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An open and shut case for retail hedge funds

Retail hedge fund products have resurged to popularity, both open-ended as well as close-ended products, but there is now a question as to which offers the best value. Although open-ended funds have greater liquidity, the older closed-ended products have been through a trial by fire with natural selection leading to a stronger product set.

The listed hedge fund market has been in recovery mode since 2008 but assets are once again on the rise and discounts have been narrowing. Statistics from the Association of Investment Companies show that in June 2008, the average discount in its hedge fund sector amounted to just 1.96 per cent, widening out to 25.7 per cent by December of that year.

This sector now sits at 8.97 per cent, only slightly wider than the rest of the close-ended universe at 8.2 per cent.

Multi-managers who favour these vehicles believe there is good value to be had as these discounts come in. David Hambidge of Premier says: “Why pay £1 for assets when you can pay 80p?”

Still, these broad sector figures mask a key shift in buying trends, which means some areas are seeing greater demand than the AIC’s discount figures would suggest. Mark James, managing director of investment funds at RBS, says historically this sector has been dominated by funds investing in third-party-managed hedge funds.

There is currently greater demand for fettered products as well as direct, single-strategy vehicles. James says the average discount for external funds of hedge funds is around 15.5 per cent versus fettered products, which is around 3 per cent. Meanwhile, direct vehicles are on discounts of around 7 per cent.

James attributes the growing popularity of internal funds of hedge funds as they do not have the same double cost implications of an unfettered product. This has become increasingly important as double charges eat away at modest returns. Lack of control over the liquidity of underlying holdings is another key issue.

“While having exposure to assets with unquantifiable liquidity does not necessarily mean it would take a long time for a listed fund to return cash to its investors, uncertainty about the timing of any capital return – as well as the valuation of such assets at the time of redemption – means shareholders in affected funds of funds are right to be cautious.”

The volatile market conditions of the past three years have meant returns from the listed sector have been disparate and could appear at a disadvantage when compared to open-ended absolute return funds. Yes, returns from listed hedge funds have been broadly disappointing – but not in all cases.

James points out that BlueCrest allBlue, a fettered fund of hedge funds trading at a premium to net asset value, has seen its NAV rise 47.4 per cent over the three years to end of 2010, while its share price has gained 61.9 per cent.

Another popular fettered product is CQS diversified. Although the vehicle only listed in December, it invests in a feeder fund that has been around since March 2007. According to James, it has delivered 10.6 per cent annualised returns since then.

Not many funds with an absolute return mandate can claim to have made those kinds of returns through the credit crisis. There are only two in the IMA’s absolute return sector that can – Schroder ISF emerging market debt absolute return, with an annualised three year return of 13.80 per cent, and Henderson credit alpha with 10.66 per cent.

James commented the listed hedge fund space has changed since its popularity peaked in early 2008. Many of the smaller, less robust funds have exited the sector either through corporate action or windups and it is a trend he expects will continue. That, along with the continued gains made by some of the well respected and well regarded vehicles in this space, may go some way to changing investors’ perceptions of the sector that were formed amid the credit crisis.

Another positive for the close-ended sector investors should keep in mind is the inherent checks and balances of their corporate structure. Not only do listed hedge funds have an independent board, as with all investment companies, but they also tend to have annual continuation votes.

This means if their discounts are too wide, investors get a regular say in whether or not the fund should continue to exist. James says there have already been several such votes and more are under way, providing continued rationalisation.

While he is not negative on the Ucits hedge fund space, James notes there are some hedge fund strategies that are simply better suited to the close-ended world. “Macro, distressed, credit – the list is a long one – they do not naturally fit in the open-ended space.”

Product choice aside, what is perhaps more interesting when looking at the open-ended hedge fund products of today is to see the parallels with what has occurred in the listed world.

AIC figures show that in June 2007, there were 25 offerings in its hedge fund sector, with total assets of £3.9bn. A year later, there were 33 investment companies in this space and total assets had more than doubled to £7.7bn. (As of January 2011, there were 30 in operation and assets were around £7bn.)

Some would argue this rapid expansion of products and assets led to a lot of ’me too’ products that perhaps were not as robust as others. The credit crisis led to a cull of many of these as their weaknesses were exposed.

We are now seeing a strong rise in both Ucits-based hedge funds and open-ended absolute return products. There are 55 funds listed in this sector, yet only 18 have a three-year track record, according to Financial Express data. Meanwhile, a recent report from Hedge Fund Intelligence shows that in 2010, Ucits hedge funds saw $9.5 bn in inflows and 129 new launches.

Just like the listed sector in 2007, there is now growing criticism that a number of open-ended launches are ’me too’ products. So what happens if there is another dislocation like 2008? Will these open-ended products survive or will it go the way of the listed sector where the weak collapse?

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