Citi Prime FinanceThe Rise of Liquid Alternatives &the Changing Dynamics of AlternativeProduct Manufacturing and Distribut...
Table of ContentsSummary of Key Survey Findings	 4Methodology 	 6Section I: Institutional Investors Evolve Use ofHedge Fun...
ƒƒ Interviewees see capital coming off the sidelinesand moving into actively managed equity long-onlyfunds, increasing the...
Rise of Liquid Alternatives Survey | 5ƒƒ The composition of the financial adviser marketis also shifting, with more assets...
MethodologyThe 2013 Citi Prime Finance & Futures AnnualIndustry Evolution report is the synthesis of viewscollected across...
Rise of Liquid Alternatives Survey | 7Chart 1: Overview of Survey Participants (continued)Chart 1-FConsultant Paricipant A...
Institutional investors have become the predominantaudience for hedge fund investing over the pastdecade. Their view on wh...
Rise of Liquid Alternatives Survey | 9Institutional Investors Then Moved into HedgeFunds for Portfolio DiversificationExte...
Rise of Liquid Alternatives Survey | 10In the first, institutional investors created anopportunistic bucket for all of the...
Rise of Liquid Alternatives Survey | 11“	We assess and place our absolute return strategies into analternatives bucket.”	 ...
Rise of Liquid Alternatives Survey | 12many of these portfolios were overdiversified and runby managers that would “chase ...
Rise of Liquid Alternatives Survey | 13gained confidence in their own ability to create adiversified portfolio, and they b...
Rise of Liquid Alternatives Survey | 14Chart 7 shows that in the post-GFC years, the shareof market controlled by funds of...
Rise of Liquid Alternatives Survey | 15a new record level. This increase in interest frominstitutions reflects heightened ...
Rise of Liquid Alternatives Survey | 16Leading Institutions Shift from a Capital-Basedto a Risk-Aligned PortfolioSeveral p...
Rise of Liquid Alternatives Survey | 17Sharp equity declines in that period underscoredto these investors that with a 60/4...
Rise of Liquid Alternatives Survey | 18“	Ifweallocatetherightwayanddoourhomeworkrightitwillcreateaportfoliothat is differe...
For those readers who were familiar with industrytrends covered in last year’s survey and who haveskipped Section I of thi...
Rise of Liquid Alternatives Survey | 20performance where idiosyncratic risks re-emerge,thus benefitting hedge fund trading...
Rise of Liquid Alternatives Survey | 21institutions to reposition more directional equityand event driven hedge funds alon...
Rise of Liquid Alternatives Survey | 22New Long-Duration Credit Funds Are Used toProtect Against a Second Liquidity ShockW...
Rise of Liquid Alternatives Survey | 23Rather than looking to take on such exposure in anuncovered way, however, change ha...
Rise of Liquid Alternatives Survey | 24Moving to a long-duration structure is thus a markedchangeinapproach.Thefactthatthi...
Rise of Liquid Alternatives Survey | 25“	I was shocked at the level of institutional demand I encountered for theseDiversi...
Rise of Liquid Alternatives Survey | 26In Europe, these funds are known as diversified growthfunds, (DGFs) and they have a...
Across Europe, continued regulatory change anduncertainty, combined with more risk-averse investorsentiment, is encouragin...
Rise of Liquid Alternatives Survey | 28AIFMD Marketing Considerations Draw MoreFunds OnshoreAIFMD does not have a specific...
Rise of Liquid Alternatives Survey | 29the current breakdown of the European investor base.As shown, European investment i...
Rise of Liquid Alternatives Survey | 30Chart 21.Post-GFC, the entire investor community, andinvestors in Europe in particu...
Rise of Liquid Alternatives Survey | 31Alternative UCITS Investment LimitationsSlow Growth Post-2010Institutional enthusia...
Rise of Liquid Alternatives Survey | 32For investors, the platforms identify, complete duediligence on and provide access ...
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
Citi prime services report on liquid alternatives
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Citi prime services report on liquid alternatives

  1. 1. Citi Prime FinanceThe Rise of Liquid Alternatives &the Changing Dynamics of AlternativeProduct Manufacturing and DistributionMay 2013
  2. 2. Table of ContentsSummary of Key Survey Findings 4Methodology 6Section I: Institutional Investors Evolve Use ofHedge Funds in Their Portfolio 8Section II: Increased Risks in Institutional PortfoliosDrive Investors’ Need for Hedge Fund “Insurance” 19Section III: European Regulatory Pressures Force a Reallocation ofAlternative Assets Away from Private Fund Structures 27Section IV: U.S. Regulations Flatten Barriers BetweenPrivately and Publically Offered Funds 35Section V: Changing U.S. Wealth Adviser Dynamics AreDriving New Demand for Alternatives Products 39Section VI: Overall Industry Assets to Rise as Hedge Funds BecomeMore Institutional & Liquid Alternatives Draw a New Audience 47Section VII: Expanding View on Active Fund ManagementEncourages New Product Opportunities 58Section VIII: Market Players Face Differing Credibility Gaps inTrying to Extend into New Products 65Section IX: Traditional Asset Managers and Private Equity FirmsLook to Hedge Fund Talent for Product Creation 70Section X: Hedge Fund Managers Face More Choices onHow to Evolve Their Firm and Product Offering 77
  3. 3. ƒƒ Interviewees see capital coming off the sidelinesand moving into actively managed equity long-onlyfunds, increasing the need to dampen potentialvolatility and exposures in institutions’ core equityholdings. In line with this view, HFR noted positiveinflows to equity hedge strategies in Q1 2013—thefirst such uptick in flows since Q3 2011.ƒƒ Investors are also seen moving out the liquiditycurve in search of yield and perceptions were thatinflows to shadow-banking products are back tolevels not seen since the GFC. Illustrative of thispoint, CLO issuance in the U.S. reached its thirdhighest level on record in Q1 2013. Concern aboutanother liquidity shock is helping fuel interest inlonger duration credit hedge funds. These new5-year lock-up vehicles are competing for privateequity allocations with hedge fund managerslooking to differentiate their offering by stressingthat their “trading” as opposed to “banking”mindset could offer superior protection in case ofanother liquidity event.ƒƒ Concern about a turn in the credit cycle is alsoprompting hedge funds to offer lower fee liquidcredit funds that have a long bias, but that canstill use shorting to provide insurance in case ofa shift in market dynamics. These hedge fundofferings are competing with publically tradeddiversified growth funds and with risk parityfunds for flows shifting over from long-only vanillabond allocations.We see institutional investment in hedge funds risingfrom$1.485trillionin2012(4.2%oftotalglobalassets)to $2.314 trillion by 2017 (5.3%). Proportionately, thiswill increase institutional investors’ share of hedgefund industry AUM from 66% to 71% as flows fromthis sector continue to outpace recovery, althoughwith significantly lower flows from High Net Worth &Family Office investor segments.The big story in 2013 is not, however, the outlook forthe institutional market. Rather, the topic of primaryinterest to survey participants this year was theemergence of a new “middle tier” liquid alternativesmarket catering to a retail audience whose net worthmakes them ineligible for privately offered funds.Led by U.S. wealth advisers, demand for publiclyavailable U.S. alternative retail funds has beensurging, allowing assets to more than triple from$95 billion in 2008 to $305 billion in 2012. Ourestimate outlined in this report is that the retailinvestor segment account for 85% ($259 billion)of those assets. The following factors are drivingdemand for these products.ƒƒ Regulations enacted in the 1940 InvestmentCompanies Act are working to make thesestructures more attractive for alternative strategies.ƒƒ Regulation of the private funds industry hasforced an unprecedented level of transparencyon traditional hedge funds and required thatparticipants create compliance and reportingprocedures that more closely mirror the demandsplaced on publically offered funds. The resulthas been a flattening of the differences betweenpublically offered and privately offered funds.ƒƒ Such changes come at a time when shiftingdynamics in the wealth adviser market are creatinga growing need for alternative strategies. Morewealth advisers in the U.S. market now get paida combination of fees on AUM and commissions.Ensuring the stability of their asset base isbecoming as important to these participants as totheir institutional counterparts.Institutional investor views about the role hedge funds play in their portfolio continue toevolve. In line with the shift from a capital-based to a risk-aligned allocation approachdiscussed in our 2012 survey, more interviewees now describe hedge funds as being“shock absorbers” and as offering “insurance” against losses in their portfolio versusbeing seen primarily as a diversification and risk-adjusted return vehicle. This bodes wellfor continued growth in industry assets, given participants’ assessment of increasedrisks in the market environment.Summary of Key Survey Findings
