New Hedge Funds Face Growing Pains

Terry Flanagan

How hard can it be to set up your own hedge fund? Just open an office in upmarket Mayfair or Greenwich and begin trading. Sounds easy, right?

Well, according to recent data from Hedge Fund Research (HFR), that is just what many aspiring managers are doing. Despite hedge funds on average losing a touch over 5% globally last year, the second worst annual return since the Chicago-based data and analysis provider began to track performance in 1990, there appears to be no shortage of new players to the market as managers look to position themselves for growth.

Hedge fund launches totaled 1,113 in 2011, including 270 in the final quarter of the year, according to HFR, which was after an unprecedented run of high volatility in the markets that created an exceptionally difficult trading environment. This annual figure of new launches was the highest since 1,197 hedge funds began trading in 2007.

“The asset raising environment is more discerning than 2008,” said Mark Parsonson, executive director of UK-based fund of hedge funds manager Liongate Capital Management, which has $3bn under management. “So, for the perspective of new managers starting out, it’s going to be a longer and more involved process starting a hedge fund. The investor profile of the industry is much more institutional than pre-crisis and, as a result, a higher level of standards are demanded.”

This influx of new hedge fund managers may be as a result of the impending Volcker Rule, a specific section of the U.S. Dodd-Frank Act that restricts banks from making certain types of speculative investments, including a clampdown on proprietary trading.

“Compensation is down and banks continue to scale back in certain areas,” said Parsonson. “The Volcker Rule, and other regulations, are affecting banks but many are also taking the view that they are going back to basics. Risky activities are generally being reduced across the board.

“That’s positive for hedge funds as there is less capital chasing the interesting trades. Traders are seizing the chance to take advantage of this by launching new hedge funds.”

However, Parsonson suggests that people with stellar records are still attracting vast sums, much like when top London manager Tony Chedraoui raised almost $1bn for his 2009 start-up Tyrus Capital.

“When someone with a good track record is coming to the market and saying ‘I am going to run my own fund’; they are raising significant amounts of assets—hundreds of millions of dollars,” said Parsonson. “Where there isn’t that experience or the depth or pedigree that’s where people are finding it much more difficult.”

Parsonson suggests that fund of funds remain a reliable source to raise cash but the most active seeders have been in the traditional pension fund space which, he says, “remains a very good source of assets” and also specialist seeding fund of funds.

A recent study by Swiss bank Credit Suisse has highlighted the problems faced by hedge fund managers for outperformance in the currently challenging and erratic market conditions.

Despite what appears to be a return of market fundamentals in recent months, allowing hedge funds the chance again to outperform markets, it is by no means certain that this will turn out to be the case.

But as institutional investors are beginning to move away from safe haven assets and back into equities and other risky assets, hedge funds could be well placed to benefit from this. Hedge funds globally have posted their best start to a calendar year since 2000, according to HFR, rising by, on average, just under 5% for the first two months of the year although the S&P 500 and FTSE 100 have both gained more over the same period.

“Institutional investors remain positive on hedge funds and on the outlook for further industry growth,” said Robert Leonard, managing director and global head of capital services at Credit Suisse. “They continue to look to hedge funds to generate uncorrelated returns and to reduce overall volatility within their portfolios.”

The Credit Suisse report highlighted that many investors were concerned that lots of hedge funds are just too correlated to justify their hefty fees.

And Parsonson at Liongate believes that differentiating yourself from your peers could prove to be a winning formula.

“If you look at the last few years most of the money in the hedge fund industry has gone to the largest players—because of the misperception of higher operational quality as investors have overweighted operational risk and sought safety in numbers,” said Parsonson.

“Now something like 1% of the names in the hedge fund industry control 70% of the assets. That’s starting to reverse, though. The simple reason is that everybody has the brand names now and there is not much differentiation across them. Because of their size, they can do less interesting things than smaller managers. And if you look over the long term, smaller to mid-sized funds historically outperform these larger ones.

“Investors are starting to realize that you can build a more interesting portfolio, and do slightly different things, with a combination of these large and these small managers side by side.”

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