The Scapegoats Come Good
Return of the hedge funds

Hedge funds will this year register their first net inflows of assets since 2007. But stubbornly high fees and reputational damage mean private banking clients are still wary of investing with them.

Hedge fund managers were made scapegoats for their role in shorting bank stocks during the financial crisis, became victims of the Madoff scandal and largely failed to deliver on the promise of absolute returns when investment markets turned sour.

Now there are signs that this most elite of financial sectors is starting to regain its old sparkle. A low-growth yet highly volatile economic environment and demand from cautious institutions and private clients has allowed the hedge fund industry to register its first inflows since the start of the crisis.

Up to the third quarter of this year, analysts at Hedge Fund Research (HFR) estimate hedge funds benefited from a $42 billion influx of funds from wealthy investors and institutions. Compared to outflows of $154 billion in 2008 and $131 billion in 2009, it is easy to see why the champagne corks are starting to pop again in Mayfair, Geneva and across the hedge fund world.

Private banks and the family offices of ultra high net worth individuals are starting to invest in in-house hedge fund selection teams and, in some cases, are launching their own funds.

Jacques de Saussure, managing partner at Geneva-based Pictet & Cie, sees alternative investments as an important solution to investors in today’s investment markets.

“High volatility has attracted people to non-directional strategies which makes hedge funds a strategy many clients are interested in,” he said.

Pictet Alternative Investments (PAI), has 43 staff who work to select the best private equity and hedge fund managers for its fund of fund products. Sixteen of them are hedge fund investment professionals and five are private equity investors. The bank is looking to add more hedge fund experts to cater for increased demand, 80 per cent of which, Saussure said, was from US institutional clients. PAI, the 20th largest fund of hedge fund business globally, saw net inflows of $340 million in the year to date, taking assets under management to $8.2 billion.

The Madoff blues
Not all in the funds of hedge fund industry, which makes its money by charging fees for managing a portfolio of hedge fund managers, have fared so well.

Though Pictet was not affected, the image of fund of hedge funds was hit particularly hard by the Bernard Madoff fraud in 2008. While individual hedge funds are starting to see inflows, multi-manager funds continue to see net outflows, with $14 million being withdrawn in the year to date, according to statistics from HFR.

Fairfield Greenwich Advisors, an investment management firm, had the highest Madoff exposure, at around $7.5 billion, or half of its total assets under management.

Surprisingly, a number of the traditionally more conservative Swiss private banking businesses, including Union Bancaire Privée, Reichmuth & Co., Hyposwiss and Banque Bénédict Hentsch & Cie, were also affected, either through investments directly through Madoff or feeder funds. Nicolas Campiche, head of alternative investments at Pictet, said fund of funds weren’t dead.

“We live and die by performance and risk, so the interests of the manager are aligned,” he said. Reputation and the need for transparency, bespoke services and the segregation of client assets from hedge fund assets were all important factors in re-establishing trust in the industry he said.

Those sentiments are largely shared by Richard Breuns, global head of products at ABN AMRO Private Bank. In October, the bank made fund of hedge funds products available to its clients through a tie-up with third-party platform Lyxor Asset Management. He said the partnership was due to an increasing appetite among ABN’s private banking clients for hedge fund investments.

Pressure on fees
In addition to Madoff and related outflows of assets from worried investors, fund of funds, and hedge funds more generally, have been under further pressure on fees.

The sustainability of the so-called two and 20 structure, a management fee of 2 per cent on assets and a yearly fee of 20 per cent on any increase in assets, has been called into question.

The only hedge fund category to outperform cash during the financial crisis were so-called macro strategy funds, which make up only a small part of the overall industry. These funds are driven by macroeconomic factors, and essentially made money by betting that interest rates would come down as economic growth slowed. The performance of the rest of the industry, however, has led investors to question whether hedge funds can justify their fees.

There is little evidence this has had an impact on fees so far, according to David Maude, an Italy-based independent financial consultant.

“There may be some pressure at the margins but for the most part they have been quite resistant,” he said.

“The market is likely to shift people into more regulated structures, like UCITS funds. There is also pressure from ETFs, which mimic hedge fund-type returns, and that might start to have a bearing on fees longer term.”

Representing just 1.89 percent of high net worth investor (individuals with investable assets exceeding $1m) portfolios in 2009, hedge funds remain a niche part of the private client industry. They are more popular among UHNW investors (those with investable wealth greater than $30m), however, and despite recent hiccups and high fees, hedge funds will play an ever more important role in delivering returns in the current market environment.

Will Cain is a financial journalist and former editor of Private Banker International

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