  4. 4. Rise of Liquid Alternatives Survey | 5ƒƒ The composition of the financial adviser marketis also shifting, with more assets flowing toindependent Registered Investment Advisers(RIAs) and independent and regional broker-dealers. These advisors have an open architectureapproach to product and are active in supportingnew fund launches. RIAs also have discretion overtheir client portfolios and can purchase alternativeretail products on their behalf.Our analysis in this report shows U.S. retail demandfor alternative 40 Act mutual funds and alternativeETFs pushing assets up from $259 billion in 2012to $779 billion by 2017. If this trend has a spillovereffect in the global marketplace, as severalinterviewees expect, we could also see demandfor alternative UCITS rekindled, but from a retailaudience rather than from the institutional investors.In total, we see global demand for liquid alternativesfrom the retail audience reaching $939 billion by 2017and $1.3 trillion when demand from a small sub-setof institutions drawn by their liquidity is factored in.This would make the liquid alternatives market nearlyas big as the entire hedge fund industry at the endof 2008.What is especially impactful about this trend, beyondthe size of the potential asset pool is the way surveyparticipants saw these new products being managed.They expect liquid alternatives to trade in-parallelwith privately offered funds and therefore the sameportfolio manager would be able to isolate a subsetof their more liquid trading ideas and package themin a publically offered fund wrapper. This would helpto differentiate the product from their higher feeprivately offered fund, but allow for an expanded useof the team’s investment research.In many ways, this approach marks an expansionin the concept of “actively managed” product. Theemerging view is that a manager can pursue multiplealpha streams and better manage their portfolio riskby layering on increasingly sophisticated investmenttechniques as a fund becomes more illiquid. In thisdynamic, it is easier for a manager to convinceinvestors about their ability to use fewer skills increating a new product than it is for a portfoliomanager to add more sophisticated alternative skills.In a sense, this new way of looking at productmanufacturing and active management is a resultof the convergence trend that has been blurring thelines between traditional asset managers, hedgefunds and private equity firms. Our model has beentracking changes in this space for several years, andwe now believe the convergence trend to be complete.Investors can source an entire range of productfrom each type of investment firm, and for the moreliquid of these strategies they can also source themanagement of that fund in a publically offered or aprivately offered fund structure.Investors interviewed do not see each type ofinvestment manager as equally well suited to createand manage those funds. Traditional asset managersrun into a credibility barrier as they attempt to moveinto alternative products. Private equity firms areseen as offering more of a deal-based as opposedto transactional mindset, making it hard for them tooffer strategies that require active trading to manageday-to-day risk.The result has been that both types of investmentmanagers are now looking to bring hedge fund talentinto their organizations to close their capabilitygaps, create more credible alternative strategies andenable them to better leverage their infrastructure,brand and distribution networks. This pursuit is takingplace in parallel with their organic growth efforts,and is increasingly characterized by the recruitmentof hedge fund teams and by leveraging the portfoliocreation expertise of fund of hedge funds eitherthrough a direct acquisition or a strategic partnership.Hedge funds are thus in a strong position. Thedemand for their skill set is creating new options forsmaller managers that are struggling to appeal to anincreasingly institutional audience base and cover theincreased costs of regulation. Institutional interestcontinues to support growth in managers that areable to surpass the institutional threshold and enterthe direct allocators’ and consultants’ sweet spot.Managers that have chosen to continue raising assetsup to the $5.0 billion AUM band and beyond can nowconsider new paths for developing their organization.Increasingly, these large hedge fund firms will need toconsider whether they want to 1) offer their productexclusively to buyers eligible for their privatelyoffered funds; 2) choose to sub-advise a fund in thepublically offered market, either as a single manageror as part of a multi-alt structure that contains severalother hedge fund firms or 3) extend their franchisefully into the publically offered fund domain andbegin creating and issuing their own product, thusbecoming a new breed of alternative asset manager.Experimentation and evaluation of each of theseoptions is occurring in real time. Numerouslaunches of publically offered funds have alreadybeen announced for 2013, and reports are that thepipeline is filling rapidly. This presents a new erain the industry’s growth, one that brings with it theopportunity to bring more diverse trading skill to alarger audience.
  5. 5. MethodologyThe 2013 Citi Prime Finance & Futures AnnualIndustry Evolution report is the synthesis of viewscollected across a broad set of industry leadersinvolved in the global hedge fund, traditionallong-only asset management, and private equityindustry. Comprehensive interviews were conductedin the U.S., Europe and Asia, with hedge fundmanagers, asset managers, private equity companies,consultants, fund of hedge funds, pension funds,sovereign wealth funds, endowments & foundations(E&Fs), and intermediaries.To better comprehend evolving industry dynamics,we conducted 82 in-depth interviews Collectively,our survey participants represented $336 billion inhedge fund assets and $5.6 trillion in overall assetsmanaged or advised. The interviews were conductedas free-flowing discussions rather than constructed,one-dimensional responses to multiple-choicequestionnaires. We gathered more than 100 hoursof dialog, and used this material to drive internalanalysis and create a holistic view of major themesand developments.This report is intended to be a qualitative andquantitative prediction of future industry trends:constructed around the comments and views of theparticipants. We have also built indicative modelsbased on those views to illustrate how asset flows andopportunity pools may develop in the near future.The structure and presentation of the reportisintended to reflect the voice of the participants,and is our interpretation of their valued feedback. Tohighlight key points, we have included quotes fromour interviews; however, citations are anonymous,as participation in the survey was done on a strictlyconfidential basis.As can be expected, there are a few topics that thissurvey has touched upon that have been covered inmore detail by other recent publications from CitiPrime Finance & Futures. In those cases, we havereferenced that document and, where it toucheson broader adjacent trends, we have noted it butremained on topic for the subject at hand.The following chart shows the survey participantsthat we interviewed this year, representing all majorglobal markets.Chart 1: Overview of Survey ParticipantsSurvey ParticipantsChart 1-A39%7%7%9%38%InvestorsHedge Fund ManagersAssetManagersConsultantsIntermediariesSurvey ParticipantsRegional Survey ParticipantsChart 1-DRegional Survey Paricipants51%18%31%USEMEAAPAC
  6. 6. Rise of Liquid Alternatives Survey | 7Chart 1: Overview of Survey Participants (continued)Chart 1-FConsultant Paricipant AuA (Millions of Dollars)$1,186,000Total AuAHF AuA$82,300Consultant Participant AuA(Millions of Dollars)Chart 1-BInvestors and FoF Participant AuM(Millions of Dollars)Total AuM$2,188,650HF AuM$99,803Investors and FoF Participant AuM(Millions of Dollars)Chart 1-EAsset Manager Paricipant AuM (Millions of Dollars)$1,069,000Total AuMHF AuM$38,125Asset Manager Participant AuM(Millions of Dollars)Chart 1-CHedge Fund Paricipant AuM (Millions of Dollars)Total AuM$440,240HF AuM$116,090Hedge Fund Participant AuM(Millions of Dollars)
