Investors should remember the advantages listed hedge funds have over traditional hedge funds, says Edward Cartwright of LGT Capital Partners
Back in the heady days of 2002 and 2003, wealth managers all over Europe, but especially in the UK, were looking for innovative ways to offer their clients exposure to hedge funds. They rapidly embraced new closed-ended investment companies launched by some of the world’s leading fund of fund managers and then, later, became even braver and bought offerings from single hedge fund managers using the same sort of investment vehicle.
The advantages over traditional hedge funds were clear. Such companies could provide daily liquidity, as the shares tended to trade on a major stock exchange, and enhanced transparency, as the company’s holdings would have to be reported in its annual report as well as, in many cases, the semi-annual report.
Additionally, the manager would benefit from a stable pool of investment capital, ensuring swings in sentiment would not force it to add or subtract from its portfolio, as is the case with open-ended vehicles. Last, but by no means least, by putting such assets into a listed investment company, gains would be taxed as capital not income, resolving one of the perennial problems with investing in most hedge fund and fund of fund products.
Hedge funds seek to achieve returns with low correlation to traditional asset classes. In order for this to work for closed-ended investment companies, share prices need to track the underlying net asset values closely. Almost all the prospectuses of listed alternative investment companies give the boards powers to issue stock when the share prices reach significant premiums, and to buy stock back when there are meaningful discounts.
Winter of discontent
In the beginning, all went well. New products emerged and the industry grew consistently. By the beginning of 2008, the market cap of hedge fund vehicles listed in London alone was almost £10bn.
And then stock markets collapsed. In October 2008, within the space of five days, the average discount in the listed hedge fund sector went from around 2% to 15%. The rush for the door was very swift; the market makers in investment companies had seen their investment capital disappear and the amount of stock boards were permitted to repurchase was, in general, far smaller than the amount of stock being offered. Additionally sterling devalued against the dollar by over 35% in less than four months. Most managers were running dollar-based portfolios hedging back into sterling on a monthly basis, in order to provide a sterling-denominated net asset value. Most listed hedge funds effectively saw their assets contract by over a third in sterling terms.
Margin calls on the currency hedges in place were severe and far speedier than the pace at which managers could raise liquidity by redeeming underlying holdings. By the winter of 2008/2009, the situation had deteriorated, as many hedge funds were unable to meet the swathe of redemptions they were experiencing, and started to suspend redemptions. This left investment companies owing money to their bankers but unable to raise sufficient liquidity to pay on time. Consequently, many were forced to suspend the hedging of their portfolios for quite some time. Some have yet to re-establish a currency hedge, thus exposing their investors to an additional level of volatility.
Improvement
By the Spring of 2009, as with many other asset classes, things began to improve and have continued to do so pretty much ever since. As issues with balance sheet overdrafts were resolved, boards were able to buy back stock much more aggressively. Since the end of 2008, more than £2bn of assets has been returned to investors through buy backs, tenders and other corporate actions. Discounts, having troughed in December 2008 at an average of around 26%, have improved to around 13%.
Will this improving trend continue? I think it will. There are several reasons, but here are the main ones:
1) The hedge fund industry has now “normalised” and managers are able to handle their liquidity requirements in an orderly fashion.
2) Although capital utilised by market makers remains far lower than was the case two years ago, confidence amongst traders is improving and investment capital appears to have increased, albeit modestly.
3) Most shares of listed hedge funds continue to trade at far larger discounts than ever envisioned at the time of their launch. Most boards are now acting in a responsible manner, understanding that they need to continue to address the discrepancy between those prices and the underlying net asset value.
4) The key driver to the original collapse in confidence and share prices was the UK private wealth management industry, which wanted out almost at any price, certainly at the end of 2008. By now, it is logical to assume those that wanted out are, broadly, out.
I do not expect discounts to evaporate swiftly. Given the events of the past 18 months, it will be a slow process in many cases. However, most companies that have survived have, in my opinion, credible portfolios of holdings, and boards that understand what needs to happen.
Darwinism will ensure those that do not perform cease to exist. However, it is a promising sign some of the best-performing companies’ shares now trade close to net asset value, and in a couple of cases, at a premium.
Evolution
There has been much comment on how the evolution of the Ucits III structure will impact the listed hedge fund sector. I believe it is less of a threat than most commentators have suggested. The major stumbling block for Ucits III is dealing liquidity. Ucits III funds have to offer investors fortnightly dealing windows at a minimum.
If managers have learnt one thing during the 2008/2009 crisis, surely it is big mismatches in dealing liquidity and the liquidity of underlying holdings creates tremendous risk in times of market stress. Although Ucits managers are permitted to “gate” investors or suspend redemptions in moments of crisis, it is doubtful their investors will be willing to accept such an eventuality if it comes to pass.
Ucits III can work for very liquid hedge fund strategies, such as managed futures and other trading strategies. However, there are advantages in allocating to less liquid strategies, and this is where investment companies can play a useful role. The listed vehicles that will attract investors are those with the ability to generate returns modestly correlated to equities and bonds, coupled with sensible discount control mechanisms and boards willing to take decisive action when required.
Edward Cartwright is head of business development for listed investment companies at LGT Capital Partners
