Research shows that hedge fund investors naively allocate to winning investment strategies.
Fiona Rintoul asks if this increases the case for regulation through the controversial AIFM Directive
Just as the debate about hedge fund regulation was heating up earlier this year, the European School of Management & Technology (ESMT) in Berlin released new research to add fuel to the fire. The research, which followed 1,543 hedge funds over ten years and was produced in collaboration with the Rotterdam School of Management, showed that investors systematically reward investment styles that have performed well over the previous three quarters, substituting one investment style for another regardless of whether this means they will be taking on higher levels of risk.
According to ESMT, the research is the first to show correlated investment behaviour based on style. Previous studies had not separated out style-based choices from choices based on the performance of an individual manager or fund – and the Berlin-based school drew far-reaching conclusions from the results.
“We have a two-fold issue here: whether investors’ naivety is leaving them overly exposed to risk they are not properly evaluating, and whether the growth of the hedge fund industry, combined with that naivety, means the sector poses a threat to financial stability,” says Guillermo Baquero, assistant professor at the ESMT and an author of the research.
The Alternative Investment Fund Managers (AIFM) Directive has polarised opinion. It’s fair to say that hedge funds are not warmly embraced by everyone in Europe. At the same time, many in the alternative investment industry see the AIFM Directive at best, as a knee-jerk reaction to the crisis and at worst as politically motivated. The word ‘vendetta’ passes some lips.
‘It wasn’t us,’ the industry protests. This can sound a little like foot stamping, but there is quite a lot of evidence stacked up in hedge funds’ favour.
“It’s very important to note that several think tanks and central banks have come to the conclusion that hedge funds were not responsible for the credit crisis,” says Chris Manser, global head of fund of hedge funds at Axa Investment Management.
But what of the ESMT research, which, not to put too fine a point on it, seems to show that investors are daft as brushes when it comes to choosing hedge funds?
“You cannot stop investors chasing performance,” says Yunus Mangera, legal counsel at Key Asset Management, and this is certainly the case. It is also true that investors chase performance in other asset classes and that this does not always mitigate in favour of market stability.
Particularly worrying, however, is ESMT’s conclusion that investors are highly likely to reward the very extreme movements in style that are often associated with the riskiest areas of hedge fund investment.
Levels of sophistication
“Despite the perception that hedge fund investors are more sophisticated, our research suggests that this is not the case and that investors are overly reliant on yesterday’s performance,” says Banquero. “This is particularly worrying at a style level, as investors are, in effect, moving in and out of strategies irrespective of whether they are exposing themselves to higher or inappropriate levels of risk for their needs.”
Well, there are hedge fund investors and there are hedge fund investors, suggests Robert Howie, European head of alternatives research at Mercers, the investment consulting firm. Less sophisticated hedge fund investors, such as private banks and high-net-worth individuals, although they may have substantial assets to invest, may not have a great information flow on which to base their decisions and may use past performance as a guide.
“Some investors are performance chasers and some are not,” says Howie. “Based on the research we do, the average pension fund typically accesses hedge funds through funds of funds and has a long-term horizon. Pension fund money is sometimes sticky for the wrong reasons, but it is also sticky for the right reasons.”
At the level of individual investor risk, it is of course pension funds that provoke the greatest concern among governments and the public. But pension funds are also the investors who need hedge funds the most, according to Jeff Holland, a director at Liongate Capital Management.
“European pension funds have real issues with being underfunded,” says Holland. “Pension funds need access to hedge funds for the better risk-adjusted returns hedge funds offer.”
The trouble with the draft AIFM Directive on the table – and it’s very much a work in progress with discussions now slated to last until September – is that it could restrict the access that pension funds arguably need to hedge funds if, for example, the so-called third-country provisions are adopted, or make it more expensive. The consultancy Kinetic Partners has estimated that the cost of implementing the directive for the UK industry alone would be £2-3bn (€2.4-3.6bn), though others have suggested this estimate is too high.
