The liquid alternatives industry is growing at a faster rate than traditional hedge funds as investor interest in these regulated structures shows no sign of abating, according to a study by Barclays Prime Services.
The liquid alternatives space grew by 43% in 2013, while hedge funds saw their assets increase by 15% to reach $2.6 trillion, said the Barclays study. However, liquid alternatives are still in their infancy and 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, it added.
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.
“Liquid alternatives have a lot of catching up to do with hedge funds in terms of overall Assets under Management (AuM) but they are witnessing impressive growth,” said Ermanno Dal Pont, head of capital solutions for Europe, Middle East and Africa (EMEA) at Barclays Prime Services in London.
Managers themselves are sufficiently bullish. Ninety per-cent of managers told the Barclays survey they expected at least ‘moderate’ growth in 40 Act products. “Many of these managers surveyed expect ’40 Act products to eventually become a significant part of their overall business mix, and many are also considering new ’40 Act products,” read the survey. 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 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 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.
“Managers running liquid alternative structures need to devote a lot of time to gaining the confidence of DC plans, which tend to be conservative and risk averse. It is essential managers educate the plan sponsors about the benefits of liquid alternatives. However, our report also makes clear that the RIA and broker-dealer channel is probably the easiest target for hedge fund managers with ’40 Act products,” said Dal Pont.
The Barclays study also said funds of hedge funds could be given a lifeline by launching ’40 Act products. This is debatable though. A survey in 2013 by BNY Mellon and Casey Quirk of 23 funds of hedge funds running $159 billion, revealed 55% offered a registered vehicle available to retail and mass-affluent investors, although uptake has been low, with these products accounting for just 8% of their overall sales in 2012. Eleven percent viewed retail funds of hedge funds as a promising growth area, although 32% reckoned it was unlikely to expand.
Retail funds of hedge funds do face distribution, tax, legal, operational and compliance challenges. Subchapter M requirements when investing in US- domiciled partnerships are onerous and force funds of hedge funds to conduct look-thru exercises on their underlying hedge funds to ensure they are in compliance. Furthermore, some hedge funds may not be overly transparent in disclosing their holdings, and this could lead to problems for registered funds of hedge funds with their manager selection process.
Others argue excitement about liquid alternatives is overhyped, pointing out that growth in absolute return UCITS vehicles In Europe has been sluggish, while 130/30 funds faded into oblivion during the financial crisis. The Barclays study attributes the sluggish growth in UCITS to simple supply and demand issues. Investors often believe UCITS routinely underperform hedge fundes while the DC pension market in Europe is limited. Furthermore, private banks and wealth managers in Europe have retreated from hedge fund investing and are yet to re-enter the alternatives market.
There are a number of serious impediments that could stifle the emergence of liquid alternatives. While the distribution benefits are hard to falter, 40’ Act hedge funds are subject to onerous restrictions. The absence of leverage (capped at 33% of gross assets), lack of performance fees (with a management fee of between 70 basis points (bps) and 1%), restrictions on investing in illiquid assets (capped at 15% of AuM), rigorous corporate governance standards and mandatory third party custody will all lead to higher compliance costs, at a time when profits are rapidly receding. These costs could also make it unsustainable for smaller hedge funds to launch regulated products.
“Firms running illiquid strategies such as credit or distressed debt will struggle to shoehorn their investment vehicles into a 40 Act structure. We believe strategies such as long/short equity, commodity trading advisors (CTAs) or managed futures are a solid fit for 40 Act structures. Nonetheless, building the infrastructure to ensure compliance with the 40 Act rules is not cheap and more importantly building a retail distribution capability will require managers to have size and scale – unless they choose simply to sub-advise someone else’s product,” said Dal Pont.
