In ten years’ time a large number of today’s hedge funds will have disappeared and the challenge for investors today is being able to wade through the volume of hedge funds and allocate to those that are going to survive according to Dr Magne Orgland (pictured), Managing Partner and Head of Asset Management at Wegelin and Co, Switzerland’s oldest bank.
At the Hedge Funds World Zurich conference hosted by Terrapin on Tuesday 15 November spoke about the benefits of alternative Ucits to experienced investors.
Orgland said FoHF firms, which dedicate enormous amounts of manpower and due diligence to identify the next best manager, have always existed to service institutions like pension funds, endowments and family offices.
However, the FoHF model has come under increasing pressure since the ’08 financial crisis. As Orgland pointed out, FoHFs offer numerous benefits: manager selection, operational due diligence, diversification and style rotation. The problem is, performance has lagged. Suddenly, institutions aren’t quite as convinced by FoHFs as they once were. “I would say performance has been a little bit disappointing. If you compare performance of the HFR Weighted Hedge Fund Index to the HFR FoHF Index the FoHF Index has underperformed by about 3 per cent per annum,” said Orgland.
The critical reason for this is the extra fees that come with FoHFs: 5.1 per cent compared to 2.2 per cent for Ucits funds according to figures presented by Orgland. Undoubtedly this impacts on performance, but what Orgland didn’t do was compare the costs of Ucits FoHFs to offshore FoHFs, which perhaps gave a slightly skewed impression.
The Madoff incident was potentially an even bigger hammer blow to FoHFs than any debate over cost-related performance. “The FoHFs business suffered because it failed to deliver on operational due diligence. Some did, but not all. It proves they cannot necessarily catch all problematic hedge funds,” commented Orgland.
He then went on to say that alternative Ucits funds are the “logical next step in fund evolution as the industry matures and demand grows for regulated hedge funds”. The advantages to investors have been well documented: namely that they offer lower operational risk, increased transparency, rigorous risk management, minimum bi-weekly liquidity as well as protecting investors from losses stemming from asset managers’ mistakes.
Orgland said that rigorous counterparty risk management and stress testing, as well as tight control of leverage, further benefited investors but admitted that the myriad requirements of running a Ucits put fund sponsors at a disadvantage. However, he believes there’s a lot of growth potential within the alternative Ucits space, even though similar performance to offshore funds cannot be fully expected.
Ultimately it depends on strategy. If you consider CTA Ucits, they’ve slightly underperformed their offshore equivalents since 2007: 3 per cent compared to 4 per cent according to Orgland. There are a couple of reasons for this. Firstly, Ucits hedge funds cannot invest directly in commodity futures. Rather, they have to do it indirectly through an index using a total return swap. Also, they cannot use as much leverage. Underperformance is a combination of lower leverage and the cost of using a TRS, which Orgland said amounted to 50 to 100 basis points.
By comparison, Fixed Income Ucits funds are a more effective strategy. The global meltdown helped deliver decent performance compared to offshore funds, in large part because of the strict liquidity terms they have to abide by. The HFRX Relative Value Index was down -1.8 per cent p.a. between January 2008 and August 2011 whereas the UCITS Alternative Index Fixed Income returned +2.1 per cent per annum.
As Orgland commented: “If you’re bullish on economic growth and you’re not afraid of illiquidity you should go with offshore funds, but if you are concerned about a potential second financial crisis, alternative UCITS are the way to go.”
That’s not to say, even remotely, that single manager hedge funds and FoHFs are going to fall out of favour. Alternative Ucits are merely a useful addition to the overall investment funds universe. Investors mustn’t expect them to generate outlandish outperformance. Some might, and as already suggested, it could well be that the strict liquidity rules will help certain strategies like fixed income. One thing that Orgland also pointed out was that increasing numbers of novelty Ucits are being launched that don’t have an offshore equivalent, which should keep investors interested.
But could the increasing tendency for managers to bypass the ‘no shorting’ rules by using total return swaps threaten the long-term reputation and simplicity of the Ucits brand? Hedgeweek posed the question, to which Orgland responded: “Total return swaps aren’t used in all alternative Ucits. According to the Ucits regulatory framework you can buy an index like the Goldman Sachs Commodity Index for example, but not individual commodity futures. TRS are used to get around this restriction. It’s a complex set-up and comes with increased costs. Question marks surround it, therefore it’s mainly used by managers running CTA Ucits at present.”
The jury is still out on how effective alternative Ucits can perform over time. It’s fair to say, however, that certain strategies seem well placed to potentially give investors a good source of diversified returns.