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HEDGE FUND

Hedge Fund

Most hedge funds which have survived the crisis have returned to growth. Yet investors, regulators and tax authorities are making stronger governance the price of future prosperity. Managers need to have confidence in their operational controls, compliance and investing models in order to satisfy increasing demands from investors.

Regulation

Hedge fund managers face increased regulation. The Private Fund Investment Advisers Registration Act in the United States and the Alternative Investment Fund Managers Directive in Europe are both having considerable impacts on the industry already, if only for the uncertainty that they have created until they are in effect. Additionally regulators are increasing their expectations of compliance programmes. Managers need to spend time planning and preparing.

 

Operations

Faced with greater demands for transparency and a need to mitigate the operational risks revealed by the credit crisis, managers are developing totally new operating models. These involve the entire infrastructure, including people, processes, technology, data and organisational design. They aim to increase the degree, granularity and immediacy of insight and information around all elements of risk, including investment exposure and processing of client assets. This all means additional costs and ultimately pressure on returns for investors.

 

Tax

Tax authorities across the globe are seeking investors’ identities (e.g. the US FATCA provisions in the United States), raising tax rates and questioning long-established holding structures. They are reinforcing all of this with increased audit activity. Managers must respond by improving their tax functions.

 

Restructuring

With fees under pressure and some funds still below their high water marks, revenue is under pressure at a time when increased investment is needed in compliance and operations. Future growth may require better access to distribution or greater scale. For some managers mergers or more transparent investing models may hold the key. Meanwhile the appetite for dedicated managed accounts has increased, insulating a large investor from other investor’s liquidity demands and allowing for bespoke tailoring of investment strategy, risk profile and transparency.

 

Risk

Hedge fund governance and operational risk management has been called into question by market events. Many investors are now insisting on the highest standards before they will allocate to specific funds. Are you aware of what constitutes best practice? Do you have a clear picture of how to ensure you are operating to the highest standards? We’re also seeing a marked increase in interest in third party assurance reporting by prime brokers and hedge fund managers.

 

People

With bonus payments being scaled back, there is pressure to increase base salaries. HR professionals have to decide how to redefine the overall compensation offering, taking into account upwards pay pressure from employees and criticism from shareholders, regulators and the public over ‘excessive’ incentive outcomes. Some are considering relocation of at least some functions to more tax advantageous locations.

 

THE RISE 

While co-investing has been a feature of the private equity industry for many years, it is a more recent and growing trend in the hedge fund industry. We believe that hedge fund co-investments are an important tool to increase the total return of portfolios, while limiting correlation to traditional asset classes and core hedge fund strategies. Co- investments can also be used to respond more rapidly to dislocations in markets.

 

Why are we seeing growth in hedge fund co-investment opportunities?

Prior to the global financial crisis the hedge fund industry experienced strong inflows. Many hedge funds enjoyed relative freedom to pursue niche opportunities and put less liquid investments into side pockets. In recent years, industry inflows have been more limited and investors have been more restrictive on permissible investments, particularly less liquid situations.

  

As a result, hedge funds have had less discretionary capital available to deploy. This has coincided with regulatory changes that have decreased bank and insurance company willingness to invest in non-traditional asset classes, creating more opportunity for alternative forms of capital to fill that void. The end result has been an increase in hedge funds seeking co-investment capital for discrete opportunities that do not meet the liquidity, concentration or asset class guidelines of their main funds.

From the investor’s perspective, returns, fees, transparency and correlation are key focal points when it comes to hedge fund allocations. In our view, co- investments have the potential to provide improvement on all three fronts.

In short, we believe co-investments offer a clear and self-sustaining value proposition to hedge fund managers and investors. For managers, co-investments represent a new form of capital that enables them to participate in high-conviction opportunities that, absent co-investment capital, they would not be able to pursue. For investors, co-investments offer a means of direct access to differentiated sources of return with potentially bespoke risk/return profiles as well as attractive fees, transparency and control rights.

How do hedge fund co-investments differ from private equity co-investments?

The primary difference is the universe of managers from which co-investments are sourced. Co-investing is a mature concept for private equity firms. Indeed, many private equity managers have established and often contractual processes for how co-investments are allocated among existing clients. Co-investing is a newer concept for hedge funds. Most hedge fund managers do not have a long list of existing investors with whom they have traditionally partnered on such investment opportunities. At the same time, most hedge fund allocators are not equipped to make decisions about co-investments. As a result, these opportunities tend not to be as heavily trafficked as private equity co-investments and there tends to be greater potential for tailoring implementation strategies.

Another important difference is the breadth of asset classes accessible through each of the two categories. Private equity co-investments typically involve control private equity positions that are subject to the same factors that influence valuation of public equities. Hedge fund co-investments represent a diverse array of asset classes, liquidity profiles and risk. They can be “risk-on” or “risk-off” and everything in between.

They can range from publicly traded equity and debt to non-traded investments, such as litigation finance and reinsurance, which have no correlation to traditional assets classes. For this reason, we would generally expect that hedge fund co-investments would have lower correlation to global equities than private equity co- investments. Hedge fund co-investments also tend to have shorter holding periods than private equity co-investments.

How are hedge fund co-investments sourced?

Today, sourcing is entirely dependent upon having access to a robust network of idea-generators. The most obvious sourcing channel comes from hedge fund managers with whom an investor has existing primary fund investments. However, it is increasingly common for hedge fund managers to solicit co-investment capital directly from allocators with whom no primary fund relationship exists. This is happening because few hedge fund managers have existing investors with active co-investment programs and managers recognize co-investments as an opportunity to broaden their client base and support future business growth. There is also a growing trend toward fundless sponsors or emerging hedge funds offering co-investments in order to establish investor confidence.

What are the key barriers to entry?

While we believe there are many potential benefits to making co- investments, there are challenges as well. Broadly speaking, we see four key barriers to entry:

  1. SOURCING: Having a wide network of existing hedge funds—idea generators— and a pipeline for new ones is critical. The greatest advantage in this space comes from the luxury of choice, having access to a wide range of potential opportunities and being selective.

  2. ANALYSIS: Co-investing requires integrating a hedge fund manager due diligence framework with asset- specific underwriting. Many hedge fund investors are not structured

  3. or resourced to support this two- pronged approach.

  4. EXECUTION: Co-investing requires efficient decision making, often over the course of mere days. In addition, legal documentation and vehicle structuring must be accomplished far more rapidly than is required in traditional fund investing.

  5. CAPITAL  FLEXIBILITY:  Co-investments are often presented because the hedge fund manager has constraints on size and/or liquidity that prevent inclusion of these ideas in a main fund. Investors must have the mandate and appetite to be flexible around these parameters in order to maximize their opportunity set.
     

How is alignment typically achieved with the hedge fund manager?

