What's Trending - Allocator Perspectives on Investment Strategies - Q4:2018 - BNY Mellon

Allocator Perspectives on Investment Strategies

Allocators have been under intense pressure to increase the performance of their hedge fund portfolios. As a result, hedge fund managers have been creating innovative solutions for the purpose of retaining existing assets and expanding their businesses. What innovative approaches have investors been seeing? How have managers been evolving to meet the needs of today?

HEDGE FUNDS: PRODUCT INNOVATION AND THE SEARCH FOR GROWTH

Increased demand for lower-cost beta strategies has put pressure on active managers to provide higher returns at lower-cost. Hedge funds have been a particular focus as investors reassess how alpha-generating strategies should fit in their portfolios and how much they are willing to pay for them. This pressure to increase performance while reducing costs has been a catalyst for creativity and innovation across the hedge fund space.

AREAS OF INNOVATION

Areas of innovation include new approaches designed to increase returns, investment expansions into new markets, and business expansions via new fund structures. The views expressed herein were shared by different investment consultants, fund of funds, and wealth management firms.

New Approaches Designed to Increase Returns: There are a number of approaches managers have been taking to increase returns, including:

Pairing new co-invest funds with existing funds: There has been an increase in co-invest funds that managers are offering to investors. The rationale is that by pairing co-invest funds with flagship strategies, investors have the opportunity to increase performance on a blended basis. These co-invest funds sometimes consist of a single idea.
Co-invest funds are being offered across single strategy hedge fund managers - most prominently with long/short equity and event driven strategies. Multi-strategy managers have more capacity than single strategy managers and, as a result, are less likely to offer co-invest funds.
Pairing new long-only funds with existing funds: More and more hedge fund managers are offering long-only carve-outs of their existing long/short strategies. These long-only portfolios are concentrated, typically have much lower management fees (if any), and have performance fees over an index-based hurdle.
To prevent the cannibalization of their long/short strategies, some managers have been pairing their new dedicated long-only funds with their long/short funds. The rationale is that the blended return from both funds will be higher due to increased beta and reduced fees.

Other managers have been marketing long-only carve-outs as stand-alone strategies. Fees for these funds include: (i) 1% management fee and 15% incentive fee, (ii) 1% management fee and 20% incentive fee, and (iii) 0% management fee and 30% incentive fee. Additionally, some performance fees include hurdle rates.

Fee reductions: Managers have been offering their existing investors reduced fee choices. For example, some managers give investors a choice between (i) a higher incentive fee with a lower management fee, or (ii) no incentive fee with a high management fee.

Fee reductions may also come in the form of loyalty discounts for long-time investors. For example, investors of five years or more may be eligible for the following investor-level AUM breakpoint discounts:

AUM Breakpoint Discounts
$200MM or higher	0.30% management fee reduction
$75-200MM	0.20% management fee reduction
$25-75MM	0.10% management fee reduction
$25MM or less	0.05% management fee reduction

To capture new capital inflows, some systematic managers have developed hedge fund replication strategies, which have fees that are significantly lower than their hedge fund counterparts. These newer funds have largely been event-driven replication strategies and come with a flat fee of 1.00%.

Another way investors continue to offset fees is by providing managers with seed capital. In return, they receive the benefits of ownership interests in the management company for a period of time. Investors have found that these revenue sharing arrangements continue to be an effective tool to lower their fees, which increases net returns on their investments.

Creating funds that reduce taxes paid: When selecting hedge fund strategies, wealth management firms have to consider the impact that federal and local taxes have on fund returns. Since many hedge funds are trading-oriented strategies, they often come with a high level of short-term capital gains. (Short-term capital gains are generally taxed at a higher rate than long-term capital gains.)
In order to help investors increase portfolio returns, several hedge funds are offering tax-advantaged strategies, which generate substantial short-term capital losses. These loss carry-forwards can be used to offset gains in other parts of investor portfolios (which, when blended together, reduce portfolio-wide tax liabilities). These strategies are currently being offered by systematic equity market neutral managers, who have tweaked their existing code to facilitate short-term losses.
Build-out of quantitative infrastructure: There has been a large increase in the number of managers investing in technology and infrastructure to facilitate quantitative investing, as well as incorporating alternative data into their investment modelling process. Since there are many variations of systematic strategies and opportunity sets they are trading, performance varies widely across the space. As a result, it is hard to directly correlate the increased use of alternative data sets with performance.

