Growth through diversity
For the sake of staying relevant to the greatest range of managers, this second section will focus on the key considerations when diversifying in the traditional sense – launching a new type of investment product. These include:
- Can we raise enough assets to make a new product worthwhile?
- What impact will the new product have on our existing investors?
- What impact will the new product have on our brand?
The three biggest concerns managers have when considering the launch of a new product type all relate to investors (Exhibit 2.1), the HFM Insights survey shows. Top of the list, perhaps unsurprisingly, was the potential for a launch to ruffle the feathers of existing investors, cited as a top-three concern by almost two thirds of respondents. A London-based fund of hedge funds (FoHF) manager specialising in emerging managers told HFM Insights they wouldn’t invest early in a new product outside a manager’s core competency, preferring to observe its progress from a distance.
More than that, if one of their existing managers launched a non-core product that proved a notable failure, an amber flag would be raised. Investors are wary of anything that might take a manager’s eye off the ball – wobbles during product diversification fall squarely in that category.
Managed accounts and Ucits funds were the new product types being considered by the greatest number of hedge fund managers HFM Insights surveyed (Exhibit 2.2). Of the 57% of respondents yet to launch a Ucits fund more than a third were considering their first, while of the 39% of respondents not already offering a managed account more than half were considering it. Co-investments, ‘40 Act hedge funds and EU-AIFs were the three least popular options. However, as has been the case for many billion dollar club (BDC) hedge fund firms, managers considering their first managed account may ultimately launch a sub-AIF at an EU-based managed account platform.
HFM Insights also surveyed managers on their interest in diversification by trading style but could not identify a significant shift. Why? Because only the largest asset and hedge fund managers have the resources needed to buy or build competitive systematic capabilities – GAM’s purchase of Cantab last year is a prime example. These firms, along with investment consultants and smaller systematic hedge fund managers, have been quick to attend the investor community’s ravenous appetite for low-cost alternative/smart beta products. Most discretionary managers are as yet unable to embrace quant, although this will likely change as the budding ‘quantamental’ movement advances and the pressure to improve systems generally creates secondary benefits for product development. Larger European managers, for example, will likely beef up their internal research resources – including data scientists – as a response to the added complications of purchasing third-party research under Mifid II.
1) Product expense
The first and probably highest hurdle to product diversification. Cost is a notable challenge for hedge fund firms mulling their first Ucits launch. HFM Insights research suggests that most managers looking to launch their first Ucits hedge fund would need to raise at least $100m in order to make it profitable. Recent studies have cited break even points for traditional hedge funds as $88m (Aima/Global Prime Partners) and $25-30m for a standalone ‘40 Act hedge fund (Gemini Fund Services). The low-end cost and consideration for managers looking to launch their products on a budget are displayed in Exhibit 2.3.
i) Third-party platforms
Ucits and AIF distribution and/or structuring platforms remain a particularly popular route to market for managers based in and outside of the EU. They take a cut on the first profits as compensation for operational costs and distribution efforts either as an overall percentage or a figure more closely linked to the cost of running the individual subfund. The typical cut taken by Ucits hedge fund platforms in the first of these models is 25-50bps. Managers of larger sub-funds looking to withdraw their fund and take back the platform’s cut – multi- million-dollar in some cases – face a potentially
hefty ‘exit fee’.
ii) Internal platforms
Several Europe-based BDC hedge fund firms have chosen to create their own internal Ucits platforms and swallow the large upfront costs to benefit down the line. In addition, these firms retain greater control of their product range and benefit from economies of scale when launching additional sub-funds. One such manager HFM Insights interviewed said it could run additional Ucits sub-funds on its platform with as little as $30m in AuM. UK-based managers who have established an Irish or Luxembourg-based platform have also future-proofed their range from any regulatory fallout from Brexit.
2) Product monitoring
Compliance expectations relating to EU-regulated funds, managed accounts, and standalone ‘40 Act funds may require a smaller manager to make additional hires. Even firms that have outsourced the launch of a product to a fund platform will have new internal responsibilities with regards monitoring certain limits and thresholds. If launching a product via a Ucits platform, firms with at least 20 members of staff should be able to subsume the additional duties within their existing team. But managers with less than 20 staff may need to hire an employee or compliance consultant to monitor the evolving regulatory landscape.
3) Product structure
Structuring a new product correctly can be the difference between successful diversification and asset cannibalisation. The issue is most pertinent when relaunching a strategy in a new format. In some cases, it may be hard to justify not running the new product pari passu to the original – a quant strategy, for example. In others, regulatory constraints may make a strategy impossible to replicate, meaning a great deal of thought must be given to the balance of features between the original and new. Is the relaunched strategy a diluted version of the original? If so, investors will expect to see this reflected in the terms.
i) Fee structure
Most managers with offshore originals charge less for their Ucits hedge fund product due to the diluted ‘power’ of the strategy, although some managers have used the added regulatory burden to justify higher fees. Either way, will the respective investor groups be happy with their lot? Additional complications may arise if the same team/PM is trading across two different products. Pleasing everyone with pari passu products is becoming increasingly difficult as low interest rates force more continental European institutional investors to consider investing in onshore alternatives (sub-advisors to ‘40 Act hedge funds will not face such problems as few existing offshore investors would consider a product with multiple fee layers).