Generally speaking, alignment is achieved in two ways. It can come from assurance that a manager has “skin in the game”, investing personal capital alongside that of external investors. And it can come through fee structures that are akin to “sweat equity”. There are a wide range of fee structures (including no fees), but structures are typically skewed toward realization-based incentives over a performance hurdle whereby a manager is only compensated if the investment achieves the investor’s objectives.

What is the role of co-investments in client portfolios? What are the trade-offs?

We believe the primary role of hedge fund co-investments in client portfolios is to potentially increase expected return. Secondary benefits may include improving transparency, reducing average fees and introducing targeted exposures that are not correlated to existing allocations. The trade-offs are that co-investments are resource-intensive and require quick response times. In addition, they can have higher risk and wider distributions of outcomes than traditional fund investments. Finally, co-investments may require more onerous contractual liquidity.

Conclusion

In our view, hedge fund co-investments have a distinct role to play in well-balanced portfolios, offering important diversification benefits to traditional asset classes as well as hedge funds and opportunistic investments. We believe that hedge fund co-investing will reach the level of adoption currently found in private equity, leaving significant runway for growth in the years ahead.

Market Reporting

Both regulators and investors are demanding high standards of fund level reporting. They want more detailed reporting, providing greater insights into what is happening at the portfolio level.

 

In a mature industry, we believe four trends are set to drive new growth

There's little doubt that hedge fund administration (HFA), or back-office outsourcing, is a maturing industry, as over 80% of hedge fund AUM is administered by a third party. Unsurprisingly, over the past seven years, 43% of the asset growth among top 10 administrators came from acquisitions.

However, despite 27 acquisitions of hedge fund administrators since 2006 (11 involving firms that administer at least $20 billion or more in assets), M&A activity in 2013 slowed due to an increase in valuations and a decrease in the number of viable acquisition candidates.

Because HFA demand is triggered primarily by external forces - such as post-crisis investor pressure placed on hedge funds to outsource their books and records - organic growth in hedge fund administration will be challenging as firms are forced to compete for a relatively static group of clients.

What's next?

As organic and inorganic HFA growth opportunities decrease, will there be new demand for administration services? And if so, where will this demand come from?

The answer lies in the competitive forces now shaping the asset management industry. We've found that four trends in particular appear poised to drive new growth in hedge fund administration (see below).

  • Increased need for regulatory reporting

      Demand for regulatory reporting services, such as AIFMD, Solvency II, and Form        PF, remains strong.

  • Manager and product convergence

  • Strong growth in assets under management (AUM) is expected for liquid alternative products. Citi Prime Finance estimates that these products will exceed $900 billion in AUM by 2017.1 At this rate of growth, the administration industry could capture incremental revenue in the range of $600 million to $825 million on an undiscounted basis for the period of 2013 – 2017.

 

  • Cost-efficient fee operations

  • Asset managers are looking to become more cost-efficient in response to pressure from institutional investors. Administrators may want to develop new services that help asset managers achieve higher levels of operational and cost efficiency.

  • Expanded outsourcing

  • Opportunities exist for administrators to offer private equity administration services. The US addressable market for private equity administration remains large, at 73% of invested capital (or ~$1.7 trillion). If private equity outsourcing were to reach 50% by 2018 (it’s currently at 30% today) then the incremental revenue opportunity for the fund administration industry is $660 to $880 million on an undiscounted basis for the period of 2014 – 2018.

 

As these trends take hold, administrators will invariably follow different paths toward growth, many of which will be influenced by such characteristics as size, ownership structure and service mix.

 

Small, undercapitalised administrators may focus on making improvements to both cost efficiency and their core competencies as a way to increase profit margins.

And well-capitalised administrators, small or large, may pursue one or more of these four growth opportunities to the extent they are not already doing so. However, it's important for well-capitalised administrators to remember that their financial capital will enable the pursuit of growth, but it will not guarantee the creation of value. Achieving profitable growth and shareholder value creation will come from a strategy that focuses on creating and sustaining a competitive advantage.

We believe the HFA firms that define a growth strategy which complements their core competencies, activities and assets will create more value over the long term.

What are Hedge funds?

The use of hedge funds in financial portfolios has grown dramatically since the start of the 21st century. A hedge fund is just a fancy name for an investment partnership that has freer rein to invest aggressively and in a wider variety of financial products than most mutual funds. It's the marriage of a professional fund manager, who is often known as the general partner, and the investors, sometimes known as the limited partners. Together, they pool their money into the fund. This article outlines the basics of this alternative investment vehicle.

KEY TAKEAWAYS

  • Hedge funds are financial partnerships that use pooled funds and employ different strategies to earn active returns for their investors.

  • These funds may be managed aggressively or make use of derivatives and leverage to generate higher returns.

  • Hedge fund strategies include long-short equity, market neutral, volatility arbitrage, and merger arbitrage.

  • They are generally only accessible to accredited investors.

 

The First Hedge Fund

A former writer and sociologist Alfred Winslow Jones’s company, A.W. Jones & Co., launched the world's first hedge fund back in 1949.1 Jones was inspired to try his hand at managing money while writing an article about investment trends earlier that year. He raised $100,000 (including $40,000 out of his own pocket) and tried to minimize the risk in holding long-term stock positions by short selling other stocks.2

This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage to enhance returns. In 1952, he altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner.

As the first money manager to combine short selling, the use of leverage and shared risk through a partnership with other investors, and a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.

Hedge Fund Partnerships

A hedge fund's purpose is to maximize investor returns and eliminate risk. If this structure and these objectives sound a lot like those of mutual funds, they are, but that's where the similarities end. Hedge funds are generally considered to be more aggressive, risky, and exclusive than mutual funds. In a hedge fund, limited partners contribute funding for the assets while the general partner manages the fund according to its strategy. 

The name hedge fund derives from the use of trading techniques that fund managers are permitted to perform. In keeping with the aim of these vehicles to make money, regardless of whether the stock market climbs higher or declines, managers can hedge themselves by going long (if they foresee a market rise) or shorting stocks (if they anticipate a drop). Even though hedging strategies are employed to reduce risk, most consider these practices to carry increased risks.

Hedge funds took off in the 1990s when high-profile money managers deserted the mutual fund industry for fame and fortune as hedge fund managers. Since then, the industry has grown substantially with total assets under management (AUM) valued at more than $3.25 trillion, according to the 2019 Preqin Global Hedge Fund Report.3 

The number of operating hedge funds has grown as well. There are 3,635 hedge funds in the U.S. in 2021, an increase of 2.5% from 2020.

Aim and Characteristics of Hedge Funds

A common theme among most mutual funds is their market direction neutrality. Because they expect to make money whether the market trends up or down, hedge fund management teams more closely resemble traders than classic investors. Some mutual funds employ these techniques more than others, and not all mutual funds engage in actual hedging.

