. That’s even as hedge fund closings have exceeded new starts for two years running.

“Some hedge fund managers fear cannibalizing existing products,” said Andrew Dreaneen, head of product and business development at a Schroders Plc platform that allows its clients to access hedge funds. “Also, they worry about what the investment restrictions, additional liquidity on offer combined with a less familiar buyer base, may do in terms of influencing their ability to generate a return similar to their flagship hedge fund.”

Limiting Risk

UCITS, an acronym that goes back to a 1985 European Union directive aimed at harmonizing retail investment funds in the region, are allowed to employ some hedge fund techniques, while limiting risks. They can use derivatives to create some leverage and short exposure, but not as much as traditional hedge funds. Trading certain assets such as commodities and real estate is restricted, and offering daily or weekly redemption options limits their ability to allocate a large percentage of assets to high-conviction bets.

While traditional hedge funds typically require a minimum investment of $1 million, investors can allocate a fraction of that into UCITS hedge funds, making them affordable to even retail investors.

Clients allocated a net $88.7 billion to European UCITS hedge funds in the past six years, compared with just $5.2 billion that went into traditional hedge funds. Yet only 37 percent of hedge funds started in the region last year were UCITS funds, according to Eurekahedge. That’s down from 44 percent in the prior year, though the longer-term trend does show a gradual increase.

Performance concerns alone don’t explain the mismatch of flows and fund starts. The HFRU Hedge Fund Composite Index, which measures performance of UCITS hedge funds, gained 0.9 percent last year, trailing the average 5.5 percent return in traditional hedge funds, according to data from Hedge Fund Research Inc. Over three years, however, returns were almost the same. A UCITS index tracking returns in U.S. dollars did even better.

UCITS hedge funds charge an average 1.14 percent management fee, according to Kepler Partners, which tracks about 500 such funds. Some 20 percent of them, controlling about 44 percent of the industry’s assets, do not charge any performance fees.

Some of the biggest asset gathers in the past year aren’t that cheap. Marshall Wace Liquid Alpha Fund returned 12 percent since inception in June of 2015 through December. It charges a management fee from 1 percent to 2.25 percent and keeps 20 percent of profits, in line with traditional hedge funds, but it offers clients the freedom to withdraw money on a daily basis.

‘Why Not?’

Schroders in August started the Schroder GAIA Two Sigma Diversified fund, a UCITS fund subadvised by Two Sigma Advisers, the $38 billion New York firm known for its scientific, computer-driven approach to investing. The fund invests in equity, bond and foreign exchange markets, and has returned 8.3 percent since inception. It charges a management fee of 1.4 percent and performance fee of 20 percent.

“Many of the institutional investors don’t need the liquidity but if it’s there with a similar pricing and expected return to the flagship hedge fund, why not take it?” said Dreaneen of Schroders.

A survey of 130 institutional investors overseeing more than $700 billion in hedge fund assets by Deutsche Bank last year found nearly 70 percent of respondents allocating to alternative UCITS funds and a further 5 percent planning to make their first investment in 2016.

“Of course it is still possible to raise money in Europe using the traditional structure, but the direction of travel is clear," said Anita Nemes, global head of capital introduction and hedge fund consulting at Deutsche Bank AG. “We’ve seen significant inflows into the alternative sector via the UCITS fund format and this looks set to continue."

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