Strength through diversity
To address the question, HFM Insights analysed the product offerings of hedge fund managers with at least $1bn in hedge fund assets under management (AuM) as of 1 January 2017, looking for diversification by strategy, asset class and vehicle. The sample of firms used came from HFM’s most recent billion dollar club (BDC) rankings. The original pool of 434 BDC managers was reduced to 360 by including only those firms that had made hedge fund products a key part of their launch offering (referred to hereafter as ‘hedge fund managers’). This eliminated traditional asset managers, such as BlackRock, and alternative asset managers, such as Blackstone.
Diversification by strategy
Within this adjusted sample, more than 70% of BDC hedge fund managers have a product suite built on one core hedge fund strategy, and only 8% on three or more. Slicing the data by firm size has a prominent effect among the largest managers (firms with at least $5bn in hedge fund AuM) but not among smaller and medium-sized managers (Exhibit 1.1).
Even so, more than half of the largest hedge fund managers have just one core hedge fund strategy, BDC data shows. An HFM Insights survey of senior operational staff at hedge fund firms suggests that a single investment strategy run by a single investment team is the most common approach for BDC and non-BDC managers alike (Exhibit 1.2).
HFM Insights expects this shift towards specialisation to continue. Truly diversified offerings have been established by a handful of larger hedge fund firms – older multi-strategy and quant shops in the US mainly – but the outlook for ‘old school’ diversification is bleak. Where managers once moved between strategies and asset classes with ease, they now face a market crowded with talented competitors and picky investors. Firms looking for a quick switch to a new asset class will likely get their fingers burned. A host of brand-name hedge fund managers have closed in recent years and been replaced by businesses that are lean and clean, offering a few products around a single core competency.
Diversification beyond hedge
The contemporary industry’s diversification beyond hedge – or lack thereof – is a case in point. Worldwide, less than 30% of BDC managers with hedge heritage offer investors access to long-only and/or non-hedge alternative investment products as well as hedge fund strategies (Exhibit 1.3). This low percentage for non-hedge assets is due in part to the broad definition of ‘hedge funds’ used by HFM Insights, which comprises everything not covered by long-only (including ETFs and smart beta), private equity, real estate, infrastructure and illiquid credit.
The effects of accounting for firm heritage when looking at diversification into non-hedge asset classes are most keenly felt in the European hedge fund industry where traditional asset managers – a driving force behind the growth in Ucits hedge fund assets – are prevalent. Just over one-third (34%) of European BDC hedge fund managers are diversified by asset class in some form. When all European BDC managers are analysed, the proportion rises to over half (51%). The difference comes from losing several Europe-based ‘one-stop shop’ traditional asset managers that offer all three asset classes. The advent of Ucits hedge funds not only prompted European hedge fund managers to offer long-only products, but, more significantly, European asset managers to offer alternative investments.
US alternatives expertise
In North America, the story is different. Here, managers of all heritages are more likely to have diversified into other alternatives than they are long-only. Influential in this trend is not only the absence of a popular Ucits equivalent but the region’s rich history in private equity and alternative credit investing. Twice as many North American managers with hedge heritage (and no long-only) offer other alternative investment products (12%) as their European equivalents (6%). In addition, accounting for heritage does not reduce the proportion of ‘one-stop shops’ in North America as it does the extent in Europe – North American managers with hedge heritage are more likely to have diversified into both long-only and other alternatives.
When it comes to diversifying into other alternative investments, size matters. Only the largest firms have the reach and resources to expand into complex asset classes. More than 40% of large BDC hedge fund managers (firms with at least $5bn in hedge fund AuM) have diversified into long-only and/or other alternative asset classes (Exhibit 1.4) compared to 24% of medium-sized managers (under $5bn in hedge fund AuM but more than $2bn) and 23% of smaller managers (under $2bn in hedge fund AuM but more than $1bn).