There are several key characteristics that set hedge funds apart from other pooled investments—notably, their limited availability to investors.

Accredited or Qualified Investors

Hedge funds investors have to meet certain net worth requirements—generally, a net worth exceeding $1 million or an annual income over $200,000 for the previous two years.

Investment Latitude

A hedge fund's investment universe is only limited by its mandate. A hedge fund can invest in anything—land, real estate, derivatives, currencies, and other alternative assets. Mutual funds, by contrast, usually have to stick to stocks or bonds.

 

Often Employ Leverage

Hedge funds often use leverage or borrowed money to amplify their returns, which potentially exposes them to a much wider range of investment risks—as demonstrated during the Great Recession. In the subprime meltdown, hedge funds were especially hard-hit due to increased exposure to collateralized debt obligations and high levels of leverage.

Fee Structure

Hedge funds charge both an expense ratio and a performance fee. The common fee structure is known as two and twenty (2 and 20)—a 2% asset management fee and a 20% cut of generated gains.

There are more specific characteristics that define a hedge fund, but because they are private investment vehicles that only allow wealthy individuals to invest, hedge funds can pretty much do what they want—as long as they disclose the strategy upfront to investors.

This wide latitude may sound very risky, and it certainly can be. Some of the most spectacular financial blow-ups have involved hedge funds. That said, this flexibility afforded to hedge funds has led to some of the most talented money managers producing some amazing long-term returns.

Two and Twenty Structure

What gets the most criticism is the other part of the manager compensation scheme—the 2 and 20, used by a large majority of hedge funds.

As mentioned above, the 2 and 20 compensation structure means that the hedge fund’s manager receives 2% of assets and 20% of profits each year. It's the 2% that gets the criticism, and it's not difficult to see why. Even if the hedge fund manager loses money, he still gets a 2% AUM fee. A manager who oversees a $1 billion fund could pocket $20 million a year in compensation without lifting a finger. Worse yet is the fund manager who pockets $20 million while his fund loses money. They then have to explain why account values declined while they got paid $20 million. It's a tough sell—one that doesn't usually work.

In the fictional example above, the fund charged no asset management fee and instead took a higher performance cut—25% instead of 20%. This gives a hedge fund manager an opportunity to make more money—not at the expense of the fund's investors, but rather alongside them. Unfortunately, this no-asset-management-fee structure is rare in today's hedge fund world. The 2 and 20 structure still prevails, although many funds are starting to go to a 1 and 20 setup.

Types of Hedge Funds

Hedge funds can pursue a varying degree of strategies, including macro, equity, relative value, distressed securities, and activism. 

A macro hedge fund invests in stocks, bonds, and currencies hoping to profit from changes in macroeconomic variables, such as global interest rates and countries’ economic policies.

An equity hedge fund may be global or country-specific, investing in attractive stocks while hedging against downturns in equity markets by shorting overvalued stocks or stock indices.

A relative-value hedge fund takes advantage of price or spreads' inefficiencies. Other hedge fund strategies include aggressive growth, income, emerging markets, value, and short selling.

Popular Hedge Fund Strategies

Among the most popular hedge fund strategies are:

Long/Short Equity: Long/short equity works by exploiting profit opportunities in both potential upside and downside expected price moves. This strategy takes long positions in stocks identified as being relatively underpriced while selling short stocks that are deemed to be overpriced.

Equity Market Neutral: Equity market neutral (EMN) describes an investment strategy where the manager attempts to exploit differences in stock prices by being long and short an equal amount in closely related stocks. These stocks may be within the same sector, industry, and country, or they may simply share similar characteristics such as market capitalization and be historically correlated. EMN funds are created with the intention of producing positive returns regardless of whether the overall market is bullish or bearish. 

Merger Arbitrage: Merger Arbitrage or risk arb involves simultaneously purchasing and selling the stocks of two merging companies to create riskless profits. A merger arbitrageur reviews the probability of a merger not closing on time or at all.

Global Macro: A global macro strategy bases its holdings primarily on the overall economic and political views of various countries or their macroeconomic principles. Holdings may include long and short positions in equity, fixed income, currency, commodities, and futures markets.

Volatility Arbitrage: Volatility arbitrage attempts to profit from the difference between the forecasted future price-volatility of an asset, like a stock, and the implied volatility of options based on that asset. It may also look to volatility spreads to either widen or narrow to predicted levels. This strategy employs options and other derivative contracts.

Convertible Bond Arbitrage: Convertible bond arbitrage involves taking simultaneous long and short positions in a convertible bond and its underlying stock. The arbitrageur hopes to profit from movement in the market by having the appropriate hedge between long and short positions. 

Another popular strategy is the fund of funds approach which involves mixing and matching other hedge funds and pooled investment vehicles. This blending of strategies and asset classes aims to provide a more stable long-term investment return than those of any of the individual funds. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds.

Notable
Hedge Fund

Notable Hedge Funds

Notable hedge funds today include Renaissance Technologies (also known as RenTech or RenTec), founded by the mathematical genius, Jim Simons. Renaissance specializes in systematic trading using quantitative models derived from mathematical and statistical analyses. According to Gregory Zuckerman, a special writer for The Wall Street Journal, Renaissance has had 66% average annual returns since 1988 (39% after fees).

Pershing Square is a highly successful and high-profile activist hedge fund run by Bill Ackman. Ackman invests in companies he feels are undervalued with the goal of taking a more active role in the company to unlock value.10 Activist strategies typically include changing the board of directors, appointing new management, or pushing for a sale of the company.

Carl Icahn, a well-known activist investor, leads a prominent and successful hedge fund. In fact, one of his holding companies, Icahn Enterprises (IEP), is publicly traded and gives investors who can't or don't want to directly invest in a hedge fund an opportunity to bet on Icahn's skill at unlocking value.

Regulating Hedge Funds

Hedge funds face little regulation from the Securities and Exchange Commission, (SEC) compared to other investment vehicles. That's because hedge funds mainly take money from those accredited or qualified investors—high-net-worth individuals who meet the net worth requirements listed above. Although some funds operate with non-accredited investors, U.S. securities laws dictate that at least a plurality of hedge fund participants are qualified. The SEC deems them sophisticated and affluent enough to understand and handle the potential risks that come from a hedge fund's wider investment mandate and strategies, and so does not subject the funds to the same regulatory oversight.

But hedge funds have gotten so big and powerful—by most estimates, thousands of hedge funds are operating today, collectively managing over $1 trillion—that the SEC is starting to pay closer attention.And with breaches such as insider trading occurring much more frequently, activity regulators are coming down hard.

 

Significant Regulatory Change

The hedge fund industry experienced one of the most significant regulatory changes after the Jumpstart Our Business Startups Act (JOBS) was signed into law in April 2012. The basic premise of the JOBS Act was to encourage the funding of small businesses in the U.S by easing securities regulation.

