Fitch Ratings has warned that second thoughts from recent fund of hedge fund investors could potentially see $50bn (€32bn) pulled from the hedge fund industry, laying bare the liquidity mismatches that have grown-up over the past three years.
As institutional investors have moved in, funds of funds’ share of global assets in hedge funds has rocketed from 10 per cent in 2002 to more than 50 per cent today, making the entire sector hugely sensitive to fund of funds investor sentiment.
Aymeric Poizot, senior director with Fitch Ratings Fund and Asset Manager Group identifies the $50bn that flowed into funds of funds during 2007 as being “potentially at risk”. According to Fitch research based on data from HFR, the $8bn invested in Q1 (and put to work from Q2 onwards) has made a cumulative return of 3.34 per cent – not bad in the context of broader market chaos, but not Libor-plus, either. The $11.4bn invested in Q2 has lost 1.46 per cent of its value; Q3’s $22.5bn has lost 0.27 per cent; and the unfortunate Q4 entrants who put $11.3bn into funds of hedge funds have now lost 3.85 per cent.
“There is a risk of simultaneous massive redemptions,” Mr Poizot observed.
This is potentially a big problem because of the liquidity mismatch between the fund of funds and the underlying funds. Funds of funds generally offer monthly liquidity with 30 days’ notice, but Mr Poizot has seen such vehicles offering much looser terms, while underlying funds have been locking them up for longer. A sudden unwind could result in a liquidity spiral for underlying funds – particularly nasty for relative-value and other leveraged strategies.
Is that likely? According to HFR, hedge funds attracted $16.5bn of new capital in Q1 2008 – which sounds like a lot until one recalls that the first half of 2007 was seeing quarterly net inflows in the heady $60bn range. And fund of fund flows almost ground to a halt, with just a couple of billion in new money coming in, in stark contrast to last year’s double-digit quarterly figures.
However, closer scrutiny suggests that redemptions were generally strategic rather than panic-driven: event driven saw flows from merger arbitrage to distressed and special situations; equity hedge and relative value saw inflows; and investors appeared to be taking profits from their recent runaway global macro returns.
IN BRIEF
The cost of regulation at the top 100 financial services institutions could rise to £50bn (€63bn) by 2010, according to research by Deloitte. Capital adequacy and market practice directives are already forcing significant investment, and the current credit and volatility concerns may prompt further governance and risk control measures. The report advises that firms appoint a board-level individual to oversee controls.
Global managers are searching for alternative asset classes as they look to diversify their portfolios and shield themselves from instability in traditional markets, according to a report from Mercer. During 2007, searches in alternatives rose by 20 per cent, with real estate in particular demonstrating growth.
The National Association of Pension Funds in the UK has joined Wheels Common Investment Fund in a legal challenge against HM Revenue and Customs on the application of VAT on investment management services supplied to occupational pension funds. A European Court of Justice ruling last year stated that investment trusts need not pay VAT on investment management services. The NAPF estimates that pension funds would save £100m (€125m) per year and would receive £300m in backdated tax, should the challenge succeed.
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