  7. 7. Institutional investors have become the predominantaudience for hedge fund investing over the pastdecade. Their view on where hedge funds fit into theirportfolio, and their investment goals for their hedgefund allocations, have both undergone significantchange over the years, with market leaders movingfrom capital-based allocations that placed hedgefunds in the satellite of their portfolio to risk-alignedconsiderations that move hedge funds into their coreequity and bond holdings.We provided an in-depth analysis of these changesin last year’s survey, Evolving Investor PortfolioConstruction Drives Product Convergence, andfor those familiar with that report, we recommendskipping this introductory section and beginning yourreading of this year’s survey with Section II: IncreasedRisks in Institutional Portfolios Drive Investors’ Needfor Hedge Fund “Insurance”. For those unfamiliarwith that report, Section I should provide a sufficientsummary of our previous work to lay the groundworkfor understanding the importance of developmentsin the past year, as well as the outlook for 2013and beyond. Last year’s report can be obtained bycontacting the team at prime.advisory@citi.com.Few Institutional Investors Participated inHedge Funds Prior to 2000General equity market conditions in the 1990sprovided investors with strong returns on theirinvestment portfolio. As highlighted in Chart 2, theaverage annualized trailing 3-year return for globalequity markets was +15.7% as measured by MSCIWorld Index, and the U.S. equity market measured bythe S&P 500 provided investors with +21.9% returns.It should be noted that investors with allocationsto the technology sector witnessed even strongerreturns during this period. In addition to the equitymarkets, interest rates offered a reasonable returnon fixed-income assets. Chart 2 illustrates that the10-year U.S. Treasury average yield was 6.01% from1994 to 2000.Given these market dynamics, institutional investorswith traditional long-only equity and bond investmentssaw their portfolios expand. In particular, pensionfunds’assetgrowthoutpacedtheirliabilities.Asshownin Chart 2, global pension assets as a percentageof their liabilities averaged 108.5% from 1998 to2000 according to the Towers Watson Assets/Liability Index.During this era, hedge fund interest was beginningto grow, and the industry saw assets rise from $167billion in 1994 to $491 billion in 2000. The majority ofthese flows were coming from high net worth investorsand family offices (HNW/FO) that met the QualifiedInvestment Person (QIP) threshold requirements, andwere thus allowed to allocate to private partnershipsand offshore funds.These investors viewed hedge funds as a mechanismto capture excess performance. As seen inChart 2, the HFRI Equity Hedge index returned+21.8% for investors during this period, but withonly two-thirds of the monthly volatility of the equitymarkets. Placing hedge funds into their portfolioallowed HNW/FO investors to amplify their returns,but with less risk than if they had purchased moreoutright long equity positions.At this time, only a small set of leading endowmentsand corporate pensions were looking at hedge fundsfor their potential to provide an illiquidity premiumand diversified alpha source. Their pioneering useof hedge funds became the foundation for a massivewave of investments from other institutional investorsafter the technology bubble.Section I: Institutional Investors Evolve Use ofHedge Funds in Their Portfolio
  8. 8. Rise of Liquid Alternatives Survey | 9Institutional Investors Then Moved into HedgeFunds for Portfolio DiversificationExtensive losses in the equity market correction afterthe technology bubble caused many institutionalinvestors to reassess their portfolio’s exposures inthe early 2000s. Chart 3 illustrates that returns fromequity markets were muted from 2000 to mid-2007.The average trailing 3-year return for the MSCI WorldEquity Index was +3.6%, and the S&P 500 was only+2.0%. Against this backdrop, institutional investors’pension liabilities increased at a faster pace. Assetsfell from covering 108.5% of projected liabilities inthe years just before 2000 to only covering 86.6% ofof liabilities on average from 2000 to 2007.Hedge fund assets grew significantly during the earlypart of this millennium, increasing four-fold (from$491 billion in 2000 to $1,868 billion) by 2007, asshown in Chart 3. A massive wave of inflows from theinstitutional audience accounted for the majority ofthat growth.The rationale for including hedge funds in institutionalportfolios was to provide return diversification andstability to the overall portfolio by having a “portablealpha” stream able to capture returns from illiquidinvestments that were seen as uncorrelated toinvestor’s core long-only equity and bond holdings.As shown in Chart 3, hedge funds continued toperform well in these years, as 3-year trailing returnsfor the HFRI Equity Hedge Index showed an averagegain of +9.7%—superior to both the equity and bondmarket returns.Institutional investors’ investments in hedge fundsduring this period outpaced HNW/FO investments,although allocations from this latter group alsocontinued to grow. As seen in Chart 4, institutionalinvestors significantly increased their exposure tohedge funds, from $125 billion in 2002 to $878 billionby 2007. This compares to HNW/FO investors thatincreased their allocations from $500 billion to $990billion in the same timeframe. Due to the sheersize of their investable assets, institutional clients’percentage of the industry’s assets increased to47%, up from 20% in 2002.Institutional Flows Outpace HNW/FO AllocationsInstitutions needed to update their portfolio approachin order to create an allocation for hedge funds, sincetheir investment portfolios had consisted almostentirely of long-only equity and bond holdings inprevious years. Two configurations for allocating tohedge funds emerged in this period.Chart 2: Hedge Fund Industry AuM Relative Performance: 1994-2000Chart 2* Global pension liability & asset information based on Towers Watson Global Survey with data indexed as percent of 1998 coverage.Data shows annual average for listed period. Only defined benefit assets are considered.Sources: Citi Prime Finance analysis based on MSCI, S&P, Bloomberg, HFR & Towers Watson data.MillionsofDollarsAuMHedge Fund Industry AuM & Relative Performance: 1994-20001995 1996 1997 1998 19991994 2000$167B$491BAverage Trailing 3yr(annualized) Return VolatilityMSCI World Equity 15.73% 12.04%S&P 500 21.94% 12.50%HFRI Equity Hedge 21.79% 8.32%Avg 10yr USTreasury-Yield 6.01%Global Pension Assets asPercent of Liabilities* 108.5%Capture Excess Performance0$600,000$500,000$400,000$300,000$200,000$100,000Chart 2* Global pension liability & asset information based on Towers Watson Global Survey with data indexed as percent of 1998 coverage.Data shows annual average for listed period. Only defined benefit assets are considered.Sources: Citi Prime Finance analysis based on MSCI, S&P, Bloomberg, HFR & Towers Watson data.MillionsofDollarsAuMHedge Fund Industry AuM & Relative Performance: 1994-20001995 1996 1997 1998 19991994 2000$167B$491BAverage Trailing 3yr(annualized) Return VolatilityMSCI World Equity 15.73% 12.04%S&P 500 21.94% 12.50%HFRI Equity Hedge 21.79% 8.32%Avg 10yr USTreasury-Yield 6.01%Global Pension Assets asPercent of Liabilities* 108.5%Capture Excess Performance0$600,000$500,000$400,000$300,000$200,000$100,000