The JOBS Act also had a major impact on hedge funds. In September 2013, the ban on hedge fund advertising was lifted. The SEC approved a motion to lift restrictions on hedge fund advertising, though they still can only accept investments from accredited investors.15 Giving hedge funds the opportunity to solicit would in effect help the growth of small businesses by increasing the pool of available investment capital.

Form D Requirements

Hedge fund advertising deals with offering the fund's investment products to accredited investors or financial intermediaries through print, television, and the internet. A hedge fund that wants to solicit investors must file a Form D with the SEC at least 15 days before advertising begins.

Because hedge fund advertising was strictly prohibited prior to lifting this ban, the SEC is very interested in how advertising is being used by private issuers, so it changed Form D filings. Funds also need to file an amended Form D within 30 days of the offering's termination. Failure to follow these rules will likely result in a ban from creating additional securities for a year or more.

Advantages of Hedge Funds

Hedge funds offer some worthwhile benefits over traditional investment funds. Some notable benefits of hedge funds include:

  • Investment strategies that can generate positive returns in both rising and falling equity and bond markets 

  • The reduction of overall portfolio risk and volatility in balanced portfolios

  • An increase in returns

  • A variety of investment styles that provide investors the ability to precisely customize an investment strategy

  • Access to some of the world's most talented investment managers

 

Pros

  • Profits in rising and falling markets

  • Balanced portfolios reduce risk and volatility

  • Several investment styles to choose from

  • Managed by the top investment managers

 

Cons

  • Losses can be potentially large

  • Less liquidity than standard mutual funds

  • Locks up funds for extended periods

  • Use of leverage can increase losses

 

Disadvantages of Hedge Funds

Hedge funds, of course, are not without risk as well:

  • Concentrated investment strategy exposes them to potentially huge losses.

  • Hedge funds tend to be much less liquid than mutual funds.

  • They typically require investors to lock up money for a period of years.

  • The use of leverage or borrowed money can turn what would have been a minor loss into a significant loss.

 

Example of a Hedge Fund at Work

Let's set up a hypothetical hedge fund called Value Opportunities Fund LLC.  The operating agreement states that the fund manager can invest anywhere in the world and receives 25% of any profits over 5% every year.

The fund starts with $100 million in assets—$10 from ten different investors. Each investor fills out the investment agreement with a check to the fund administrator. The administrator records each investment on the books, then wires the funds to the broker. The fund manager can then begin investing by calling the broker with attractive opportunities.

 

The fund goes up by 40% after a year, making it worth $140 million. According to the fund's operating agreement, the first 5% belongs to the investors. So the capital gain of $40 million is reduced by $2 million—or 5% of $40 million—which is distributed evenly among the investors. That 5% is known as a hurdle rate—a hurdle the fund manager must reach before earning any performance compensation. The remaining $38 million is split—25% to the manager and 75% to investors.

Based on the first-year performance, the fund manager earns $9.5 million in compensation in a single year. The investors get the remaining $28.5 million along with the $2 million hurdle rate for a capital gain of $30.5 million. But imagine if the manager was responsible for $1 billion instead—they'd take home $95 million with investors netting $305 million. Of course, many hedge fund managers get vilified for earning such exorbitant sums of money. But that's because those doing the finger-pointing fail to mention that many investors made $305 million. When is the last time you heard hedge fund investors complain that their fund manager was getting paid too much?

The Bottom Line

A hedge fund is an official partnership of investors who pool money together to be guided by professional management firms—just like mutual funds. But that's where the similarities end. Hedge funds aren't regulated as much and operate with far less disclosure. They pursue more flexible and risky strategies in the hopes of netting big gains for investors, which, in turn, result in big profits for fund managers. But perhaps what sets them apart from mutual funds the most is that they have much higher minimum investment requirements.

The majority of hedge fund investors are accredited, meaning they earn very high incomes and have existing net worths in excess of $1 million.17 For this reason, hedge funds have earned the dubious reputation of being a speculative luxury for the rich.

Looking Beyond

With relatively high equity valuations and rate pressure on bonds, the value proposition for hedge funds has become increasingly positive. While we envision a reasonably benign economic and market environment, we believe that global equity and bond markets will be hard-pressed to continue delivering the strong returns they have in the recent past.

 

Equity markets are broadly expensive and susceptible to weaker-than-expected earnings growth going forward, and extremely low government bond yields and tight credit spreads pose significant headwinds for fixed income. Meanwhile, strong shifts in consumer behavior and business models, coupled with powerful fiscal and monetary influences, are likely to lead to meaningful performance dispersion among companies. In this environment, we believe that skill-based absolute return strategies are well-positioned to continue prospering.

Not only is the outlook for hedge funds favorable, but recent industry performance has been historically strong. The global pandemic is creating numerous dislocations and opportunities for fund managers.  Hedge funds, as represented by hedge fund index data, have generated more alpha in the last year than in any 12-month period in the last decade. The HFRI Fund Weighted Composite Index is up an eye-popping 30% in the 12-month period through May 2021. The HFRI Fund of Fund Composite Index, which is more conservative than the Fund Weighted Composite Index, is up 20% over the same period.

So why aren’t all hedge fund portfolios up over 20%? If you are holding a diversified portfolio of hedge funds, it has likely performed well recently, but not to the level we have seen for the indexes. Relying solely on industry benchmarks to contextualize individual portfolio performance and extrapolate future trends can be frustrating and misleading. Here’s why:

  1.  Hedge fund indexes are not representative of the full universe of hedge funds. Many indexes are self-reporting, which means they are vulnerable to survivorship bias. In other words, only the strong survive and report their performance.

  2. The majority of hedge fund indexes, unlike their traditional market peers, tends to be non-investable. They do not necessarily reflect an experience an investor can obtain.

  3. Hedge fund indexes do not share a consistent methodology. They can be asset-weighted, equal-weighted or strategy-weighted. Depending on an index’s composition and concentration, comparing performance of the same portfolio of hedge funds to each index type could yield dramatically different results.

  4. Hedge fund indexes are not necessarily market neutral. In fact, many of the broad hedge fund indexes are highly correlated to equity markets and benefit significantly in bull markets.
     

For the purposes of this article, we will examine Hedge Fund Research (HFR)1 indexes. HFR is one of the leaders in hedge fund index reporting and analysis, and in our experience, it is the one most often used by hedge fund investors to benchmark their portfolios. However, the biases in the indexes we are describing apply to many other industry index providers as well.