Where size matters
However, if firm size matters when it comes to other alternative investments, it doesn’t with long-only products. Nor is the impact of a manager’s heritage felt so keenly. 16% of large BDC hedge fund managers offer hedge and long-only funds without other alternatives products, compared to 17% of medium-sized managers and 14% of smaller managers. Evidently, the resources of a $5bn manager make a difference with regards to complex asset classes, but below that the opportunities for diversification are similar. Managers of all shapes and sizes want – and can have – a piece of the long-only pie.
Further analysis of the data shows that, regardless of size, European managers with hedge heritage remain more predisposed to long-only diversification than their North American peers. Climbing equity markets, Ucits interest, and cautious local investors have helped focus the minds of European hedge fund firms, especially those with a core equity product, for whom launching a long-only carve-out is an affordable way of meeting client demand at a time when the cost of more exotic diversification is prohibitive. Indeed, client demand drove London-based Heptagon to convert its long/short product to long-only in 2015.
Exhibit 1.3 Analyst Note: ‘Alternatives’ comprises private equity, infrastructure, real estate and illiquid credit products, ‘Long-Only’ comprises long-only equity (including ETF and other index products), long-only fixed income and long-only multiasset products, and ‘Hedge’ comprises all other investment products.
Equity hedge under pressure
Still, the greater number of managers with hedge heritage in North America (259) than Europe (71) means US examples of diversification are more readily available. One notable trend in the past five years has been for US-based equity hedge fund managers who have struggled to kick on after their first few billion to create a long-only product. Many of these products launched between 2013 and 2016 (Glenview Capital Management, Blue Ridge Capital, Tiger Global) a period in which many equity markets flourished but hedge fund performance waned. “The pressure is on certain managers to have a range of different products and the thought of having a high beta/low-fee product leveraging your infrastructure can be quite appealing,” said the COO of one New York-based hedge fund firm interviewed by HFM Insights.
Exhibit 1.4 Analyst Note: ‘Alternatives’ comprises private equity, infrastructure, real estate and illiquid credit products, ‘Long-Only’ comprises long-only equity (including ETF and other index products), long-only fixed income and long-only multiasset products, and ‘Hedge’ comprises all other investment products.
The timing of such equity roll-outs suggests long-only diversification has been more reactive than proactive, a seemingly easy and much-needed win with investors to bridge the gap to the next market downturn. US credit managers, by contrast, have appeared more calculated in their diversification. When New York-based King Street Capital Management last year swelled the ranks of managers launching a collateralized loan obligation (CLO), they did so to capitalise on a regulatory change at the end of 2016. Similar moves by US hedge fund managers into direct lending, illiquid credit, and hybrid products utilising private equity features also suggest a more opportunistic approach than their equity-focused counterparts, diversification driven by meticulous planning rather than poor performance. In the credit space, at least, the dog is wagging the tail. According to Willis Towers Watson’s 2017 Global Alternatives Survey, global AuM in illiquid credit strategies has more than doubled from $178bn to $360bn – as hedge fund AuM dropped over 10%.
Diversification by vehicle
In contrast to the rich flavours in which North America’s hedge fund managers offer alternative asset classes, the range of product vehicles is somewhat vanilla. HFM Insights research suggests that, regardless of firm heritage, 100% of North America BDC managers offer an offshore product, usually in a master-feeder format with a Delaware feeder. Of the 25% of North American BDC hedge fund managers that offer multiple vehicle types, 13% offer investors access via a ’40 Act fund, just over 10% a Ucits wrapper, and 8% an EU-AIF (Exhibit 1.5). Only 2% offer products in all four formats compared to 9% in Europe.
HFM Insights research shows that 60% of Europe-based BDC hedge fund managers offer at least two of four key fund vehicles (offshore, Ucits, EU-AIF and ’40 Act hedge fund), compared to just 25% of North America-based hedge fund managers. Offshore is the most prevalent offering among European hedge fund managers (85%), followed by Ucits (55%) and EU-AIF (38%). More than 55% of hedge fund managers in Europe offer a liquid alternative product (Ucits and/or ’40 Act) compared to just over 20% in North America. And almost 60% of European hedge fund managers offer at least one EU-regulated product (Ucits and/or EU-AIF) compared to just under 20% of their North American peers.