  9. 9. Rise of Liquid Alternatives Survey | 10In the first, institutional investors created anopportunistic bucket for all of their illiquidinvestments that could be used as the allocatorsaw fit across hedge funds, private equity, venturecapital, mezzanine financing and other types ofinvestments. This was the model most commonlyadopted by the E&Fs and, later, by the majority ofsovereign wealth funds.Pension funds pursued a different approach. Asrecommended by their traditional consultants,pensions initiated their investments into hedge fundsby carving out a dedicated exposure for a new ‘assetclass,’ as hedge funds were (incorrectly) referred toat the time.In both approaches—opportunistic and hedge fundsas a dedicated asset class—the hedge fund allocationwas relegated to a satellite of the investor’s mainequity and bond portfolio. In this construct, themajority of a portfolio’s exposures and subsequentrisk still came from the traditional equity and bondlong-only allocations that were typically 80% to 95%of a pension portfolio and the majority of assetsfor many sovereign wealth funds and E&Fs. This isillustrated in Chart 5.Institutions Initially Used Funds of HedgeFunds to Manage Their InvestmentsDuring this time period, hedge funds were a newfrontier for the vast majority of institutions, and thetraditional consulting community that advised theseinvestors. There was little familiarity with either themanagers or the strategies; moreover, the rapidinflux of capital from both HNW/FO and institutionalsources was creating a seller’s market, where apremium was placed on being able to access topmanagers who would quickly sell out the capacity oftheir funds.Since institutional investors were interestedprimarily in having a broad exposure to the hedgefund industry rather than to a specific manageror strategy, the consultants that advised theseparticipants recommended that they turn over theirhedge fund allocation to a fund-of-fund intermediary.Chart 6 shows that between 2002 and 2006, fundsof hedge funds’ share of total hedge fund industryassets increased from $207 billion (33% of theindustry’s total AUM) to $656 billion (45% of AUM).Chart 3: Hedge Fund Idustry AuM Relative Performance: 1994-2007Chart 3* Global pension liability & asset information based on Towers Watson Global Survey with data indexed as percent of 1998 coverage.Data shows annual average for listed period. Only defined benefit assets are considered.Sources: Citi Prime Finance analysis based on MSCI, S&P, Bloomberg, HFR & Towers Watson data.0MillionsofDollarsAuMHedge Fund Industry AuM & Relative Performance: 1994-20071995 1996 1997 1998 1999 20001994 2002 2003 2004 2005 2006 20072001$2,000,000$1,800,000$1,600,000$1,400,000$1,200,000$1,000,000$600,000$400,000$200,000$167B$491B$1,868BAverage Trailing 3yr(annualized) Return VolatilityMSCI World Equity 15.73% 12.04%S&P 500 21.94% 12.50%HFRI Equity Hedge 21.79% 8.32%Avg 10yr USTreasury-Yield 6.01%Global Pension Assets asPercent of Liabilities* 108.5%Capture Excess PerformanceDiversification & Risk Adjusted ReturnsAverage Trailing 3yr(annualized) Return VolatilityMSCI World Equity 3.59% 14.02%S&P 500 2.03% 14.57%HFRI Equity Hedge 9.75% 8.36%Avg 10yr USTreasury-Yield 4.52%Global Pension Assets asPercent of Liabilities* 86.6%$800,000Chart 3* Global pension liability & asset information based on Towers Watson Global Survey with data indexed as percent of 1998 coverage.Data shows annual average for listed period. Only defined benefit assets are considered.Sources: Citi Prime Finance analysis based on MSCI, S&P, Bloomberg, HFR & Towers Watson data.0MillionsofDollarsAuMHedge Fund Industry AuM & Relative Performance: 1994-20071995 1996 1997 1998 1999 20001994 2002 2003 2004 2005 2006 20072001$2,000,000$1,800,000$1,600,000$1,400,000$1,200,000$1,000,000$600,000$400,000$200,000$167B$491B$1,868BAverage Trailing 3yr(annualized) Return VolatilityMSCI World Equity 15.73% 12.04%S&P 500 21.94% 12.50%HFRI Equity Hedge 21.79% 8.32%Avg 10yr USTreasury-Yield 6.01%Global Pension Assets asPercent of Liabilities* 108.5%Capture Excess PerformanceDiversification & Risk Adjusted ReturnsAverage Trailing 3yr(annualized) Return VolatilityMSCI World Equity 3.59% 14.02%S&P 500 2.03% 14.57%HFRI Equity Hedge 9.75% 8.36%Avg 10yr USTreasury-Yield 4.52%Global Pension Assets asPercent of Liabilities* 86.6%$800,000
  10. 10. Rise of Liquid Alternatives Survey | 11“ We assess and place our absolute return strategies into analternatives bucket.” — Insurance Company“ About 10% of the overall portfolio is allocated to this independentbucket labeled Alternatives, which is essentially hedge funds. This hasremained constant even during 2008 and in the years since.” — Corporate PensionAs clients’ allocations to hedge funds increased,traditional consultants became more educated aboutthe various hedge fund managers and strategies.A new breed of consultant, with expertise in thealternatives space, also emerged. As knowledgeincreased about the industry and resources forhelping them manage their investments, manyinstitutions began to move away from funds of hedgefunds allocations.Several factors were seen as limiting interestin continued use of funds of hedge funds asintermediaries, but the most frequently cited was theadditional layer of fees their services imposed on theinvestor. In these early years, most funds of hedgefunds charged an additional 1% management feeand 10% performance fee on top of their underlyingmanagers’ 2% & 20% arrangements. In addition,Chart 5: Institutional Investor PortfolioConfigurations Pre-GFCHedgeFundsPrivateEquity &RealAssetsInvestmentsSeeking anIlliquidityPremiumSatelliteCommoditiesAlternative orOpportunisiticChart 5PassiveActiveEquityPassiveActiveCredit &RatesLong OnlyFundsMeasuredAgainsta Benchmark80-95% ofPension Portfolios40-70% of SWFs,Endowments& FoundationsCoreofPortfolioEquityBondsLiquidityIlliquidLiquidSource: Citi Prime Finance.Institutional Investor PortfolioConfigurations Pre-GFCHedgeFundsPrivateEquity &RealAssetsInvestmentsSeeking anIlliquidityPremiumSatelliteCommoditiesAlternative orOpportunisiticChart 5PassiveActiveEquityPassiveActiveCredit &RatesLong OnlyFundsMeasuredAgainsta Benchmark80-95% ofPension Portfolios40-70% of SWFs,Endowments& FoundationsCoreofPortfolioEquityBondsLiquidityIlliquidLiquidSource: Citi Prime Finance.Institutional Investor PortfolioConfigurations Pre-GFCChart 4: Hedge Fund Industry Assets by Investor TypeChart 4Source: Citi Prime Finance Analysis based on HFR data.0MillionsofDollarsHedge Fund Industry Assets by Investor Type2003 2004 2005 20062002 2007$1,200,000$1,000,000$800,000$600,000$400,000$125B20%$878B47%$990B53%$500B87%$200,000High Net Worth& Family OfficesInstitutional Clients:Pension Funds,Soverign Wealth Funds,Endowments & Foundations
  11. 11. Rise of Liquid Alternatives Survey | 12many of these portfolios were overdiversified and runby managers that would “chase returns” by quicklymoving into and out of managers based on who hadperformed strongly in the most recent period.By 2006, the institutional wave of money into fundsof hedge funds had peaked and begun to retreat.As can be seen in Chart 6, although overall funds ofhedge fund flows continued to rise, reaching a record$799 billion in 2007, their share of overall industryAUM had begun to decline . A new model began toemerge just before the global financial crisis (GFC),and this model has gained traction in the years afterthe GFC.More Experienced Institutions Began toDirectly Allocate their CapitalAs institutional investors and their consultantsbecame more familiar with hedge funds, marketleaders began to work with their intermediariesor build out their own investment teams in orderto directly invest in single-manager hedge funds.Typically, there was a progression to this changeoverfrom intermediary led to direct investing.Often the initial allocation was to a multi-strategyfund, where the portfolio manager had discretion tomove capital between the various underlying strategysleeves of its master fund. Over time, institutions“ There has been a constant theme of dis-intermediating the middle man inthe traditional hedge fund market. Pension plans and sovereign wealthfunds have the wherewithal to directly invest as clients. Originally, theseguys came into hedge funds many years ago and were using fund of fundsbecause the rosy return environment meant that the fees on fees natureof that investment wasn’t as big a deal. Now, they’ve been invested inhedge funds for many years and their boards are comfortable and theyknow the managers and they are thus more confident to go direct.” — Asset Manager“ There is still a role for traditional fund of hedge funds that can solve forclient’s issues such as governance, but the additional fee drag in a lowreturn world will continue to be an issue.” — Full Service ConsultantChart 6Source: Citi Prime Finance Analysis based on HFR data.31%Hedge Fund Investment Approach Being Used by Investors2003 2004 2005 20062002 200745%41%39%37%35%33%45%55%67%33%Direct(Right Axis)Fund of Funds(Left Axis)43%54%66%64%62%60%58%56%FundofFundsDirectChart 6: Hedge Fund Investment Approach Being Used by Investors