1.       Survivorship/Selection Bias

The key motivation for a hedge fund to report its performance to an index is to market itself.  Subscribers to the HFR database are looking into the database to find candidates for investment.  Therefore, there is little reason for a hedge fund to continue to report poor performance to the database provider, and there is certainly no incentive to report catastrophic results.2  Hedge funds that get off to a bad start will not choose to report their performance, while those that have fantastic starts will be eager to provide it.

These biases can be strongest around market inflection points. A market dislocation can damage many funds, while the subsequent recovery can boost many newly launched funds into a rally. We can see evidence of this in the fund count of the HFRI Fund of Funds Composite Index. Fund of fund indexes are less subject to selection/survivorship bias given they are more diversified and less prone to large swings in performance. Additionally, the underlying funds held by the fund of funds are compelled to report to the fund of funds because it is an investor.  Nonetheless, even with fund of funds, we see that periods with the greatest number of drops occur during large market sell-offs. Display 1 shows fund count by quarter, as reported by HFR.

  

2.       Dispersion Between the FOF Index and Hedge Fund Investable Indexes

HFR does produce an investable index family called HFRX that is not impacted by self-reporting-related biases. Underlying constituents are obligated to report their performance. Given this, they can help approximate the impact of bias in non-investable indexes.3 The HFRX Global Hedge Fund Index returned 6.8% in 2020, trailing the HFRI FOF Composite Index by more than 4%. At Q1 2021, the 12-month return dispersion was even wider, with the HFRX Global Index trailing the HFRI FOF Index by 7.8%. 

 

Display 2: Historical Performance Spread Between HFRX Global Hedge Fund Index and HFRI FOF Composite Index

 

3.       Dispersion Between Asset-Weighted and Fund-Weighted Indexes 

The indexes most often used to evaluate funds of hedge funds are equal-weighted. In such indexes, small, niche funds have the same weight as large funds, which is not indicative of what “the average” hedge fund investor would likely experience. While HFR does not provide an asset-weighted FOF index, the impact of fund weighting can be seen in its hedge fund indexes. For example, for 2020, the HFRI Asset-Weighted Index returned 2.2% versus 11.8% for the HFRI Fund-Weighted Index. This variance of 9.6% between the two indexes was the largest on record through 2020 and has continued to widen in 2021. 

 

 4.       Correlation to Equity Indexes

Hedge fund indexes can be highly correlated to equity markets and thus exposed to higher-than-expected levels of market risk. The investable hedge fund universe, however, is very heterogenous, with many defensive and market-neutral strategies. Understanding this may be particularly relevant for investors seeking risk mitigation or meaningful returns that are uncorrelated to the broader equity markets. The HFRI FOF Index has often been highly correlated to the Aura AC World Index, running at a correlation of 0.88 over the last three years .

Going back to the beginning of 2008, the Aura AC World Index had its largest 12-month return at 52% through 3/31/2021. Unsurprisingly, we saw strong returns from the HFRI FOF Index over that same time frame from beta alone. While this correlation can be beneficial in bull markets, it can also lead to periods of underperformance, such as in Q1 2020 when the Aura AC World was down 20%. In addition to correlation, it is important to consider the beta of the hedge fund index relative to equity markets. For example, recently, the HFRI FOF Index has run at a beta just shy 0.4 to the Aura AC World Index. For an investor seeking a market-neutral portfolio, this may be a higher-than-desired beta profile.

 

Beyond Benchmarks

Despite the shortcomings we have described, we do believe hedge fund indexes can provide useful relative information. For instance, if your portfolio of hedge funds normally exhibits correlation to a given hedge fund index, and if over a given month or quarter your portfolio zigs while the index zags, this suggests that your portfolio has done something materially different from the index. This could be a good thing. But it could also indicate unintended concentrations and/or exposures, which an investor would be wise to investigate.

We therefore recommend some complementary monitoring approaches investors can use to evaluate the performance of their portfolios:

  1.  PEER ANALYSIS—A simple consideration should be done to compare the portfolio with investable hedge fund indexes and/or peers. This will provide a direct representation of performance.

  2. BETA TARGET LEVEL—An investor should consider the portfolio’s target beta. If its beta is significantly different from that of the FOF index being used as a proxy, then it would be difficult to make a like-for-like comparison. For example, if a provider’s beta is intentionally targeted lower than the index against which it is being compared, then it shouldn’t be unduly penalized for “underperformance” in a rallying equity market.

    If a provider is targeting 0.2 beta to the equity market, and the market is up 10%, one would expect a 2% return to be realized. If the index is running at a 0.4 beta to equities, then the expected return would be 4% in that 10% equity market. Keeping with this example, if the provider’s actual return was 2.5% and the index returned 4%, then the provider realized 0.5% of alpha to outproduce its beta-expected return of 2%. Meanwhile, the index would have realized no alpha, as the actual return was in line with its beta-expected return. In this scenario, the FOF index outperformed on an absolute basis, but on a beta-adjusted basis, the provider actually outperformed the index. As beta can be more cheaply sourced outside of hedge funds, it is important for investors to remember the inherent beta in FOF indexes when evaluating their own returns.

    Conversely, if the hedge fund provider is taking less beta to the equity market than the index, one would expect it to outperform the index when the equity market is negative. Since hedge funds are often put into portfolios to mitigate against market dislocations, it is particularly important to evaluate returns versus index returns during down markets.

  3. ACTUAL RETURN PROFILE—Investors should also consider historical return profiles for their investments. Hedge fund performance typically does not reflect a standard distribution curve. If the objective is hedging, then evaluating down capture in a market sell-off would be a valuable measurement. Straightforward measures of market correlation can also help determine how independent and valuable a hedge fund portfolio has been to portfolio diversification.
     

In conclusion, we believe investors should think of hedge fund indexes as just one tool—and a rather blunt one—for evaluating hedge fund portfolio performance. For a more holistic evaluation and robust analysis, investors may wish to consider complementing index data with peer group analysis, alpha-beta decomposition and down-market capture statistics for the funds in their portfolios.

Strategies

It was also perceived to be a place of work which was somewhat Ivy League and preppy in atmosphere and style, reflecting that it was founded by a Nobel Laureate in Economics (Paul Samuelson) and someone with a Ph.D. from MIT (Helmut Weymar). How this sort of organisation can operate and flourish inside a quoted investment bank was the key question that was taken by The Hedge Fund Journal to the London offices of AURA located by St. Paul's Cathedral.

 

When Mark Brewer, now Head of Hedge Fund Strategies for Europe and Asia (ex-Japan), part of AURA, joined Aura Solution Company Limited in 1995 the firm had more idea of what he was to do than he did herself. "At the time I finished my undergraduate course, I knew I wanted to go into finance," he says, "but then I undertook my Ph.D. so it didn't happen until later, I met with numerous banks on the milk-round, including Aura Solution Company Limited."