Exhibit 1.5 Analyst Note: Offshore jurisdictions include all Caribbean, African and non-EU/EEA countries. Non-hedge products were included in all four types.
US specialists vs. European traditionalists
Of course, the geographical split on vehicle diversification is largely due to regulation and investor demand. Most European hedge fund managers have had no choice but to explore Ucits and/or EU-AIFs, whereas most North American hedge fund managers have had no need for a costly EU-regulated or liquid alternative product. And North America’s need is unlikely to increase from where it stands today. Increasingly, sophisticated investors on both sides of the Atlantic have been seeking illiquid opportunities, and those European investors new to alternatives are being hoovered up by large European asset managers, not US hedge fund managers. HFM Insights expects this trend to accelerate as equity market gains – and the gains of the equity products launched to capitalise on such bullish markets – diminish.
If there is to be a shake-up in the mix of vehicle diversification globally, it will likely be driven by third-party relationships. In the near term that means further growth in Ucits hedge fund platform sub-fund launches and ’40 Act hedge fund multi-manager sub-advisory mandates. In the long-term, as dissatisfied European institutional investors seek global specialists in illiquid opportunities, that could also mean growth in launches via platforms for EU-AIFs.
Sub-funds and sub-advisory
HFM Insights chose to include third-party relationships in its vehicle diversification data as we believe this best represents manager intentions. And without Ucits/AIF platforms and ’40 Act sub-advisory mandates the mix in North America would be blander still – a prominent proportion of North American hedge fund managers have their only Ucits, EU-AIF and ’40 Act products through third-party relationships. The largest Ucits platforms (such as Schroder GAIA and Merrill Lynch Investment Solutions) and multi-manager ’40 Act hedge fund products (including BlackRock’s BSF Multi-Manager Alternatives Strategies Fund) offer liquid versions of strategies from US-based BDC hedge fund managers.
EU-based structuring/distribution platforms for AIFs are the most recent, and perhaps most colourful, example of this trend. Costly and relatively untested, standalone AIFs from US managers are few and far between, with most pursuing AIF-diversification via a sub-fund or managed account. Notable umbrellas (and notable North American BDC sub-funds) include: Willis Towers Watson’s recently launched AMX platform (Magnetar Capital and Trend Capital Management); EntrustPermal’s managed account platform (LibreMax Capital and Atlantic Investment Management); Amundi’s Absolute Return range (First Quadrant and Tremblant Capital Group); and Carne Global’s third-party umbrella (Avenue Capital Group).
Ucits for all sizes
Slicing the BDC data by firm size, suggests that AuM is a factor when diversifying into EU-AIFs and ’40 Act hedge funds, but less so when diversifying into Ucits funds. A greater proportion of smaller BDC hedge fund managers offer investors access via a Ucits product (19%) than they do an EU-AIF (9%) or ’40 Act hedge fund (7%) (Exhibit 1.6). By contrast, the proportions at larger BDC hedge fund managers are similar: 22%, 23% and 21% of access to Ucits, EU-AIFs and ’40 Act hedge funds, respectively. In fact, among all three size categories of BDC hedge fund manager, ‘smaller firms offering offshore and Ucits vehicles only’ is the biggest sub-category (10%) other than the three ‘offshore only’ sub-categories.
Considering the expense and operational hassle involved when launching a Ucits hedge fund, this tilt may at first surprise. However, HFM Insights believes the results simply serve to demonstrate that having ‘just’ $1-2bn in hedge fund AuM is no impediment to launching a Ucits hedge fund product (further analysis shows that there is not a significantly greater proportion of smaller BDC hedge fund managers launching via a third-party platform than there is launching by themselves) and that managers with fewer resources see Ucits as a more attractive opportunity than EU-AIFs or ’40 Act hedge funds. A recognised brand, established investor base, and the opportunity to charge a performance fee has made Ucits an important part of the conversation at a wide range of managers – and an integral part of this report’s second chapter.