In October 2008, Mercer adopted a view that any new allocations to hedge fund-type strategies should be delayed. This was based on a view that certain risks of hedge fund investing were accentuated. Some of these risks are prime brokerage, counterparty risks, potential redemptions and illiquidity in the markets.
We also noted that hedge funds were facing additional headwinds from higher transaction costs and the short-selling restrictions imposed in most markets.
In this article, we reconsider this view; the focus is not a fundamental reassessment of the asset class but is aimed at those investors who have already decided to make a new allocation to hedge funds, but delayed the investment based on market developments.
We believe that some of the risks have abated but the hedge fund landscape has changed significantly.
As such, new investments should be based on a number of good practice principles.
This is considered in more detail below.
Landscape for hedge funds
It is important to note that the potential risks to hedge funds vary depending on the nature of the strategy.
As an industry, hedge funds have been addressing counterparty risk issues and have spent the latter part of 2008 diversifying their counterparty exposures to seek a degree of protection.
The risk from redemptions also appears to be reducing, albeit the immediate analysis suggests that there has been a significant loss of capital for the industry.
Of the fund of hedge fund managers Mercer surveyed (in an internal survey), the range of redemptions received at the end of 2008 and for the first quarter of 2009 has typically been from 10 per cent to 25 per cent of assets.
Despite this decline, some positive news comes from the apparent decrease in the rate of withdrawals. As this pressure eases, some stability should return to the system.
The issue with regard to illiquidity of investments is, we believe, in the process of being addressed.
At the end of last year, we were concerned that hedge funds would lose value as a result of the repricing of illiquid assets in the markets and on the back of forced de-leveraging as a by-product of meeting redemptions and reduced financing from prime brokers.
In addition to these re-pricing risks, many hedge funds have changed the client’s understanding of the liquidity terms.
This has resulted in investors having to acquaint themselves with new terminology such as ‘gates’ and ‘side-pockets’ and the risk that funds may introduce these.
It is extremely difficult to predict accurately what new government regulations will be placed on hedge funds and the likely impact of these on their return potential.
Regulation is not a panacea, however, on balance we believe that potential regulation may help to further ‘institutionalise’ the industry and as such provide some additional comfort to investors.
Good practice principles
So, risks remain. The average hedge fund, like the average long-only manager, is generally not worth considering, especially in this environment. Counterparty risk remains, liquidity is poor in many markets, new regulations are likely, and the broader global economy may not yet have reached a nadir.
However, dislocation can bring opportunity and a select number of strategies and managers may well be in a position to capture some of these opportunities.
We therefore recommend that clients who are thinking about new allocations should consider the principles set out below.
Principle 1: Clients should avoid being providers of liquidity
Many hedge funds are still facing redemption pressures.
We believe that clients should avoid new investments with a fund that is threatened by high levels of redemptions. This is both because the remaining assets may be illiquid or unattractive investments, and because high levels of redemptions may be a risk to the broader business.
Practically, we believe that investors need to assess what redemptions a hedge fund (or hedge fund of funds) is experiencing. They also need to consider the likelihood of redemptions in the future. For example, what does the manager’s client base look like? Does one large client dominate the fund? How many truly institutional clients does the fund have?
Principle 2: Clients need to be comfortable with the liquidity of the fund
This is, in part, connected to the issue of redemptions. Clients should be comfortable both with the liquidity provisions of the fund itself (what are the terms around gates and side pockets, for example) and also the underlying assets (in the case of a fund of hedge funds, the underlying hedge funds).
In many cases, hedge funds have been forced to reduce liquidity by market conditions and to protect the remaining investors.
These actions have nonetheless taken investors by surprise. Investors should therefore fully understand the current liquidity terms and the managers’ ability to change these.
Principle 3: Clients should demand greater transparency as part of a more institutional service
Funds of hedge funds have historically provided the institutional link for investors, but the level of the client servicing (in particular, the transparency they provide) can vary significantly from manager to manager.
Investors should know who is managing their money, how they are doing it, and what positions are in the book.
Clients need to ensure they are getting the clarity they need on the underlying investments.
In this regard, clients should discuss with their managers the nature and format of the information they will receive to satisfy themselves that they can appropriately monitor the investment.
Principle 4: Comfort on the independence and freshness of the pricing
We have highlighted above that the opportunities in the markets may be large, but we also stress that this is only the case if the losses have been priced into the funds. Investors need to seek reassurances from the managers on independence and freshness of the pricing.
Principle 5: Controlled counterparty risks
As we have noted above, while the risk of another counterparty collapse may have been reduced, it remains a significant consideration.
Some hedge funds have addressed the issue earlier than others and can demonstrate that these risks are managed and controlled, even if not eliminated. Some strategies are also less impacted than others.
Investors should be comfortable with the risks to which any new investment will expose them.
Principle 6: Financial leverage should be low
The opportunities that are available in the marketplace shouldn’t require much leverage and we would encourage clients to look at other strategies if they are seeing high levels of leverage.
Principle 7: Challenge the fees (within reason)
Institutional investors are attractive clients for hedge funds. Investors should make sure they are paying fees that are appropriate.
The principles above should, we believe, form the basis of new investments in hedge funds. By their nature some strategies are more likely to overcome these hurdles, while others will find it harder.
Winners and losers
It would be inaccurate to suggest that the industry is back to business as usual, or even that it will ever return to what it once was, but winners and losers are starting to emerge.
More importantly, the level of uncertainty has dropped, especially on an individual manager and strategy basis.
Overall, we continue to believe that specialist active management by talented managers can add value, and that giving managers the flexibility to exploit these opportunities in a risk-controlled way can add value net of fees.
However, investors intending to make new allocations should do so based on the principles set out above.
Simon Fox is a senior associate at Mercer and Divyesh Hinodcha is the global director of consulting.
No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.