  12. 12. Rise of Liquid Alternatives Survey | 13gained confidence in their own ability to create adiversified portfolio, and they began to invest in a setof single managers.This direct engagement of institutional investorswith single-manager hedge funds had a profoundeffect on the industry. In order to secure thesedirect allocations, managers began to invest morein the non-investment side of their business andbuilt more robust infrastructures that allowed forimproved controls.This was the beginning of what many call the“institutionalization” of the hedge fund industry.Initially, managers made these investments toadvance the argument to investors that they couldgenerate alpha in their portfolio and differentiatetheir returns. Post-GFC, the requirement to havean institutional caliber infrastructure became athreshold standard for managers seeking allocations.Institutional interest in directly allocating capitalrose sharply in the period immediately after the GFC.Significant problems with the fund of hedge fundmodel came to light in that crisis. Many funds ofhedge funds had created a mismatch between theirstated liquidity terms and the holdings in theirportfolio that left them unable to meet investorrequests for redemptions. This shook investorconfidence in their expertise.Furthermore, funds of hedge funds exposure tothe Madoff fraud revealed a lack of rigor in theirsupposedly superior manager evaluation andselection ability and many institutions made apermanent shift in approach.Chart 7Source: Citi Prime Finance Analysis based on HFR data.26%Hedge Fund Investment Approach Being Used by Investors2004 2006 2008 20102002 201246%41%36%33%45%55%67%31%DirectFundofFunds54%74%69%64%59%2003 2005 2007 2009 201128%34%66%72%Fundof FundsDirectChart 7: Hedge Fund Investment Approach Being Used by Investors“ Our hedge fund program is currently split 70% direct allocationsversus 30% indirect via fund of hedge funds. We are moving quickly toan 80%/20% split and eventually we will end up at a 95%/5% split.” — Public Pension“ We have seen a move towards Institutions rather than funds of fundsinvestors which has been led by the US. Pensions have grown in assetsand now fund of funds account for just 20% of our investor base.” — $1.0 to %5.0 Billion AuM Hedge Fund“ Public pensions represent 60% of our assets. 20-25% are funds offunds or managed accounts without look through and many of those arealso likely pensions coming via a different channel.” — $10 Billion AuM Hedge Fund
  13. 13. Rise of Liquid Alternatives Survey | 14Chart 7 shows that in the post-GFC years, the shareof market controlled by funds of hedge funds fellprecipitously from their peak of 45% in 2006 to34% in 2010, when we first forecast a continuationof this trend. As predicted, their market share hascontinued to decline, falling to only 28% in 2012.Volatility-Dampening Aspect of Hedge FundsGained ProminenceSince the GFC, confidence that hedge funds canoutperform the underlying markets has beenstrained, and more emphasis has been placed on theirrole in controlling volatility.The idea that hedge funds are a vehicle from whichto capture excess market return has lapsed for thetime being for many institutional investors; investorsstill experienced sharp losses in their hedge fundportfolios during the GFC, and returns in recentyears have not been differentiated from those of thetraditional equity and bond markets. As shown inChart 8, the annualized trailing 3-year HFRI Index was+3.3% on average between 2007 and 2012—barelybetter than 10-Year U.S. Treasuries (+3.04%) and onlyslightly above the major equity indices (MSCI WorldEquity Index [+2.41%] and SP 500 [+2.45%]).Indeed, in November and December 2011, hedgefund returns actually fell more than equity marketreturns — a phenomenon that many investors thoughtimpossible. This lack of performance has been amajor deterrent to the HNW/FO audience that hadoriginally moved into hedge funds because of theirperceived ability to generate outsized returns. Asshown in Chart 9, allocations from this audiencefell sharply in 2008 from their peak of $990billion and have not recovered in subsequent years,hovering around the mid-$700 billion area for thepast several years.Institutional investor allocations recovered quicklypost-GFC, however, and have subsequently risensharply, driving total hedge fund industry AUM to“ Our expectations for alternative funds is to provide protection on thedownside (maximum 50%) and good upside participation with a 6-9%annualized return.” — Insurance Company“ We treat our hedge fund allocation as market shock absorbers.Our hedge fund allocation is meant to be a stable value asset.” — EndowmentChart 8* Global pension liability asset information based on Towers Watson Global Survey with data indexed as percent of 1998 coverage.Data shows annual average for listed period. Only defined benefit assets are considered.Sources: Citi Prime Finance analysis based on MSCI, SP, Bloomberg, HFR Towers Watson data.0MillionsofDollarsAuMHedge Fund Industry AuM Relative Performance in Various Periods‘95 ‘96 ‘97 ‘98 ‘99 ‘00‘94 ‘02 ‘03 ‘04 ‘05 ‘06 ‘12‘01$2,500,000$2,000,000$1,500,000$1,000,000$500,000Diversification Risk Adjusted Returns$167B$491B$2,252BCapture Excess Performance‘07 ‘08 ‘09 ‘10 ‘11Shock Absorption$1,868BAverage Trailing 3yr(annualized) Return VolatilityMSCI World Equity 3.59% 14.02%SP 500 2.03% 14.57%HFRI Equity Hedge 9.75% 8.36%Avg 10yr USTreasury-Yield 4.52%Global Pension Assets asPercent of Liabilities* 86.6%Average Trailing 3yr(annualized) Return VolatilityMSCI World Equity 15.73% 12.04%SP 500 21.94% 12.50%HFRI Equity Hedge 21.79% 8.32%Avg 10yr USTreasury-Yield 6.01%Global Pension Assets asPercent of Liabilities* 108.5%Average Trailing 3yr(annualized) Return VolatilityMSCI World Equity 2.48% 18.16%SP 500 2.45% 16.63%HFRI Equity Hedge 3.30% 9.80%Avg 10yr USTreasury-Yield 3.04%Global Pension Assets asPercent of Liabilities* 74.0%Chart 8* Global pension liability asset information based on Towers Watson Global Survey with data indexed as percent of 1998 coverage.Data shows annual average for listed period. Only defined benefit assets are considered.Sources: Citi Prime Finance analysis based on MSCI, SP, Bloomberg, HFR Towers Watson data.0MillionsofDollarsAuMHedge Fund Industry AuM Relative Performance in Various Periods‘95 ‘96 ‘97 ‘98 ‘99 ‘00‘94 ‘02 ‘03 ‘04 ‘05 ‘06 ‘12‘01$2,500,000$2,000,000$1,500,000$1,000,000$500,000Diversification Risk Adjusted Returns$167B$491B$2,252BCapture Excess Performance‘07 ‘08 ‘09 ‘10 ‘11Shock Absorption$1,868BAverage Trailing 3yr(annualized) Return VolatilityMSCI World Equity 3.59% 14.02%SP 500 2.03% 14.57%HFRI Equity Hedge 9.75% 8.36%Avg 10yr USTreasury-Yield 4.52%Global Pension Assets asPercent of Liabilities* 86.6%Average Trailing 3yr(annualized) Return VolatilityMSCI World Equity 15.73% 12.04%SP 500 21.94% 12.50%HFRI Equity Hedge 21.79% 8.32%Avg 10yr USTreasury-Yield 6.01%Global Pension Assets asPercent of Liabilities* 108.5%Average Trailing 3yr(annualized) Return VolatilityMSCI World Equity 2.48% 18.16%SP 500 2.45% 16.63%HFRI Equity Hedge 3.30% 9.80%Avg 10yr USTreasury-Yield 3.04%Global Pension Assets asPercent of Liabilities* 74.0%Chart 8: Hedge Fund Industry AuM Relative Performance iv Various Periods
  14. 14. Rise of Liquid Alternatives Survey | 15a new record level. This increase in interest frominstitutions reflects heightened concern aboutpotential losses in their portfolio, and the role thathedge funds can provide in dampening that risk.Although hedge fund performance has been on parwith the major equity indices, managers were able toachieve those returns with significantly less volatility.The 3-year trailing HFRI Index reported annualvolatility of 9.8% on average from 2007 to 2012,whereas the MSCI Global Equity Index registeredaverage annual volatility of 18.16% and the SP 500showed average annual volatility of 16.63%.Reducing volatility in their portfolio has become adriving force for most institutions post-GFC, as theTowers Watson Asset/Liability Index fell to new lows.On average, between 2007 and 2012 global pensionswere only able to cover 74% of their obligationswith their existing asset base. Given that challenge,ensuring that they do not lose money is becomingalmost as important a driver as making sure that theycan generate returns.As a result, major institutions have begun to viewhedge funds as a “shock absorber” for their portfolio.While they are hoping to realize consistent returnsfrom these investments, they are looking for them tooffer downside protection in achieving those returns.This has helped draw continued inflows from theinstitutional audience. Institutional assets in thehedge fund industry increased from $878 billion in2008 to $1.17 trillion by 2010, when we first wroteabout these trends. As we forecasted, assets fromthis segment have continued to grow rising to$1.48 trillion in 2012.Since interest from HNW/FO investors has flattenedduring this same period, these increased institutionalallocations have had a profound effect on theindustry’s structure: Whereas institutional assetsaccounted for 47% of the industry’s total holdingsin 2008, that figure was up to 61% in 2010 and hascontinued to expand, reaching 66% in 2012.Changing views on how to construct their portfolioare likely to set the stage for continued growth ininstitutional flows in coming years.“ Pensions and large investors want a ‘don’t lose money/give me steadyreturns’ approach to investing and we are designing our product tofit this need.” — $1.0 to $5.0 Billion AUM Hedge FundChart 9Source: Citi Prime Finance analysis based HFR data.0MillionsofDollarsHedge Fund Industry Assets by Investor Type2004 2006 2008 20102002 2012$1,500,000$1,$200,000$900,000$600,000$300,000$125B20%$500B80%2003 2005 2007 2009 2011$878B47%$990B53%$748B39%$1.17T61%$1.48T66%$766B34%Institutional Clients:Pension Funds,Soverign Wealth Funds,Endowments FoundationsHigh Net Worth Family OfficesChart 9: Hedge Fund Industry Assets by Investor Type