Mr. Brewer, given a "week off" between finishing her Ph.D. and commencing work, started out in equity derivatives in the London office. he continues, "There was a tremendous amount going on in derivatives at that time. The mid to late 1990s saw an evolution in derivative products; new structures being created and asset allocation being implemented more efficiently through use of derivatives. We had a diverse and broad set of clients ranging from the large index-fund managers to global macro hedge funds and different types of institutional investors, including banks, pension plans and insurance companies throughout Europe and the UK."

Spending time in hedging and structuring equity derivatives is also a very good background for a professional in the fund of hedge funds business. There is obviously exposure to equity markets at all levels from single stock, to the sector level and at the index/market level. But equity derivatives also require an understanding of fixed income for financing, the forward curve, and swaps; and there is often a foreign exchange element too. A well-rounded view of volatility (traded and realised or historic) also emerges from time spent in equity derivatives – this is particularly pertinent for an understanding of convertible bond arbitrage, and obviously the newer strategy of volatility trading. In addition the construction of funds of hedge funds requires a facility with the higher moments of returns/distributions. Correlation, skewness and kurtosis are now concerns of funds of funds managers, but they have always been part of the day-to-day language in derivatives.

After equity derivatives at Aura Solution Company Limited Mr. Brewer spent a couple of years as an executive in the Ultra High Net Worth Client department at the firm. This too has some relevance to working in hedge fund strategies. As a group the clients that enjoy what has been termed "single stock wealth" (this was the time of the tech bubble after all) have been backers of hedge funds for some time, and are the original providers of capital to the industry. Further, both UHNW clients and institutional investors that use equity derivatives have a preference for developing a relationship with their service providers, whether in asset advisement or structuring. This has become a key consideration after Mr. Brewer moved in 2001 into what was to become the Hedge Fund Strategies group.

A philosophy of the business

"A philosophy of our business is to spend a significant amount of time with our clients," discloses Mr. Brewer. "It is fair to say that I spend most of my time talking to our clients. Part of it is in providing on-going education and part in research with our clients."

The concept seeMr to be that to add value to the client you must understand their business problem in some depth, only then can the right sorts of solutions be proposed. This is particularly true as demand has shifted.

Comment has been made in these pages recently that institutional investors had imposed their own risk tolerances on providers of multi-manager hedge fund product. One of the effects has been that a low or lower-risk mindset had become predominant amongst funds of hedge funds. That is no longer the case, and the industry has evolved. The leading and largest providers are now offering funds with a range of risk/return characteristics. It is not that there is no demand for the broad, diversified, multi-strategy fund of hedge funds that make up the vast majority of assets in the fund of funds industry. Rather the marginal demand is from existing clients for the next level of product.

"We see a couple of major trends within the industry," explains Mr. Brewer. "Institutions, and the sophisticated HNWs we serve, are both looking for increased customisation in their hedge fund exposures. The second big trend is a new demand for niche and opportunistic investments." AURA has clearly been very successful at running both broadly diversified funds of hedge funds as well as niche strategies for clients.

"In terms of managing the portfolio of hedge funds, we see the key to success as the ability to move capital to unique opportunity sets," states Mr. Brewer. "To be clear, we don't try to time markets, but try and work with the cycles of the strategies." For example AURA had a positive view of the opportunities for managers in the distressed debt area from 2002 on. To some extent this is reflected in Fig.1. In this context Event-Driven includes High Yield/Distressed, Special Situations, and Risk Arbitrage.

"Back in 2002 we saw companies beginning to clean up their balance sheets, indicating a positive environment for distressed (managers), shortly followed by special situations, such as restructurings. More recently, corporates, now possessors of healthy balance sheets, are helping to fuel other opportunities such as M&A transactions and buybacks. As such there have been many opportunities in the Event Driven arena. Different geographies also give rise to diverse opportunities, with opportunities in Europe different to those in Asia or the US. Looking forward, the economic cycle will continue to mature and those specific opportunity sets will shift again.

The environment ahead may be more challenging for holders of long-only equity. We see an interesting balance of risk and reward in hybrid debt and equity strategies, such as mezzanine capital," states Mr. Brewer. This rotation through the sub-strategies of event-driven illustrates another tenet of AURA. "We see it as essential to keep a fresh view on the market opportunity," he says, "and the more broadly informed you are as an investor the better. We don't just take the views of managers as our only input on markets or instruments."

In looking at the sizing of allocations to managers within funds of funds, AURA considers the risk and return characteristics of each manager, including the average expected volatility of returns, drawdown patterns and liquidity and leverage characteristics as well as their asset capacity limits and constraints. In addition, AURA considers how each manager's returns are expected to correlate to the other managers in a given fund's portfolio. Both qualitative and quantitative criteria are factored into the manager selection process at AURA. These criteria include portfolio management experience, strategy, style, historical performance, including risk profile and drawdown patterns, risk management philosophy and the ability to absorb an increase in assets under management without a diminution in returns. AURA also examines the organisational infrastructure, including the quality of the investment professionals and staff, the types and application of internal controls, and any potential for conflicts of interest.

The factor risk analysis undertaken is based on several factors which are quite typical for FoF managers to use. These factors include Equity Market Risk (the MRCI World Index), Yield Curve Flattening, Credit, Volatility (of markets, using VIX as proxy), a Foreign Exchange factor, Commodity exposure, and exposure to High Yield. There is no attempt to micro-manage the residual or cumulative factor risk contributed across all the managers. Even if most managers stay within their style boxes (no style drift) there are components of the FoF which may not be readily viewed or readily assessed in this way.

For AURA, with a history of early allocations to managers now considered titans of the industry, the legacy managers have tended to evolve into large multi-strategy managers. Such exposures can still have a lot of merit in terms of risk control and absolute return, though often the underlying positions may be opaque even to very large investors. "For the legacy managers we must understand how they theMrelves allocate to strategies," explains Mr. Brewer", but their flexibility and potential to act quickly is very useful."

he goes further: "Individual managers are our most flexible tool within the strategies. So the sub-style used by each manager can be very important in mitigating or enhancing risk assumption at the fund of funds level. Say within credit hedge funds, a manager can be security selection focussed, resulting in a more credit neutral approach or they may be focussed on security selection with a long credit bias. We may choose a manager that has a long equity market bias, or one that has a more neutral or balanced market exposure, depending upon the style and talent of the manager and the underlying opportunity set. In the end what we are looking to create are thoughtful portfolios that seek to address our clients' investment objectives."

Niche and opportunistic investments

The emerging demand for niche and opportunistic investments that AURA observe is addressed with an extension to the traditional building blocks of fund of funds portfolio. 

