By Simon Miller

Hedge funds are politically known as pariahs. Politicians hold them responsible for the short selling of currencies and companies and following the financial crisis have taken steps to curtail their activities.

Even so, they remain a major global investment player with $1.9 trillion (£1.21 trillion) of assets under management (AUM) in 2011 and institutional investors remain the biggest source of capital for hedge funds, accounting for around a half of AUMs.

However, despite the downturn, the industry still remains highly concentrated with the largest 100 hedge funds accounting for around two-thirds of total industry assets.

Geographically, New York remains the leading centre for the hedge fund industry with around 42 per cent of global hedge fund assets managed from there in 2011 according to TheCityUK’s estimates. London was the key European player with 18 per cent of AUM out of 21 per cent for the whole of Europe.

Around 800 funds are located in the UK in 2011, managing some 85 per cent of European-based hedge funds’ assets and the country is also a leading centre for hedge fund services such as administration, prime brokerage, custody and auditing.

Globally, the industry saw regular and healthy growth in the last decade rising from estimated assets of $490.58 billion in 2000 to a pre-financial crisis high of $1.868 trillion in 2007 with $195.5 billion in net flow assets.
The financial crisis saw the industry hit hard with a drop in estimated assets to $1.4 trillion in 2008 with a negative asset net flow of $154.4 billion in 2008.

The last two years have seen the industry slowly climb back up the scale even if events in Europe and fears over a China slowdown impacted on business.

According to Deutsche Bank’s Alternative Investment Management Survey 2012, global hedge fund assets under management rise to $2.01 trillion with total flows of around $70 billion - a $25 billion rise from 2010. To put it
into perspective, the total global AUMs came to $56.2 trillion in 2010.

However, assets under management fell by three per cent according to TheCityUK’s Hedge Funds 2012 figures.

The lobby group says that, although off its 2007 peak, assets had risen 237 per cent over the decade with new hedge fund launches outpacing fund liquidations for the second year running.

Deutsche agrees, saying: “While we saw a slow-down of inflows into equity hedge and event driven strategies, managers that have performed well in those strategies continue to attract assets and have a healthy pipeline of inflows.”

Europe, of course, is an obvious reason for the 2011 dip as confidence across the board took its toll.

With markets reacting to macro headlines rather than actual fundamentals, it was difficult for managers to “generate alpha based on security selection, and we saw higher correlation between the returns generated”, Deutsche comments.

For Nordic bank SEB, all major strategies showed negative results in 2011, with Equity Hedge performing the absolute worst with a downturn of 19.1 per cent. In its investment outlook, SEB commented: “The previously profitable flight to safe government securities lost some ground during the October risk rally, when both the investment grade and high yield markets rose substantially.”

It found that although the “risk-off” themes that worked well during Q3 were in favour again in November “after a turbulent year, it was natural to cut back positions towards the year-end, which resulted in rather modest movements during December”.

And it is not just market concerns that could affect performance this year and going forwards.

Following the financial crisis, politicians around the world look to what they perceived as the biggest risk to stability in the global economy and pointed a finger at hedge funds.

In March, the European Securities Markets Authority (Esma) published consultations on short selling and UCTIS while work continues in the States through the Dodd-Frank act.

The Esma regulation sees the requirement to have in place an arrangement to settle a short sale and the manner in which notifications of short positions are made.

According to Deutsche, the time pressure on Esma had left open important measures that had not been covered, leaving activities to be clarified once the regulation comes into practice on 1 November 2012.

“For example, Esma does not define ‘liquidity’ for the specific purpose of the regulation but, instead, refers to the definition of liquidity in the Markets in Financial Instruments Directive,” the bank comments. “For the purpose of putting in place a reliable locate arrangement however, this definition is not appropriate.”

The other consultation that Esma published was concerning Exchange Traded Funds and other UCITS issues.

“It is likely that Esma’s proposals will affect the availability of ‘necits’ [new UCITS] to investors as strategy indices, which are typically assembled for the purpose of necits are unlikely to meet the criteria in the guideline,” says Deutsche.

The other factor exercising the hedge fund arena is the investigation into the ‘shadow banking sector’.

The term is used to describe a large segment of financial intermediation that is outside the balance sheets of regulated commercial banks and there are fears that credit hedge funds in particular and hedge funds in general have been considered part of the banking industry and not the asset management industry and so targeted by regulators.

