The Great Migration?

A total blood transfusion and a complete change of scene. It sounds like a Victorian doctor’s prescription for an overwrought, wealthy patient, but in fact it’s a fair approximation of two developments that have been dominating the collective mind of the UK hedge fund industry over the last three years. New clients have replaced the old, and many hedge fund managers have been thinking of moving to Switzerland or even to the Far East.

The change in clients has been radical. Damien Loveday, global head of hedge fund research at Towers Watson, one of the world’s largest investment consultants advising pension schemes and other institutional investors, says: “One hedge fund manager we know had something like $16bn of assets under management three years ago, and $16.5bn a year ago. On the face of it that’s not a particularly large change, but actually, over the course of those two years, it saw outflows of $16bn and inflows of $16.5bn. It was a complete change of investors.

“We’ve seen the same at three other funds, and there’s been a huge change in the hedge fund industry’s investor base.”

The high net worth individuals that formed the bedrock of the hedge fund industry’s clientele from the late 1960s to the late 2000s have turned their backs on the industry. The managers they thought would protect their capital in every kind of market simply failed to do so.

Sure, hedge funds as a whole lost only half as much as equity markets in 2008 – in dollar terms, the average hedge fund lost 19% that year, according to data provider Hedge Fund Research, while the MSCI World Index fell 40% – and hedge fund managers never guaranteed they wouldn’t make a loss; but nevertheless their wealthy clients were shocked and appalled to see their hedge fund investments lose double digit percentage points.

Two years ago, Michael Sonnenfeldt, founder of the wealthy investor US networking group Tiger 21, said his members felt they had been “played for a fool” by hedge fund managers, had cut their portfolio weightings in hedge funds from 11% to 3%, and were unlikely to return for at least a generation.

A decade or so ago, high net worth individuals accounted for most investments in hedge funds, according to investment consultants. An Alternative Investment Survey published by Deutsche Bank this year showed high net worth individuals now account for only 6% of all direct investments in hedge funds, with another 9% channelled through private banks. With perhaps another 10% channelled through funds of funds, high net worth individuals now account for only about a quarter of all investments in hedge funds.

Funds of hedge funds – an intermediary, typically between relatively new or small investors on the one hand and hedge funds on the other – have also been cut down as a channel for investments into hedge funds. Their investors were unhappy about their returns and the fact that they couldn’t get their money out when they wanted it, while the hedge funds to whom the funds of funds had allocated capital found them too quick to ask for their money back.

The authors of the Deutsche Bank survey summarised it thus: “The liquidity crisis of 2008, the Madoff fraud and increasing sophistication of the end-investor base, have resulted in large outflows, particularly in Europe, and raised questions about the validity of the fund of hedge funds business model.”

Institutional investors – such as pension schemes, charitable endowments and insurance companies – have taken the place vacated by high net worth individuals and funds of hedge funds. About a third of institutional investors surveyed by Deutsche Bank said they increased their allocations to hedge funds last year, and a fifth said they planned to increase their allocations in 2011.

One UK commodities hedge fund manager, who requested anonymity, said: “UK pension schemes are investing in us directly now, rather than through funds of hedge funds. Some of them thought that they should have an exposure to commodities and were investing passively, and they have decided they would rather have an active manager.”

This extensive change in client base is having two significant impacts on hedge fund managers:

First, institutional investors drive a hard bargain on fees. High net worth individuals didn’t seem to mind paying two and 20 – an annual management fee of 2% of assets managed, plus an annual performance fee of 20% of any gains. Pension schemes look at it rather differently.

They ask, ‘What return did you give me that I couldn’t have got if I’d invested in the same markets as you over a decent period of time?’ Then they say, ‘if you did outperform, we will give you 25% to 50% of whatever the outperformance was’.

The resulting fee structure typically includes a time frame for measuring returns; usually, this is three years but sometimes can be five; a hurdle rate, typically a benchmark that blends the markets where the hedge fund manager invests; the use of high-water marks, which means the manager cannot charge its clients performance fees just for recovering money it had previously lost them; and clawback rights, where some of the fees previously paid may have to be repaid. For all but the best-performing managers – the top 1% – the new fees are a lot less lucrative than the old two and 20.

Second, institutional investors are far more concerned about things going wrong. The members of pension schemes are ordinary working people who rely almost entirely on the scheme for their income in retirement. If the scheme invests in a hedge fund that blows up or cannot pay it back when it needs the money, it may struggle to make sure its pensioners receive their monthly cheque. And if the hedge fund gets into trouble with the regulators or the law, the pensioners will be furious.