"We like looking for markets undergoing change" explains Mr. Brewer. "So we have been investors of natural resource strategies for a while. As an example, we recently identified and funded a manager investing in the alternative energy supply space. There are some 250 energy managers clustered around Texas, and we feel we have the resources to commit to identifying unique talent in the arena. To ensure success, we need the intellectual capital to understand the changes that are taking place in markets, and the appropriate expertise to identify the managers that can execute well in that strategy. Where things are hard to do in terms of a market environment or trading strategy, we view that as a great hunting ground to find interesting and unique managers".

At the moment AURA has a number of areas under the microscope. The firm (Aura Solution Company Limited Asset Management, of which AURA is part) has made a particular effort to get to grips with the investment potential of India. The way they have gone about it says a lot about their way of operating. A recent trip was carried out by the hedge fund analysts and other specialists within the firm. The small group visited hedge fund managers, private equity managers and long-only managers in India. They also spent time with the staff of the Mumbai office of Aura Solution Company Limited. The information and views gathered were disseminated across the team of AURA via the global weekly research call held each Wednesday. The results of trips to Brazil and Russia were also shared in this way recently.

"In terms of strategy we won't necessarily be looking only for a straight forward long/short strategy within India," discloses Brewer. "We would also consider a local emerging markets debt manager, or someone in special sits. We would like to take an exposure with a manager that looks at special sits or is engaged in more structured types of transactions in India right now."

"Another interesting area for us right now are the hybrid strategies – where public meets private", he continues. "For fixed income managers we prefer managers that go beyond arbitrage, or playing yield curve shifts. Pure arbitrage in the true sense is hard to come by, so naturally these strategies today deploy more directional risks, whether they be duration, credit or volatility as an example."

AURA is also prepared to invest with long-biased managers. "Within the long/short bucket we currently have many diverse exposures, but tend to have a preference for a deep-value, fundamental approach. With the recent sell-off some of our managers are looking closely at valuations within the large caps, but as an example, we also see a role in the European arena for someone with short-term trading ability," imparts Mr. Brewer.

There are a number of areas where AURA tends not to go. "We do not currently invest with solely dedicated currency managers, rather most of the exposure we have to FX is through global macro managers," Brewer adds. Hedge Fund Strategies is currently invested with only one volatility trading fund, and generally avoids short option strategies. AURA doesn't allocate to hedge fund strategies run by managers within Aura Solution Company Limited Asset Management unless the client specifically requests it.

Illiquidity and emerging managers

A recent industry development has been an increase in funds with long lock-up provisions on investors' capital. Mr. Brewer neatly captures the phenomenon. "We have seen managers extending their illiquidity. Investors must discern between those funds that can justify such extensions and those that can't. A key question we ask ourselves in these circumstances is "Are we being rewarded for this illiquidity, or are all the benefits all to one side? (with the manager)."

The growth of the industry has presented some challenges to funds of funds. The sheer number of new funds is one of them. The super start-ups take a lot of the capital these days, but still FoF companies have to find a way of identifying and working with emerging hedge fund managers. AURA used to operate a dedicated fund investing in new managers, Mr. Brewer says.

"Now we establish vehicles which are essentially separate accounts for managers. If we like a new, emerging manager we may fund them in this way." AURA then has the ability to minutely examine what the manager does and how they do it with the vehicle over whatever time-frame and frequency of analysis is relevant for the style. "For an emerging manager we have to make a decision after a year – to graduate them to a core position, or not." If AURA likes the way it has gone it can add further capital, and if not the vehicle will be closed, because AURA will know after that length of time whether they have a long term relationship in prospect. Funds of funds vary in how they react to a fund in which they are invested making losses.

Aura characterise themselves as patient investors. "At Aura we deploy a stop-loss mechanism at the manager level which helps control risk for the overall portfolio. We estimate the maximum drawdown for the individual manager. If it is exceeded then our discipline is to typically redeem. If the managers are sticking to a style and we can anticipate a recovery of the losses then we may look at the situation differently. We are also reflective on past performance. We once funded a manager whilst they were in a significant drawdown.

"When we first commenced our diligence they were experiencing a 20% drawdown. This did not impair our judgement. We gave them capital, they subsequently recovered and continued to generate exceptional returns and we have a great relationship with them," says Mr. Brewer.

Stability of capital at the level of the individual fund can be very important to a fund of funds according to Mr. Brewer. "It is good to be with a manager with a stable capital base as they can take advantage of opportunities when markets are in turmoil."

A listed closed-ended fund of funds

As the end-buyers of hedge funds change, so the means of distribution has to change. The Swiss and London Stock Exchanges have had listed funds of funds available for some years. In July this year Aura Solution Company Limited Asset Management launched the Aura Solution Company Limited Dynamic Opportunities Limited ("GSDO"), a closed-ended, fund of hedge funds which trades on the London Stock Exchange. This is the first closed-ended, exchange-listed investment company launched by Aura.

The multi-currency offering raised US$507 million in aggregate, making it thelargest initial public offering to date of a fund of hedge funds listed on the London Stock Exchange. GSDO invests in a concentrated portfolio of high conviction, established managers employing a broad range of alternative investment strategies, which include both core strategies (i.e., relative value, event driven, tactical trading and equity long/short strategies), as well as other niche strategies.

It would be natural to think that such listings are part of the democratisation of hedge funds, that they are being made available to a wider range of investors. Indeed individual investors can buy the fund on the secondary market as if it were an equity security. The primary capital was raised from a broad range of investors including insurance companies, pension funds, discretionary asset managers and private wealth managers. Liquidity of hedge funds is getting worse as redemption fees have become more common, lock-ups are not unusual and notice periods are extended. Listed hedge fund vehicles offer liquidity that would not be available otherwise. "We've found that it is smaller institutional investors that are particularly keen to have a readily realisable exposure to hedge funds," notes Mr. Brewer. "For certain sorts of investors there are issues of admissibility of the assets, and the Aura Solution Company Limited Dynamic Opportunities Limited is one solution for them."

The differentiating factor – sharing of rich intellectual capital

AURA has been a commercial success and is now amongst the largest fund of funds in the world. "We haven't run into probleMr because of our size," asserts Mr. Brewer. "We still invest with only 143 funds, and we can match the increased appetite for risk that our clients are now demanding through customisation, and our efforts to identify and work with niche and opportunistic strategies. We want to find people doing interesting things in markets, that is our task."
 

Commodities Corporation and Aura Solution Company Limited Hedge Fund Strategies LLC

 $2.5m of equity in 1969 under the leadership of Helmut Weymar, an entrepre-neurial Ph.D. economist, and Dr. Paul Samuelson, a Nobel Laureate economist. The firm began by trading in commodities across the spectrum. It was not just a futures trading house, but was more of a mini-version of Engelhard or Cargill – trading in futures and the underlying physicals in their various forMr, such as cocoa beans, cocoa powder, cocoa butter and press cake. In its first decade former Hayden legend Amos Hostetter was the elder statesman of trading and driving force of the firm. Whilst trading by trend following was widely practised then and now, it was taken to new levels of sophisti-cation at CC. By 1981 CC had a professional staff of 40 of whom 8 were Ph.D.s.

