GAIM: Liquid alternatives' AuM could soon rival hedge funds
Liquid alternatives, such as ’40 Act alternative mutual funds and absolute return UCITS, are where exchange traded funds (ETFs) were in 2006, while some speculate the sector could rival offshore hedge funds by assets within five years.
A Barclays Prime Services study revealed liquid alternatives grew by 43% in 2013 while hedge funds saw their assets grow by 15% to reach $2.6 trillion.
“We feel liquid alternatives today are in a similar position to ETFs in 2006, and they are something we looking at closely. Liquid alternatives are cheaper than hedge funds, and offer better transparency through their daily Net Asset Value (NAV) disclosures to us,” said Stephanie Margaronis, chief executive officer (CEO) at Targamar, a family office in London, speaking at the GAIM conference in Monte Carlo.
The Barclays study – Developments and Opportunities for Hedge Fund Managers in the ’40 Act space - said it estimated assets controlled by liquid alternatives will reach between $650 billion and $950 billion by 2018. A growing chorus of service providers are predicting sizeable inflows into liquid alternatives. Citi Prime Finance said it expected $939 billion to flow into liquid alternatives by 2017. Meanwhile, McKinsey & Co estimated retail assets had grown by 21% annually since 2005 with the liquid alternatives sector now managing around $700 billion.
Others go further. “My view is that ’40 Act alternative mutual funds will grow substantially and could be nearly as big as the offshore industry having seen the inflows in 2013,” said one fund manager, speaking under Chatham House Rules.
Liquid alternatives in the US are still in their infancy though. The Barclays study said they comprise just 1%, or $137 billion of the $13.2 trillion presently controlled by the entire US mutual funds industry. Hedge funds themselves account for one third of that $137 billion. Meanwhile absolute return UCITS funds account for €231 billion of the €10 trillion UCITS space. “I believe the EU’s Alternative Investment Fund Managers Directive (AIFMD) will facilitate an increase in absolute return UCITS funds,” said the manager.
Managers themselves are sufficiently bullish on '40 Act products. Ninety per-cent of managers told the Barclays survey they expected at least ‘moderate’ growth in 40 Act products. A Deutsche Bank Markets Prime Finance survey of 60 hedge funds with collective AuM of $528 billion in December 2013 found nearly half were already running a traditional long-only product.
The driver behind this growth is primarily retail investor interest, said the Barclays survey. However, detractors of liquid alternatives routinely point out these vehicles underperform hedge funds. While this is true to an extent, 40 Act products managed by hedge fund managers delivered an annualised return of 1.6% over the last six years, just shy of the 2.3% posted by the average hedge fund.
Several brand name private equity and hedge funds, most notably AQR, Blackstone and Apollo Global Management have recognised the distribution opportunities, and developed vehicles aimed squarely at retail clients, with minimum investments of as low as $2,500 in some cases. AQR has been one of the biggest enthusiasts for retail alternatives, having launched 20 mutual funds which are now running $9.2 billion in AuM.
The distribution opportunities for '40 Act alternative vehicles are potentially enormous. Barclays highlighted there was approximately $19 trillion in assets up for grabs from defined contribution (DC) pension schemes, individual retirement accounts, annuity reserves, broker-dealers and registered investment advisers (RIAs).
One of the key investor targets among managers running regulated alternatives will be the DC plans. A report by SEI said 60% of the DC plan market’s $5.1 trillion in assets was parked in mutual funds, adding this investor class had historically been averse to alternatives. Nonetheless, the SEI report added plan sponsors had become emboldened and were increasingly investing in real estate, inflation protected treasuries and commodities in search for greater yield.
Given all of this enthusiasm and publicity, it is unsurprising regulators are taking more interest of these products. In April 2014, the SEC said it would examine around 25 liquid alternative mutual funds over the coming few months. The SEC is likely to look at how these liquid alternative mutual funds are generating returns and the risks they are taking, in addition to leverage and liquidity.
The SEC’s scrutiny of liquid alternatives mirrors concerns at the European Securities and Markets Authority (ESMA) over some of the strategies employed by UCITS funds. ESMA is likely to initiative a clampdown on managers running illiquid strategies within UCITS and recently instigated guidelines that made it harder for Commodity Trading Advisors (CTAs) to run UCITS. Some have warned liquid alternative funds in the US could face similar pressures.
“The issue of a ’40 Act alternative mutual fund or UCITS vehicle blowing up is a problem. There is a risk that some UCITS funds offering daily liquidity could struggle to return assets to investors in good time if there was a drying up of liquidity. This is a challenge too for ’40 Act firms but the regulation governing ’40 Act vehicles is far tougher, so the likelihood of a blow-up is lower,” said the manager.
At the other end of the spectrum, a growing number of hedge funds are starting to adopt private equity-type structures. “More hedge funds are investing in illiquid structures. We are seeing firms impose longer lock-ins for clients and are paying themselves performance fees only once external capital has been returned to investors,” added the manager.
A study in February 2014 by New York-based law firm Seward & Kissel found newly launched US hedge funds were imposing tougher redemption terms on investors. Eighty-nine per-cent of new funds restricted redemptions to a quarterly or longer-term basis in 2013 compared with 64% in 2012, added the Seward & Kissel report. The number of funds employing a hard lock up, usually of one year, rose dramatically from 8% in 2012 to 27% in 2013, it continued, indicating a growing convergence between hedge funds and private equity.
A report by J.P. Morgan’s prime brokerage business back in March 2013 highlighted the main catalyst for the growth in hybrid fund structures was the growing investment opportunities in less liquid distressed debt assets. Basel III and various national regulations are forcing banks to deleverage and restructure their balance sheets by devolving themselves of illiquid, non-core assets such as collateralised loan obligations and residential mortgage backed securities. Managers scooping up these high-yield securities are generating attracting returns although investor interest has remained muted.