But increased interest from sophisticated investors in retail products has, in turn, created its own issues. For example, if the new Ucits product is designed for institutional investors as well as retail investors, the former will not tolerate fellow investors being given a ‘free ride’ via traditional commingled fund accounting. Fee equalisation may prove costly, especially with a larger number of investors/share classes – is it worthwhile? Ultimately, HFM Insights believes that two distinct products – with marked differences in strategy and different PMs – should minimise investor frustrations derived from comparing performance lag and fees.
ii) Liquidity terms
Launching a liquid alternative may have an impact on the liquidity expectations of a firm’s offshore investors. One hedge fund COO HFM Insights interviewed said that the launch of a Ucits fund had required them to change the liquidity terms of their offshore funds from quarterly to monthly because they could no longer justify such a stark disparity. As with the fees and time zones, sophisticated investors will want to know the extent to which they are being disadvantaged by PMs trading for both products with different liquidity terms.
The Ucits ‘100-Club’
Reaching $100m in AuM is a recognised signal a product is through its most vulnerable stage of existence. It is a figure that holds weight in the data, but also as a symbol that influences the behaviour of investors, service providers and peers alike.
One COO HFM Insights interviewed suggested that if you launch with less than $100m you have only a fraction of the chance of surviving than if you launch with $100m. To explore this phenomenon, HFM Insights analysed more than 700 Ucits hedge funds, seeking to determine patterns in the attributes of those funds that were at or above $100m ‘critical mass’.
Higher chance of success
i) Brand-name hedge fund managers
Large hedge fund managers are the most likely type of firm to offer a Ucits hedge fund product with at least $100m in AuM. Of the 52 Ucits hedge funds from hedge fund managers with $5bn or more in AuM HFM Insights counted, more than 70% had passed ‘critical mass’. A ‘gold standard’, blue-chip hedge fund investment remains attractive even to sophisticated investors, through which they can access the ideas and tips of a star manager or team. Such ‘status symbol’ allocations are increasingly hard to come by, with many offshore funds closed to new investment. New Ucits launches open the door – albeit briefly – to this exclusive club. Schroder GAIA’s Two Sigma Ucits fund closed at $1.5bn within months of its debut. Having a brand-name manager will also help a fund through investor due diligence.
ii) Traditional asset managers
Asset managers with a heritage in traditional investments have enjoyed more success raising assets for their Ucits hedge funds than managers with hedge heritage. Of the 330 Ucits hedge funds offered by traditional asset managers HFM Insights counted, 62% had reached ‘critical mass’, compared to just 46% of the 349 Ucits hedge funds offered by hedge fund firms generally. HFM Insights expects this disparity to grow as the output of 20 or so traditional asset managers continues to drive growth in the Ucits hedge fund industry at large. The group dominates the ‘preferred lists’ of banking platforms, consultants and other large investors, and will continue to churn out high capacity
iii) Daily dealing funds
Daily liquidity is quickly becoming a popular feature of Ucits hedge fund launches. Many traditional asset managers offer it as a matter of course, and hedge fund firms hoping to compete must follow suit. US managers are more likely to offer Ucits hedge funds with weekly or bi-weekly liquidity than European managers because their strategies are more likely to be non-equity and more likely to be offered by platforms that focus on sophisticated Ucits investors; allocators who see little difference between daily and weekly dealing.
Lower chance of success
i) Equity hedge strategies
The industry is awash with long/short equity Ucits hedge funds, 282 within the HFM Insights research pool, most of which (56%) are yet to hit critical mass. If equity hedge is a case of supply outstripping demand, then the opposite is true elsewhere, with many non-equity strategies still underrepresented and attracting larger flows accordingly.
Of the 103 fixed income/credit Ucits hedge funds HFM Insights counted, 64% had reached ‘critical mass’. The proportions among multi-asset/multi-strategy and event-driven Ucits hedge funds were also well above the equity hedge average at 62% and 67%, respectively.
ii) Hedge fund managers
If Ucits is a brand game, then most hedge fund managers face an uphill struggle to convince Ucits investors to part with their money. Brand-name asset managers and hedge fund firms have a monopoly on flows. Even non-branded hedge fund firms that sought to increase their chance of attracting flows by launching on a branded distribution platform have struggled without the star power of a BDC club member. Just 46% of Ucits hedge funds offered by hedge fund managers have reached $100m in AuM, and only 48% of Ucits hedge funds offered via fund platforms. Of course, even BDC managers use distribution platforms, and here the success rate rises: among the 60 platform-based Ucits funds from BDC managers, 62% had reached ‘critical mass’.
iii) Quantitative strategies
Systematic hedge fund strategies may be enjoying a purple patch of investor flows, but the goodwill hasn’t quite passed to Ucits beyond the largest brand-name managers. Less than half the 90 quantitative Ucits hedge funds HFM Insights counted had hit critical mass, below the overall 53% average. As is the case with the offshore systematic industry, systematic Ucits assets are concentrated at the strategies offered by brand-name managers: the likes of Man Group, Winton Capital and Two Sigma. Smaller quantitative hedge fund firms face an even steeper climb than their discretionary counterparts, as unbranded ‘black box’ investments remain a particularly hard sell in the retail market, especially following the poor performance of CTAs in 2015 and 2016.
Having a recognised and reputable name is becoming increasingly important to hedge fund managers as they compete for business with traditional asset managers. The impact of brand on product diversification will be explored further in this report’s third and final section.