The hedge fund industry has grown rapidly over the last 20 years, weathering numerous challenges, including the 2008 financial crisis, to reach new highs both in terms of assets and the number of funds.
Recently, this trend has been aided by an array of economic headwinds to major asset classes, which have caused many investors to search for new diversification. As the hedge fund industry has grown, it has evolved to suit changing investor preferences. Nowhere is this more apparent than in the area of "liquid alternatives." This is the term given to certain funds, accessible to a wide client base through UCITS or similar structures in other jurisdictions that employ alternative strategies.
The rise of liquid alternatives has changed the landscape of portfolio opportunities available to mainstream investors. For many years, investing in alternatives such as hedge funds was the preserve of institutions and high net worth individuals, as investor qualification restrictions and high investment minimums excluded mainstream investors.
The development of liquid alternatives, such as UCITS and similarly structured retail funds in other jurisdictions, has opened up the benefits of alternative investing-including the potential to reduce overall portfolio risk and enhance long term performance-to a wider investor base. Reflecting growing interest in this area, alternative strategies under the UCITS structure reached $155 billion1 in value at the end of 2012, an increase of over 20% on the previous year.
Liquid alternatives can encompass a range of hedge fund strategies including equity and credit long-short, event-driven and macro investing. In response to investor demand, these funds have much more investor-friendly structures and terms than traditional hedge funds.
They offer more regular liquidity, low minimum investment levels, a flat management fee, rather than a management plus incentive fee (in some cases) and full transparency of holdings. They are also not subject to investor qualification restrictions, which opens them to a wide base of potential clients, including retail investors and defined contribution (DC) schemes.
New Areas of Demand
Taking DC schemes as an example, these platforms have in the past struggled to invest in hedge funds, because of their limitations in liquidity and transparency. This has resulted in a general absence of absolute return strategies in the DC space, despite the significant benefits that they can bring to an overall portfolio. In our view, there is likely to be strong demand for absolute return products from scheme members who have been disappointed by relative returns, as they become more familiar with the new wave of liquid alternative products.
New Appeal to Fund Managers
In the past, hedge fund managers were reluctant to develop "liquid alternatives" for a variety of reasons, including infrastructure, asset-raising and distribution challenges.
The ability to partner with larger asset managers addresses some of these key challenges and provides managers with access to markets that they may not otherwise be able to access directly. This has created an attractive opportunity for fund-of-hedge-fund managers (FoHFs) and, by extension, investors.
The Role of Funds of Hedge Funds
As the hedge fund industry has grown and strategies and instruments have become more complex, allocations to FoHFs have become increasingly valuable for both institutions and individuals seeking exposure to hedge funds. The main advantages of using FoHFs include access to due diligence and manager selection, construction of a diversified portfolio and robust risk management. These benefits are being amplified as the number of liquid alternative products and their assets continue to increase and investors with less familiarity with such strategies begin to take an interest.
Investors who wish to allocate to smaller hedge funds via liquid alternatives can benefit from FoHFs' large industry networks and their familiarity with many smaller hedge fund managers. FOHFs have ample resources to carry out robust diligence on potential investments, thus enabling them to select best-of-breed managers. Having such a skillset may prove quite valuable; given the degree of dispersion among managers in the industry (see display).
In a world facing a number of economic challenges, investors' needs for diversifying assets shows no sign of diminishing. At the same time, there has been a shift in appetite towards increased liquidity and transparency. As such, we believe that the appeal of liquid alternatives, along with their presence in the marketplace, will continue to grow over time.
Fred R. Ingham is head of International Hedge Funds at Neuberger Berman
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