  15. 15. Rise of Liquid Alternatives Survey | 16Leading Institutions Shift from a Capital-Basedto a Risk-Aligned PortfolioSeveral previously mentioned trends have cometogether in recent years to lay the foundation for asignificant change in how many leading institutionalinvestors are positioning hedge funds in theirportfolio. Rather than viewing hedge fund allocationsas part of a satellite allocation, institutional investorsare increasingly beginning to reposition certaintypes of hedge fund strategies into the core oftheir portfolio, where they are better positioned tocompete for a new pool of capital.Hedge fund managers have become less reluctantto share information about their portfolio holdingswith their investors post-GFC, as problems uncoveredat that time have led to an industry-wide view onthe need for transparency and better operationaloversight and control.The move to direct investing, and the fact thatmany hedge fund managers now have ongoingrelationships with their investors, has helpedreduce concerns about sharing information. Asinvestors have gained more insight into hedgefund holdings, they can get a more holistic view onhow those positions compare to positions heldelsewhere in their portfolio, and thus have been ableto better evaluate how their hedge fund holdingsinteract with their long-only exposures.Investors also saw that CTA/macro strategies wereable to produce significantly uncorrelated returnsduring the crisis, and that these strategies that arefocused almost exclusively in highly liquid exchange-traded markets could help diversify their portfolioand insulate them from a different set of risks thantheir more security-focused strategies.Both these realizations came about in parallelwith many institutions beginning to question thecore theories that have driven their strategic assetallocation decisions for the past 50 years.Since the emergence of modern portfolio theoryand the capital asset pricing model in the late 1950s,investors have evaluated their portfolio diversificationby the amount of capital they had allocated betweenequity strategies and bonds. This is the origin of thecommonly referred to 60/40 allocation. Investorsfollowing that model would allocate 60% of the moneythey had to invest in equities and 40% in bonds toachieve the optimal amount of return relative to theunderlying risk in the portfolio.Investors following this approach came to a rudeawakening in 2008 when they realized that there wasno true diversification benefit with this construct.Chart 10Source: Citi Prime Finance.Illustrative Institutional Investor Risk-Aligned PortfolioDirectionalityHighHighly Liquidity IlliquidLowLong /ShortActivelyManagedRatesVolatility Tail RiskDirectionalHedge FundsPassiveActiveEquity Credit LongOnlyEventDrivenMacro CTAPrivate MarketsPublic MarketsSatelliteCoreofPortfolioDistressedMarketNeutralArbitrageRelativeValueInfrastructure,Real Estate, TimberCommoditiesCorporatePrivate EquityStable Value /Inflation RiskMacro HFsAbsolute Return Real AssetsCompany RiskChart 10: Illustrative Institutional Investor Risk-Aligned PortfolioChart 10Source: Citi Prime Finance.Illustrative Institutional Investor Risk-Aligned PortfolioDirectionalityHighHighly Liquidity IlliquidLowLong /ShortActivelyManagedRatesVolatility Tail RiskDirectionalHedge FundsPassiveActiveEquity Credit LongOnlyEventDrivenMacro CTAPrivate MarketsPublic MarketsSatelliteCoreofPortfolioDistressedMarketNeutralArbitrageRelativeValueInfrastructure,Real Estate, TimberCommoditiesCorporatePrivate EquityStable Value /Inflation RiskMacro HFsAbsolute Return Real AssetsCompany Risk
  16. 16. Rise of Liquid Alternatives Survey | 17Sharp equity declines in that period underscoredto these investors that with a 60/40 capital-based allocation, 90% of their portfolio risk wasconcentrated in their equity holdings and only 10%with their bonds.In response, many market leaders have begun toreformulate their portfolios around the risks of theirunderlying investments. Commonly examined risksare the liquidity, directionality and correlation ofinvestments in the portfolio. Investments with asimilar risk profile are grouped together. The new risk-aligned model for investing is illustrated in Chart 10.This change in thinking has had a profound effecton where hedge funds are positioned in investorportfolios. Rather than viewing hedge funds as asingular allocation because of their liquidity profile,leading investors are now repositioning certain typesof hedge funds into their core portfolio holdings.This reflects a more nuanced understanding ofhow the assets held in those hedge fund strategiescorrelate with their equity and bond holdings, anda more sophisticated view about the concept of“shock absorption”.By repositioning hedge funds with a more directionalbias into their core equity and credit holdings, theinvestor aggregates all those investments that sharean underlying exposure to changes in a company’sequity or credit position. A hedge fund’s ability toprovide volatility dampening alongside more riskylong-only holdings provides the insurance thatinstitutions are looking for to insulate their portfolioin case of market shocks while allowing them totake advantage of the embedded directionality inthose strategies so as to realize some portion of themarket’s upside exposure.Similarly, repositioning CTA/macro strategies intoan investment category with other interest rate andcommodity investments that are likely to respondsimilarly to economic conditions provides insuranceagainst inflation, and some degree of stable value toinvestor portfolios.Chart 11-AAllocations to Hedge Funds by Strategy Bucket2006: $1.46T AuM21%Event DrivenRelative Value38%23%17%Equity HedgeMacroSource: HFRChart 11-BAllocations to Hedge Funds by Strategy Bucket2012: $2.25T AuM25%Event DrivenRelative Value27%27%22%Equity HedgeMacroSource: HFRChart 11: Allocations to Hedge Funds by Strategy Bucket2006: $1.46T AuM 2012: $2.25T AuM“ We use hedge funds in different parts of a clients’ portfolios. Hedgefunds have been put alongside long-only portfolios and they have alsobeen a part of the private equity allocation, especially the longer-dated hybrid structures. We don’t have a standard model hedge fundallocation that we stick to in every client’s portfolio. We expect hedgefunds to compliment the client’s existing portfolio and expect the hedgefund allocation to be a solution.” — Full Service Consultant
  17. 17. Rise of Liquid Alternatives Survey | 18“ Ifweallocatetherightwayanddoourhomeworkrightitwillcreateaportfoliothat is differentiated and when rolled up at the overall portfolio level it won’thave any more volatility than a portfolio of un-volatile managers.” — EndowmentIn this emerging approach, hedge fund strategieswith a true absolute return profile can be isolatedfrom other types of hedge fund investments andused in a more targeted manner for producinguncorrelated returns.This idea that different hedge fund strategies canbe used to different effect in various portions of theportfolio is just beginning to gain traction, but theidea of investors looking at hedge funds as a pool ofdifferent types of exposures is clearly taking hold. Acomparison of the allocation of hedge fund industryAUM in 2006 and 2012 clearly illustrates this shift, asshown in Chart 11.Back in 2006, the industry was heavily weightedto equity hedge strategies, and macro strategiesaccounted for a small portion of overall assets; therehas since been a rebalancing of AUM. By 2012, eachof the four major strategy categories had nearly a25% market share.By balancing their holdings, investors are lookingto maximize the shock absorption potential of theirhedge fund allocations and create resiliency for anyset of market conditions. This premise is likely tobe tested in the near future—as is the efficacy of therisk-aligned allocation approach—as three majorfactors are perceived as driving up the risk ininstitutional holdings and increasing the focus on howinvestor hedge fund holdings will perform.“ The underlying risk of long/short managers is equity-like so we place all ofthem in our Equity risk bucket.” — Endowment