“Start-up costs will be higher and it will be more difficult to launch a hedge fund in the way they have been launched in the past,” says Mangera. “The cost of the compliance information you will need to market across Europe could be prohibitive for funds without significant assets.”
There’s another problem too. “There’s a lot of negative press from politicians and journalists,” says Manser. “That makes it more difficult to allocate to the asset class.”
And, of course, the AIFM Directive doesn’t just apply to hedge funds, it applies to private equity funds too, creating a whole new set of problems. Importantly, caps on leverage could mean that private equity funds would be at a disadvantage compared to other deal chasers, such as family offices.
So, how did we reach this point? It is perhaps worth revisiting ESMT’s research, which basically shows that investors do not allocate intelligently to hedge funds and it raises concerns that this problem will intensify as the universe of potential hedge fund investors expands.
“Given that the minimum investment thresholds for hedge fund investing have come down substantially in recent years, expanding the market and opening it up to retail investors, it is important to consider the level of risk hedge funds – and misinformed capital flows – may pose,” says Banquero.
Again, the industry counters that institutional investors we care about the most know what they’re doing. “It’s resource intense. You need specialists,” says Manser. “But institutions are clued up. Unless you can build up internal resources, you should outsource it to a fund of hedge funds.”
The need for regulation
Nonetheless, we can all understand why people might be concerned about expanding capital flows to hedge funds, misinformed or otherwise. We all remember LTCM and more recently Madoff. But what to do about it?
“We should not be scared to tighten the regulatory screw on the hedge fund industry and force considerably greater disclosure,” says ESMT’s Banquero. “Now is the time to discuss deep, substantial and effective regulation that will genuinely be of use to investors and protect our financial system for the future.”
In this, Banquero is probably not that far away from many in the hedge fund industry. “There have been some failures,” says Holland. “As a percentage they are quite small but they attract headlines. Overall, we feel hedge fund investing makes markets more efficient provided there are sensible limitations on hedge funds and how they behave. Sensible rules that prevent financial instability are good for everyone. It’s not good for the hedge fund industry if a hedge fund fails.”
“If you go right back to what the directive was trying to achieve – ensuring financial stability and protecting investors – there’s very little to object to,” says Howie.
The trouble is most people in the alternative investment industry don’t believe the AIFM Directive will provide the sensible rules that would meet those objectives. But the directive is not all bad. Manser says one positive would be increased transparency and “transparency is always good”, while Mangera welcomes the possibility of an EU passport for hedge funds, though it is not clear if that will make the final draft.
But overall there is a feeling that the directive was cobbled together for political reasons by people who don’t really understand the industry.
“What we have is something that is much more politically motivated,” says Holland. “What’s been proposed is designed to meet a populist agenda. We have a set of proposed rules that are over-reaching and haven’t been thought through.”
Meanwhile, there’s another question for the alternative investment industry to ponder: how did it come to be so hated by politicians, the public and mainstream journalists? Why was there so little consultation with the industry in the preparation of the directive?
“There’s a bit of blame on the industry overall in terms of dealing with the public,” says Blair Hedges, head of operational due diligence at Liongate Capital Management. “We haven’t been very good at helping the public to understand what we do.”
Whatever the final shape of the directive, the industry will adapt, says Howie. In any case, the line between alternative and traditional investments is blurring. “If you look at fixed income, there are very few managers who run old-fashioned, long-only portfolios that don’t use derivatives.”
Perhaps the hedge fund industry will even learn to communicate better and will become, if not loved, at least not actively despised. “If hedge funds can prove they are adding value for their clients and not causing systemic risk to the financial system, the situation will be a lot healthier and there will be a steady increase of assets in hedge funds as people diversify their portfolios,” says Howie.
But whatever the final form of the directive, there is one thing it will not be able to guard against. “We can do better as an industry but it doesn’t mean people will not make bad judgement calls,” says Manser.
©2010 funds europe