The FINANCIAL — News of their pay packets sends our heads spinning, while the investment returns they rack up make us green with envy.
Until recently, star traders could choose the investment bank that suited them best in which to deploy their talents. However, with the Dodd-Frank Act enshrined in US law last year —effectively placing a lid on "speculative" proprietary trading by banks — several traders have since decided to instigate their own trading operations with the help of hedge funds.
Their clients are no longer banks but rather institutions or even private investors with deep pockets. This is providing a new lease of life for the industry, particularly as certain hedge-fund legends such as William Van Mueffling at Cantillon and Tim Barakett at Atticus have decided to call it a day.
The upshot is a genuine renaissance across the industry, with new blood coming in to offer proven, innovative techniques to hedge-fund investors.
During the financial crisis in 2008 and 2009, more than 2,000 hedge funds vanished from the scene. Since Q4 2009, the number of inceptions has outnumbered those shutting up shop. With new talent flooding in, hedge-fund investors are benefiting from a wider array of opportunities than in the past.
But in an industry offering more than 7,000 funds, sorting through and picking out the best is not an easy task, especially when some of the new entrants, notwithstanding excellent reputations as traders, lack a track record when it comes to managing a hedge fund. In this case, operating risks can be high, which calls for a considerable degree of alertness. Caution was still the watchword almost universally last year, as 80% of new hedge-fund investments were placed in funds with more than USD 5bn under management. However, with the industry in the throes of change, this trend could soon stage an about-turn.
The green shoots represented by this new batch of traders should siphon away more and more capital, especially since the returns delivered last year by more renowned managers were disappointing at times. The new recruits may provide some extra source of yield and further risk diversification for the benefit of funds of hedge funds and managed accounts.
The disappointing performance of hedge funds — as measured from the lowest point in equity markets between March 2009 and late 2010 — in relation to overall stock prices (which gained) obscures another fact: that hedge funds are basically long-term instruments. They shield capital during bear markets and manage to snag some of the upside when markets are appreciating. Relative to the start of the most recent bear market in October 2007, the MSCI World index was still down 18.5% at the end of 2010. By contrast, more than 50% of hedge-fund managers had made up all their losses for the period. Over several years, it can be shown that a fund of hedge funds, which picks out the best managers in accordance with industry criteria, habitually outperforms the MSCI World index.
But star managers are unable to put their talents to work if regulations become too restrictive. This facet of hedge-fund investing is one of the biggest threats to performance. From this standpoint, recent steps taken in Europe are laudable. Initial drafts of legal texts for the AIFMD (Alternative Investment Fund Managers Directive), an initiative to regulate hedge funds, had cast a long shadow over the future of the industry. Since then, however, the most restrictive aspects have been ditched, while measures to increase investor protection have been retained.
Hedge funds have emerged from the financial crisis in a stronger state. New regulations are no longer a threat to performances over the long term, while investors are benefiting from more advantageous terms, since many funds have cut management fees and relaxed subscription and redemption conditions.
However, investors wanting to gain access to top hedge funds (including the most promising newcomers) and, most of all, avoid backing the wrong horse, are continuing to turn to boutiques specialising in fund selection.
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