  18. 18. For those readers who were familiar with industrytrends covered in last year’s survey and who haveskipped Section I of this year’s report, we now resumeour update on the emerging trends in the hedgefund industry.Three important changes in the macro investingenvironment are accelerating the move toward usinghedge funds as a shock absorber in institutionalportfolios. First, perceptions that assets are movinginto active equity long-only funds is increasinginstitutions’ overall portfolio risk. Second, theresurgence of illiquid shadow-banking products iscreating renewed concern about a potential liquidityshock and encouraging investors to seek longer-duration products to insulate themselves. Finally,anticipation that we are approaching a turn in thelong-term credit cycle is prompting investors to seekprotection against rising interest rates through credithedge products.Industry flows are likely to increase in 2013 inresponse to these three factors, and hedge fundsare likely to compete more directly for institutionalallocations from asset managers and private equityfunds than in previous years.Flows to Active Equity Funds IncreaseInvestors’ Risk ProfileEquity market moves to record highs in early 2013 arebeing seen by many survey participants as a signalthat we are entering a renewed period of growth,and that the impacts of quantitative easing haveadvanced enough that cash may now be coming offthe sidelines. Many expressed views that we may bepositioned for a more directional period of marketSection II: Increased Risks in Institutional Portfolios DriveInvestors’ Need for Hedge Fund “Insurance”Chart 12Source: Towers Watson Global Pension Assets Study 2013.60IndexChangeSince1998‘02 ‘06 ‘10‘98 ‘12120100908070100%‘00 ‘04 ‘08 ‘09 ‘11118.5%68.2%73.7%90.3%75.3%‘01 ‘05‘99 ‘03 ‘07110Ability of Assets Held by Global Defined Benefit Pension Plans to Cover Liabilities:Index Changes Relative to 1998Chart 12: Ability of Assets Held by Global DefinedBenefit Pension Plans to Cover Liabilities: Index Investor Changes Relative to 1998
  19. 19. Rise of Liquid Alternatives Survey | 20performance where idiosyncratic risks re-emerge,thus benefitting hedge fund trading styles.Optimism about improved equity market returns iscoming at a time when most institutional investorsare struggling to meet their obligations. Thetechnology bubble in the early 2000s, followed bythe GFC in 2008, have both significantly affectedmost institutions.The impact of these events is clearly visible whenviewing the asset and liability situation of the world’stop defined benefit pension plans. As shown inChart 12, these organizations had sufficient assets tocover 106.9% of their liabilities in 2000 according toTowers Watson, but saw their ratio drop sharply in thewake of the Technology BubbleOver the following years, there was a rebound in theirasset coverage, but pensions were still in deficit by2007, when their asset to liability coverage was only90.3%. TheGFCpushedcoverageratiosdownsharply,to as low as 68.2%, and difficult market conditions insubsequent years have limited a recovery. By the endof 2012, assets at these organizations were still seenas only covering 75.3% of liabilities.Pensions are the largest segment of institutionalinvestors in the hedge fund market, but their struggleis reflective of similar problems at EFs, and even ofsome sovereign wealth funds.Although equity markets have risen post-GFC, theyhave not offered institutions much opportunity toincrease returns because of their discomfort with theexpanded volatility. Institutional investor interestin equities has been primarily in a risk-on, risk-offmode that has not allowed for any sustainedinvestment move.This reflects a growing realization across theinstitutional community about the over-concentrationof equity risk they had been running in their portfolios.Institutions have realized the benefits of portfoliodiversification for the past 50 years and sought suchdiversification in their allocations by balancing theirportfolio across equities and bonds—most frequentlyallocating 60% of their capital to equity investmentsand 40% to bonds. The failure of this configuration tooffer any insulation in the GFC prompted a realizationthat from a risk perspective, this 60/40 capital-basedallocation was actually a 90/10 allocation, with 90%of the risk in the portfolio belonging to the equitiescomponent and only 10% with bonds.As discussed at the end of the previous section, thischange in thinking is what has driven many leadingChart 13Source: HFR.Changes in Global Equity Hedge Event Driven Flows-$15,000$10,000$5,000-5,0000-10,000Chart 13Q12011Q12013Q22011Q32011Q42011Q12012Q22012Q32012Q42012MillionsChart 13: Changes in Global Equity Hedge Event Driven FlowsChart 13Source: HFR.Changes in Global Equity Hedge Event Driven Flows-$15,000$10,000$5,000-5,0000-10,000Chart 13Q12011Q12013Q22011Q32011Q42011Q12012Q22012Q32012Q42012Millions0%25%15%10%5%20%Chart 14Source: Citi Prime Finance analysis of data provided by HFR SP.10%2% 6% 16% 18%Historical Comparison of Index Volatility ReturnsHFRI: Equity Hedge Total Index vs. SP 500Returns12%4% 8% 14%VolatilitySP 5001992-1998HFRI Equity Hedge1999-2005HFRI Equity Hedge2006-2012SP 5002006-2012SP 5001999-2005HFRI Equity Hedge1992-1998Chart 14: Historical Comparison of IndexVolatility Returns, HFRI: Equity HedgeTotal Index vs. SP 500
  20. 20. Rise of Liquid Alternatives Survey | 21institutions to reposition more directional equityand event driven hedge funds alongside their coreequity holdings. With a risk-aligned allocationapproach, hedge funds that provide downsideprotection during market volatility can make theportfolio more resilient. This recent trend is confirmedby HFR flow data for these strategies. As illustratedin Chart 13, net flows into equity and event drivenhedge funds were positive in the 1st quarter 2013.This is the first positive quarterly flows into thesestrategies since Q3 2011.Historically, equity hedge funds have outperformedand offered lower volatility than outright equityexposure. A comparison of the SP 500 versus theHFRI Equity Hedge Index over three separate 6-yearintervals,commencing in 1992, demonstrates thatthe HFRI Equity Hedge Index exhibits approximatelytwo-thirds of the volatility with similar or betterperformance. As shown in Chart 14, the HFRI EquityHedge Index had an average annualized returnof +12.2%, with a volatility of monthly returns of9.5% from 1999 to 2005. In contrast, the SP 500Index average annual return was +2.5%, with 15.4%volatility of monthly returns.Equityhedgefundsalsoexhibitedmuchlowervolatilityduring the most recent 6-year period ending in 2012—a period that includes the major market correction of2008. Chart 14 shows that the HFRI Equity Hedgeindex reported slightly lower performance of +3.8%versus the +4.7% average annualized returns of theSP 500 index from 2006 to 2012, but annualizedvolatility was significantly lower at 9.8% compared to16.9% for the SP 500 index.Given the lessons of recent years, most surveyparticipants expect institutional investors to uptheir allocation to equity hedge when they increasetheir outright equity exposures in 2013. This is acontinuation of the story we outlined in last year’sreport showing how equity hedge strategies weremoving into an “equity risk” bucket.A recent development, discussed further in this year’ssurvey, was the strategy of using credit focusedhedge funds for insurance alongside the investor’score credit positions.“ The world has been an odd place since Lehman Brothers. Investors havebeen terrified by the macro environment and have been hiding under astone of fixed income and capital protection. That’s starting to change.We’re seeing more idiosyncratic risks and rotation into equities. This ismore of a hedge fund environment. That compares to the last few yearsof risk on/risk off.” — $1.0 to 5.0 Billion AUM Hedge Fund“ There’s no question we’ve seen significant uptick in demand for ourequity long/short book which is surprising because we’re coming offa couple of years where performance has not been that great and theequity indexes and markets performed better. We really see this asbeing linked to the idea that you can still get some of the beta with ourstrategies, but with some downside protection as well. Our strategiestend to be longer biased and they will tend to do better if markets risewhile still offering downside protection.” — Asset Manager“ After lengthy discussions with our Board, it was agreed that the overallpurpose of hedge funds in our portfolio is to be a diversifier for theequity bucket. Alpha generation is not a stated goal.” — Public Pension“ There is quite a lot of fear from investors on the rotation out of bonds intoequities. So far, the money has been coming out of money market fundsand not from bond funds. I don’t see this as a 2013 story. I think themuch-feared exit from bonds is going to be more of a 2014/2015 story.No doubt, there will be a scare or two in 2013, but the big migrationtiming is probably later.” — $1.0 to 5.0 Billion AUM Hedge Fund
