Hedge funds replicate and revive

The fund of hedge fund industry has endured a difficult time since 2008 – but there are indications the money is flowing back.

It has been reported that between 2007 and 2008 assets under administration (AUA) totalled $826bn (3,574 funds), in 2009 it was $433bn (3,212 funds), and in October 2011 had reached $667bn. It is estimated fund of hedge funds account for 32.6% of underlying hedge fund assets.*

A fund of hedge funds (FoHF) is a fund that invests in a portfolio of different hedge funds as opposed to hedge funds that invest directly in a large range of securities, such as shares, bonds or derivatives

By investing in a FoHF the investor seeks to achieve greater diversification and reduce volatility with consistent average returns. However, the return is reduced by the double layer of fees from the FoHF and the underlying fund.

However, managers have adapted their business model to attract more capital, be more competitive and address the fee and liquidity concerns of investors. They have tended to reduce performance and management fees (11.5% in 2005 and 9.5% in 2011), reduce redemptions notices (two months in 2007 to one month in 2010), and secure credit lines to improve liquidity and invest in more liquid hedge funds, depending on the FoHF strategy.

As some specific strategies are not replicable under the UCITS framework, FoHF asset managers tend to launch onshore non-UCITS investment vehicles which allow easier replication of offshore FoHF portfolios.

One of the consequences of these changes, combined with a tighter regulatory environment for Banks under Basel III, has been a change in FoHF credit utilisation. The use of leverage has never returned to pre-2008 levels and a key strength of the FoHF business model today depends even more strongly on the relationships with its service providers, in particular when it comes to accessing credit lines that will insure the liquidity of its investment vehicles during volatile market conditions. It is also important to have access to services such as trade execution, valuation, independent accounting, bridge financing and foreign exchange capabilities.

The hedge fund and FoHF markets have traditionally been lightly regulated offshore structures based in the Cayman Islands, British Virgin Islands and the Channel Islands. But the introduction of the Alternative Investment Fund Managers Directive (AIFMD) in 2013 may in the future impact domicile choice.

The AIFMD will impact hedge fund managers in two ways. Firstly, it will result in higher regulation of non-UCITS funds and non-UCITS fund managers in the European Union, but also for non-EU managers who market funds in the region. Secondly, from mid-2013, the AIFMD will provide a fund passport within the region for EU- domiciled alternative investment funds managed by EU-domiciled managers.

There are indications that hedge fund managers will adapt to the new regime by co-domiciling rather than re-domiciling their funds. A recent survey by RBC Dexia and KPMG of hedge fund managers found that only 5% of AIF managers intended to re-domicile their offshore vehicles in the EU as a result of AIFMD.

Instead, 55% said they had opted to access European institutional investors and extend their distribution network by co-domiciling and creating an UCITS or AIFMD-compliant vehicle clone of their offshore funds. It is clear the hedge fund of hedge industry is here to stay and we will continue to monitor and assess the implications of regulatory changes to its overall operating models.

Kamel  Torki
Product Manager, Alternative Investments
Global Fund Products

* Eurekahedge, HFMWeek and the Financial Times

RBC Dexia Investor Services Limited is a holding company that provides strategic direction and management oversight to its affiliates, including RBC Dexia Investor Services Trust, which operates in the U.K. through a branch authorized and regulated by the Financial Services Authority. All are licensed users of the RBC trademark (a registered trademark of Royal Bank of Canada) and Dexia trademark, and conduct their global custody and investment administration business under the RBC Dexia Investor Services brand name. These materials are provided by RBC Dexia Investor Services for general information purposes only. RBC Dexia Investor Services makes no representation or warranties and accepts no responsibility or liability of any kind for their accuracy, reliability or completeness or for any action taken, or results obtained, from the use of the materials. Readers should be aware that the content of these materials should not be regarded as legal, tax, accounting, investment, financial, or other professional advice, nor is it intended for such use.

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