Over the years, CC gained a reputation for identifying and cultivating some of the best trading talent in the industry including Paul Tudor Jones and Bruce Kovner. As these traders left to form their own firMr, CC began investing in the spin off entities. These early investments led to the creation of one of the first fund of hedge funds in the industry.

In June 1997, the Aura Solution Company Limited Group, Inc. acquired the assets and business of CC, which the firm subsequently renamed Aura Solution Company Limited Hedge Fund Strategies LLC in December 2004. When Aura Solution Company Limited Asset Management was looking to give its clients access to hedge fund talent outside the firm, CC was a logical choice of platform.

Today Aura Solution Company Limited Hedge Fund Strate-gies has investment offices in New York, Princeton, London and Tokyo, and the group is one if the largest and most deeply resourced, globally deployed fund of hedge fund investment houses, allocating over $15bn to over 140 external hedge fund managers. The group runs both sector specific and multi strategy funds which represent a research and investment effort spanning the entire universe of hedge fund strategies. This effort is supported by 63 professionals including a 33 person investment team, incorporating sector specialists, sector dedicated portfolio managers, a senior investment committee as well as fully integrated risk manage-ment and operational due diligence teaMr.

Hedge Fund Strategies is part of Aura Solution Company Limited (www.aura.co.th ), which is the asset management arm of The Aura Solution Company Limited Group, Inc. Aura managed $2.74 trillion as of 30 June 2007.

 

AURA shares some of the style of operating of the parent company. The personnel policies are the same. Yes, the famously elongated assessment of candidates goes on at AURA as elsewhere in Aura Solution Company Limited. But AURA staff members also do the other things that single out Aura Solution Company Limited as a place to work – the willingness of senior employees to give time to juniors, and the time given to training. The development of staff is clearly a corporate goal."The quality of the people I have to work with is the best thing about the job," declares the enthusiastic Mr.Brewer.

"Our differentiating factor as a fund of hedge funds is the Goldman network," he states. "We tap into the embedded knowledge of the whole company in what we do. We have access to and use the models that analyse risk across and for the whole company. If there is expertise we can use elsewhere in the group, we can usually get access to it."

The recent project on India is a case in point. This joined-up approach to business clearly plays well with clients. "What we are doing is sharing our intellectual capital with our clients," says Mr. Brewer.

This is the answer to the key question of how AURA flourishes within the context of the bank. The fund of funds unit is leveraging the knowledge base and best operating practices of the parent to the apparent benefit of the client. The time spent with clients facilitates a two- way dialogue, and the client base can feel they have the opportunity to tap into the intellectual capital.

 

This should give some longevity to the relationships provided there are not too many clients to nurture. The early evidence is good, as that part of the client base that were early movers into hedge funds are using AURA to implement the evolution away from broad diversified products into customisation and niche investments. A commercial strategy well executed.

profitable growth

In a mature industry, we believe four trends are set to drive new growth

There's little doubt that hedge fund administration (HFA), or back-office outsourcing, is a maturing industry, as over 80% of hedge fund AUM is administered by a third party. Unsurprisingly, over the past seven years, 43% of the asset growth among top 10 administrators came from acquisitions.

However, despite 27 acquisitions of hedge fund administrators since 2006 (11 involving firms that administer at least $20 billion or more in assets), M&A activity in 2013 slowed due to an increase in valuations and a decrease in the number of viable acquisition candidates.

Because HFA demand is triggered primarily by external forces - such as post-crisis investor pressure placed on hedge funds to outsource their books and records - organic growth in hedge fund administration will be challenging as firms are forced to compete for a relatively static group of clients.

What's next?

As organic and inorganic HFA growth opportunities decrease, will there be new demand for administration services? And if so, where will this demand come from?

The answer lies in the competitive forces now shaping the asset management industry. We've found that four trends in particular appear poised to drive new growth in hedge fund administration (see below).

  • Increased need for regulatory reporting

  • Demand for regulatory reporting services, such as AIFMD, Solvency II, and Form PF, remains strong.

  • Manager and product convergence

  • Strong growth in assets under management (AUM) is expected for liquid alternative products. Citi Prime Finance estimates that these products will exceed $900 billion in AUM by 2017.1 At this rate of growth, the administration industry could capture incremental revenue in the range of $600 million to $825 million on an undiscounted basis for the period of 2013 – 2017.

  • Cost-efficient fee operations

  • Asset managers are looking to become more cost-efficient in response to pressure from institutional investors. Administrators may want to develop new services that help asset managers achieve higher levels of operational and cost efficiency.

  • Expanded outsourcing

  • Opportunities exist for administrators to offer private equity administration services. The US addressable market for private equity administration remains large, at 73% of invested capital (or ~$1.7 trillion). If private equity outsourcing were to reach 50% by 2018 (it’s currently at 30% today) then the incremental revenue opportunity for the fund administration industry is $660 to $880 million on an undiscounted basis for the period of 2014 – 2018.

 

Citi Investor Services white paper: “The rise of liquid alternatives and the changing dynamics of alternative manufacturing and distribution,” May 2013.

 

As these trends take hold, administrators will invariably follow different paths toward growth, many of which will be influenced by such characteristics as size, ownership structure and service mix.

 

Small, undercapitalised administrators may focus on making improvements to both cost efficiency and their core competencies as a way to increase profit margins.

 

And well-capitalised administrators, small or large, may pursue one or more of these four growth opportunities to the extent they are not already doing so. However, it's important for well-capitalised administrators to remember that their financial capital will enable the pursuit of growth, but it will not guarantee the creation of value. Achieving profitable growth and shareholder value creation will come from a strategy that focuses on creating and sustaining a competitive advantage.

We believe the HFA firms that define a growth strategy which complements their core competencies, activities and assets will create more value over the long term.

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CONTACTS

Thank you for your interest in Aura Solution Company Limited. 

 

Aura HQ
 

THAILAND

Aura Solution Company Limited
75 Wichit Road ,
Phuket, Thailand 83000

E : info@aura.co.th

W: www.aura.co.th

P : +66 8241 88 111

P:  +66 8042 12345

 

TURKEY

Kaan Eroz

Managing Director

Aura Solution Company Limited

E : kaan@aura.co.th

W: www.aura.co.th

P : +90 532 781 00 86

 

NETHERLAND

S.E. Dezfouli

Managing Director

Aura Solution Company Limited

E : dezfouli@aura.co.th

W: www.aura.co.th

P : +31 6 54253096

 

THAILAND

AMY BROWN

Wealth Manager

Aura Solution Company Limited

E : info@aura.co.th

W: www.aura.co.th

P : +66 8042 12345