The concern is that hedge funds will be tarred with the same brush as those players that regulators and politicians alike blame in the shadow banking sector for causing the financial crash. The G20 mandated the Financial Stability Board to develop recommendations to strengthen the oversight and regulation of the ‘shadow banking’ system in November 2010, but there has been considerable debate about what constitutes a ‘shadow bank’. Recent G20 language referred to ‘money markets funds, securitisation, securities lending and repo activities, and other shadow banking entities’.

In a paper, the Alternative Investment Management Association (AIMA) strongly argues that because of hedge fund’s liquidity and maturity profiles, as well as their leverage, are such that they do not pose significant risks to the financial system.

“No hedge fund is sufficiently large, leverage complex, or interconnected that its failure or financial stress would cause such severe disruption,” it writes.

The paper continues: “Hedge funds individually or collectively are therefore not systemically important and can be seen as a stabilising (additive to overall market liquidity) as opposed to a destabilising element of the financial system.”

At the launch of the paper, Andrew Baker, AIMA CEO, commented: “Credit hedge funds – and hedge funds in general - do not operate in the shadows. Managers are extensively regulated, are subject to reporting requirements and so are not ‘bank-like’. Credit hedge funds do not belong in the same category as banks, let alone ‘shadow banks’.”

A report from Barclays Capital earlier this year, showed some surprising optimism from hedge fund investors with 56 per cent planning to increase their hedge fund allocations over the next 12 months - seven times the amount planning to reduce their allocations.

“Our analysis indicates that investors are likely to allocate approximately $80 billion of new capital to the hedge fund industry this year,” said Ajay Nagpal, Head of Prime Services at Barclays Capital, in a statement. “2012 has the potential to be the most significant year for new capital allocations to hedge funds since 2007.”

In addition to the approximately $80 billion of new assets, investors are likely to reallocate some $300 billion of existing hedge fund assets within and across hedge fund strategies. In total, the hedge fund industry could see between $350 billion and $400 billion of money ‘in play’ over the next 12 months – almost one fifth of the current total hedge fund industry AUM.
And smaller funds are getting a look-in, balancing out the fact that around 60 per cent of assets are controlled by 5 per cent of funds.

Investors are looking to increase the share of allocation going to funds with less than $1 billion in AUM. BarCap found that during the first nine months of 2011, small hedge funds doubled their share of net flows compare with 2010, with 18 per cent of total hedge fund net flows versus 9 per cent.
The survey found a 77 percentage point tilt in favour of allocating to small funds compared to a 10 percentage point tilt in favour of funds with an AUM of more than $5 billion.

“Smaller managers are frequently seen by investors to be more agile in adapting their existing strategies to generate alpha,” says Louis Molinari, head of Capital Solutions in Prime Services at Barclays Capital. “With the greater transparency, and better fee and liquidity terms that many new and smaller funds offer, investors continue to gain confidence with investing
in this segment of the hedge
fund industry.”

The survey also found that of the new flows, investors plan to allocate most to global macro and systematic / volatility strategies, as they look to add more tactical and trading-oriented strategies with relatively low correlation to equities. Reallocations would be most significant within equity and credit strategies, reflecting a combination of investors’ redemptions from poor performers, their belief in mean reversion and a preference for more specialised products within these strategies.

In addition, Deutsche’s survey predicts that increased institutional participation is driving growth as hedge funds become an “established and formidable” part of the investment landscape. Institutions now account for approximately two thirds of hedge fund assets compared to less than one fifth in 2003.

Although investors appear to be optimistic about this year, SEB warns that the continued debt crisis and expectations of poorer corporate profits “ are likely to have a continued negative impact during the first quarter of 2012”.

It adds: “The probability of a recession in the euro zone has increased, and support for this view is visible in prices, which should indicate that market players have probably already discounted many of the negatives.”

Speaking to Reuters following the publication of GlobeOp’s latest monthly index that showed a continuation of inflows into the hedge fund industry, the financial services administrator’s chief executive Hans Hufschmid commented: “Last year was a bad year for markets overall, but people feel a little more settled now.”

He added: “In the last two or three months the whole uncertainty about Europe has settled down a bit and the economic numbers in the US are looking pretty positive, and people are happier to allocate to hedge funds.”

It is a sentiment that seems to be shared among the industry. After being battered by markets and politics alike, 2012 might be a good year for hedge funds as long as they ready for the challenges ahead.

As SEB writes: “Managers must remain tactical and agile, but the investment opportunities are good, especially for high yield corporate bonds, which have not kept up with the broader upturn. The tail end of the year saw mixed returns for event driven and distressed strategic.”

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