Expansions into New Markets: Managers have been expanding into new markets, including:
- Blockchain platform currency funds: There are a number of new hedge funds investing in the currencies of blockchain platforms. Blockchain platforms are digital, decentralized, shared ledgers which allow platform participants to transact directly with each other. Each platform has a unique currency serving as a means of exchange between its participants. (These are also referred to as digital currencies or cryptocurrencies.)
  Platform currencies do not have absolute values. Just like fiat currencies, platform currencies are valued on a relative basis (relative to other currencies). For example, the price of platform currency Bitcoin will increase relative to the U.S. dollar when investors sell their U.S. dollars to buy bitcoin. On the flip side, the price of the bitcoin will decrease relative to the U.S. dollar when investors sell their bitcoin to buy U.S. dollars.
  
  Currently, blockchain platform currency investment funds are long-only investment strategies. Managers convert capital from an investor’s fiat currency (e.g., U.S. Dollars) into different platform currencies. The strategy is to wait until the platform currencies appreciate significantly (on a relative basis) before converting the platform currencies back into the original fiat currency.
  
  Since this space is relatively new, investors are waiting on the broader adoption of platform currencies by consumers before seriously considering investing in the space. Other investor considerations include whether it makes sense to own platform currencies as a stand-alone investment. For example, with equity and debt instruments, investors still have ownership in the issuer or claims against the underlying assets of the issuer. However, when owning platform currencies alone, investors do not have ownership or a claim to any other associated assets.
Business Expansion with New Fund Structures: Alternative managers have been launching new fund structures to expand their investor base, including:
- Drawdown funds for investors-in-waiting: Many investors continue to wait for the next distressed cycle to begin before investing in the distressed credit space. To address this, distressed managers have been launching drawdown funds so that investors can commit to them today while they wait for the credit cycle to turn. Investors have been seeing a number of leading managers offering drawdown funds with five- to seven- year lives.
- Periodic payment funds for current income investors: In the private wealth space, many clients invest in fixed income instruments for periodic coupon payments. This is a source of current income and what many retirees depend on during retirement. In order to expand their investor base, hedge funds have been offering fund structures (and new share classes) with periodic distributions. The frequency of periodic payments vary and include quarterly, semi-annual, and annual payments. The most common strategies offering periodic payments include high yield credit, structured credit, and stressed/distressed credit.
- Interval funds for mass affluent investors: There has been an increase in the number interval funds available for mass affluent investors. An interval fund is a ‘40 Act fund that provides investors with a periodic tender/redemption option. These strategies include:
  - Multi-Strategy Credit
  - Direct Lending
  - Reinsurance
  - Private Real Estate (Multi-Manager)
  - Private Real Assets (Multi-Manager)
  In the wealth management space, early adopters of interval funds selected these strategies for:
  - Reduced correlations: Each underlying asset has its own risks. However, the risks provided by private markets may not be correlated with public market strategies. For example, the risks that cause the public corporate credit markets to sell-off (including interest rate risk, duration, credit risk, and prepayment risk) have little to do with the risks of reinsurance contracts (including natural disaster risk). As a result, when one aspect of the portfolio is underperforming, the other part of the portfolio may have great performance. Additionally, the different parts of the portfolio behave differently during market shocks.
  - Resistance to forced selling: With daily liquid products, clients can panic and sell their shares, which can then depress market valuations. With quarterly liquid products, it’s harder for clients to act during market sell-offs and causes them to be more patient.
  - Reduced volatility: As an example, interval funds that invest in private real estate do not experience the high volatility listed REITS experience in public markets.
  - Low fees: Real estate interval funds that offer core strategies (i.e., strategies that invest in investment-grade properties) charge fees that are similar to the new typical fees of private limited partnerships.
  Wealth management firms currently exploring the interval fund space have the following concerns:
  - Investor liquidity: Interval fund boards have discretion over how much of the fund will actually be redeemed at quarter-end. Depending on the fund structure, maximum tenders can range from 5-25% per quarter. Funds with a 5% maximum tender will take investors five years to fully redeem, which is much more illiquid than most hedge fund structures. (Sometimes they are fund-level tenders and other times they are investor-level tenders.)
  - Diversification requirements and leverage limits: The ‘40 Act has diversification requirements and leverage limits, which can limit the returns that strategies can achieve.
  In the opinion of some wealth managers, mass affluent investors run the risk of investing in hedge fund-like strategies that provide lower returns and come with much more restrictive liquidity. Additionally, mass affluent investors may not realize how illiquid these strategies are, which may lead to intense dissatisfaction with interval funds and their advisors during market shocks.
  
  To address these concerns in the interval fund space, some managers have mandatory training programs for wealth management firms, including:
  - One-day in-person training sessions
  - Quarterly summaries
  - Quarterly webinars
  - Constant interaction with wealth management firms
  This way, wealth management firms can educate their clients on strategies, liquidity, and when to increase their fund investments.

CONCLUSION

Investors will continue to reassess how alpha-generating strategies should fit in their portfolios and how much they are willing to pay for them. In order to meet the needs of today, hedge fund managers will continue to create innovative solutions to retain existing assets and expand their businesses.

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