As a result, hedge fund managers aiming to attract institutional money have beefed up their risk management and compliance teams heavily. Brevan Howard, one of Europe’s largest hedge fund managers, is said to have dedicated a floor of one of its offices to this function.

This development means higher costs for hedge fund managers. Of course, they’d rather not pay it; but it is a cost that is increasingly difficult for them to avoid, because as well as a shift in the nature of the hedge fund industry’s investors, regulations are changing. The European Union’s Alternative Investment Fund Managers directive, enacted last year, will bring in a raft of reporting and compliance requirements for hedge fund managers.

The introduction of this directive has helped fuel a second major development in the hedge fund industry: serious thoughts of relocation.

While hedge funds themselves are mostly domiciled in tax havens such as the Cayman Islands, the managers who run them mostly live, work and pay taxes in or around the big financial centres such as New York and London – where they are also regulated.

The directive, and an increase in the top rate of UK income tax from 40% to 50%, has led to much talk of UK hedge fund managers quitting the country for domiciles outside the EU. Switzerland came to mind first as a potential new location, and hedge fund managers are now said to be thinking about the Far East, particularly Hong Kong and Singapore.

There has, however, been much more talk than action.

Reto Barbarits, a director of Swiss & Global Asset Management, a Zurich asset manager that runs a hedge fund, said: “It is difficult to get reliable data about the topic, but we haven’t seen a rush of UK hedge fund managers into Switzerland. Some have been reported in the press as moving, but it is more that they are thinking about moving, mainly for tax reasons, than actually moving.”

Some of the bigger UK hedge fund managers have opened offices in Switzerland. These include Brevan Howard, whose founder Alan Howard moved to Geneva last year – his wife is Swiss – and has just been joined by his co-chief executive, Nagi Kawkabani; Moore Capital, which has opened an office in Zurich with Jean-Philippe Blochet and Kornelius Klobucar; and BlueCrest Capital has seen dozens of staff move from London to its Geneva office.

But each of these firms retains its head office in the UK. Examples of hedge fund management firms that have moved lock, stock and barrel to the cantons are few and far between: Amplitude Capital, a small firm that makes extensive use of computers, is the only example most people can name.

Daniel Müller, founder, managing partner and chief investment officer of Entrepreneur Partners, a Zurich financial adviser and asset management provider for high net worth individuals that advises on hedge funds, said: “There’s a lot of talk, but I’m not aware of any hedge funds that have moved all their operations and people here.”

Issues of lifestyle aside, part of the reluctance to move stems from the fact that Swiss tax rates are not cheap, even compared with the UK.

Another part of the resistance is the realisation that relocating outside the EU will not allow a hedge fund manager to escape from compliance with the EU’s regulations – not if it wants to continue having clients in the EU. The Alternative Investment Fund Managers directive will, in effect, make it difficult for EU investors, even the largest and most sophisticated ones, to place their money with any hedge fund manager that did not comply with most of the directive’s rules.

Relocating to Hong Kong or Singapore wouldn’t change this. And such a move would risk putting a hedge fund manager out of touch with his investor base.

Richard Watkins, chief executive of hedge funds placement agent Liability Solutions – who himself moved from London to Geneva a few years ago – said: “People who invest in hedge funds have significantly cut back on their travel budgets, because they’re just not making the returns they used to. And whereas it used to take only two to six months to make a decision to invest in a hedge fund, now they require six or seven meetings and it may take a year. So there’s been a complete collapse in western investors’ interest in Asia-based hedge funds.”

Investors said they saw little evidence that an Asian presence helped investment returns. Moreover, Asia has no financial hub to match London or New York, and many hedge fund managers – though there are significant exceptions – seem to like rubbing shoulders with their rivals. Despite a five-fold increase in Hong Kong funds over the last five years, stimulated by their access to China, and Singapore hedge fund startups are on the rise after its central bank watered down licensing requirements, these hedge fund communities are still tiny.

Moreover, Watkins said: “Asian investors aren’t interested in hedge funds, they’re more interested in doing it themselves or buying property. So if you do come across someone who is moving to Asia to run a hedge fund, you can be sure they won’t be doing it to raise funds.” 

Are you thinking about upping sticks? Let us know where and why? Leave a comment below.