It is probable that institutional investors who still recall the Long Term Capital Management debacle as if it happened only yesterday will be comforted by the registration requirement, although a delegate at the recent ‘Excellence in Absolute Returns’ conference in London, claimed that registration would not prevent a Refco-like situation.
Recent research by Greenwich Associates shows that most hedge funds favour registration. Nearly 85 per cent of hedge funds in Europe are registered with at least one regulatory authority, as opposed to 57 per cent of US hedge funds. In both markets, large funds are most likely to be registered.
Hedge funds that do not want to register with the SEC will have to impose two-year lock-up periods for investors. This situation might prove equally attractive to institutional investors.
High profile hedge fund multi-managers, the Fortune Group, which hosted the conference contended that pension fund trustees nervous of “hot money” might welcome a two-year commitment to hedge funds.
Dan Shapiro, a partner at New York-based law firm, Schulte, Roth & Zabel said funds of hedge funds had informed him that this alternative to SEC registration was damaging their businesses. A two-year lock-up period conflicted with the obligation on funds of hedge funds to provide quarterly and sometimes monthly redemptions.
Hedge funds are going to be forced to decide whether they wish to become the preserve of the super-rich as they have been historically, or whether they bite the bullet, get registered with the SEC and build businesses that are palatable to the institutional investment market.
What is less open to question is whether the costs associated with registering with the SEC will be passed on to investors in higher annual management fees.
Nearly 95 per cent of hedge funds surveyed by Greenwich Associates said their compliance costs had risen in 2005. New compliance department recruitment contributed greatly to this increase. About 90 per cent of funds said their compliance staffing levels rose last year, with most funds experiencing increases in the region of 10-25 per cent. Other factors fuelling increased compliance costs were IT expenditures, fees paid to outside consultants and the expense of preparing registration documentation and planning for registration.
Any rise in annual management fees will only serve to further depress the already disappointing performance of funds of hedge funds at a time when they are trying to reverse the asset outflows of the fourth quarter of 2005.
Some commentators blame the poor returns on the rising cost of borrowing which led to massive deleveraging in the hedge fund industry in the fourth quarter of last year. They say it is not a double-digit hedge fund return environment anymore because, for instance, you can no longer borrow money at 2.5 per cent in the US.
But as we report on page 6, if fund of hedge fund returns have underwhelmed investors, spare a thought for those institutions which poured their money into investable hedge fund indices and suffered even worse performance.
The world of investable hedge fund indices is said to be in disarray and not only on account of poor returns. Although it is staying relatively tight-lipped, Standard and Poor’s is thought to be reconsidering its investable indices contract with US-based managed account platform, PlusFunds.
In 2002, PlusFunds won an exclusive licence to launch investment funds tracking the S&P Hedge Fund Index and its sub-indices.
Despite rumours of problems, managed account platforms, which are sometimes derided as “supercharged middle offices” have attracted a lot of institutional investors. One of the reasons for this success is their ability to satisfy institutional rules and guidelines and to enable a bank to wrap products with notes which, from a probity standpoint, is more appealing than looking at the name of an unregulated offshore fund.
It is perhaps naïve of institutional investors to think they can put ever-increasing amounts of money into hedge funds and still expect stellar returns. Quality must surely be sacrificed for capacity. For every one good manager, there are any number of bad managers. Industry practitioners complain that while institutional investors have expressed interest in hedge funds, talk is not being translated into action.
And hedge fund managers observe that when institutions do commit to investing, it can take up to 18 months for the money to come through. But if the oft-promised flood of institutional money was ever to deluge hedge funds, it is doubtful whether the industry could handle it effectively. Investment returns would be the first casualty.
Henry Smith, editor
henry.smith@ft.com