  21. 21. Rise of Liquid Alternatives Survey | 22New Long-Duration Credit Funds Are Used toProtect Against a Second Liquidity ShockWith equities having been seen as overly volatile anddifficult for sustained investment, institutions havebeen looking elsewhere for returns in their portfolios.This has been a difficult proposition given that the30-year bull market in fixed income and deliberategovernment interventions post-GFC have combinedto push interest rates to record lows.Against this backdrop, investors have been usingtheir credit allocations to look for returns in some ofthe more risky and opaque areas of the market. Thesearch for yield has begun to push many institutionalinvestors out on the credit curve into increasinglyilliquid products, raising concerns about a potentialrepeat of 2008 liquidity issues.One investment that symbolized liquidity fears during2008 by proving to be problematic to value andliquidate was collateralized loan obligations (CLOs).Just before the GFC, interest rates and credit spreadswere low and investors were reaching for yield, muchlike the situation today.CLOs are structured products that repackage a set ofcorporate loans that are then divided into tranches.Each CLO is unique to itself, and neither the CLOs northe underlying loans trade on any exchange. Theseproducts offered investors yields that were higherthan yields on traditional credit securities in themarket in the period leading up to the GFC, and manyinvestors seem to be mirroring this investment trendin 2013.In order to satisfy investor demand for yield, CLOissuance volume reached peak levels in 2006 and2007. As illustrated in Chart 15, quarterly issuanceof CLOs is approaching levels not seen since pre-GFC.According to SP/Capital IQ, in the first quarter of2013 CLO issuance was the third highest on record.One theme in this year’s survey was a growingconcern from many market participants that themove into these illiquid, shadow-bank products couldbe setting the industry up for another liquidity shock.“ There is definitely a trend toward people getting comfortable moving outthe credit spectrum. We’re even seeing investors looking to get directlyinto our equity CLOs. We even had an investor come to us and ask for alevered CLO portfolio. I looked at the terms and got sick to my stomach.All I could think was, ‘Oh no, not that again’.” — $10 Billion AUM Hedge FundChart 1503Q06 1Q13$35B$25B$15B1Q051Q04 3Q053Q04 3Q12CLO Issuance, by Quarter (US Vehicles)$5B3Q093Q07 3Q113Q08 1Q123Q10$30B$10B$20BSource: SP Caital IQ/LCD.1Q101Q081Q06 1Q091Q07 1Q11Chart 15: CLO Issuance, by Quarter (US Vehicles)
  22. 22. Rise of Liquid Alternatives Survey | 23Rather than looking to take on such exposure in anuncovered way, however, change has been noted ininvestors’ risk behavior relative to the earlier pre-GFC cycle. Many institutional investors have beenworking with their credit hedge fund managersto carve out a longer duration credit fund thatminimizes any possible asset-liability mismatch byleaving them free to maneuver and seek short-sideprofits without fear of redemptions if another liquidityshock were to occur.These long-duration credit funds are typicallycommanding a 5-year lock-up that is positioningthem as an alternative to a traditional privateequity investment. Long-duration funds from hedgefund managers are seen as an insurance policy forinvestors when compared to traditional private equity,as the hedge fund manager is likely to pursue itsstrategy with a “trading” as opposed to a “banking”mindset and by offering a pooled investment vehicleas opposed to a deal specific pay out scheme. Thisis seen as increasing the likelihood that managerswould be able to insulate investors’ portfolios ifanother crisis arises.This is a distinct change in approach; these credithedge fund managers previously only offeredopportunistic ‘go anywhere’ credit funds whosemandate would allow the fund to span the liquidityspectrum within the credit markets. In order toproperly manage the assets, these funds typicallyoffer investors quarterly or annual redemption rights,and also limit the percentage that can be redeemedeach period.“ People are going after CLO’S the instruments that blew up so hard.You’d think that they’d be dead but they’re actually back and people arechasing them.”— $1.0 Billion AUM Hedge Fund“ We launched a single closed, 5-year structure that sits between ahedge fund and private equity type offering. It is definitely not long-only, it’s long-biased. When you have a longer-term fund, beta is lessimportant because it evens out. We will have a longer bias than in ourco-mingled fund.” — $10 Billion AUM Hedge FundBetaAlphaChart 16Source: Citi Prime Finance.Liquid IlliquidIllustrative Institutional Investor Portfolio GroupingsRiskParityFundsGoAnywhereCreditHedgeFundsLongDurationLiquidCreditTraditionalPrivateEquityFundsDiversifiedGrowthCreditMutualFunds SMAsCompetingfor Allocationsfrom PrivateEquity BucketCompeting forAllocationsfrom CoreCredit BucketBetaAlphaChart 16Source: Citi Prime Finance.Liquid IlliquidIllustrative Institutional Investor Portfolio GroupingsRiskParityFundsGoAnywhereCreditHedgeFundsLongDurationLiquidCreditTraditionalPrivateEquityFundsDiversifiedGrowthCreditMutualFunds SMAsCompetingfor Allocationsfrom PrivateEquity BucketCompeting forAllocationsfrom CoreCredit BucketChart 16: Illustrative Institutional Investor Portfolio Groupings
  23. 23. Rise of Liquid Alternatives Survey | 24Moving to a long-duration structure is thus a markedchangeinapproach.Thefactthatthisshiftisoccurringwith direct investor input and support is a sign of howcredit hedge fund managers are partnering with theirinvestors to dampen volatility and risk in the portfolioin much the same way that directional equity hedgefund managers are being placed.Further evidence of this trend is the fact that in thepast year, credit hedge funds have begun to launchnot only long-duration funds, but they are alsocarving out the more liquid side of their portfolio andcreating long-bias credit funds that are competing forallocations from the institutions’ core credit bucket.This is illustrated in Chart 16.Rising Credit Fears Turn Equity Risk Bucketto Company Risk BucketAs illustrated in Chart 17, credit yields are lowerthan they were in 2007 in both U.S. high yield andemerging markets.In conjunction with tighter credit spreads, absoluteglobal interest rates are also at historic lows.Quantitative easing by monetary authorities aroundthe globe has brought about this lower interest rateenvironment. Changes in interest rates and wideningof credit spreads in the coming years are a majorconcern for many investors when thinking about theirfixed income exposures.To address these concerns about a turn in the interestrate cycle, investors are shifting a portion of theirliquid fixed-income bond holdings into strategies thatoffer some type of downside protection. Investorsare interested in actively managed credit hedge fundproducts that vary in liquidity and duration profiles tofill this need.Chart 174%2001 200920%14%10%19991997 20001998 200818%Historical Comparison of Credit Yields: Citi Index US HY Citi Index Emerging Market Soverign Bond6%20042002 20062003 20072005Yield to Worst, HYM Yield to Worst, ESBI, 10-20 yrs16%8%12%2010 2011 2012ReturnsChart 17: Historical Comparison of Credit Yields:Citi Index US HY Citi Index Emerging Market Sovereign Bond“ Our liquid high yield co-mingled fund is really being seen as interestingto institutional investors with plain vanilla bond portfolios. It can tradea mix of bonds, loans and mortgages. It’s mostly a long fund that offersa little bit of protection. It should be able to capture 90% of the upsideand protect against 60% of the downside.” — $10 Billion AUM Hedge Fund“ We’ve seen the pension side coming out of a portion of their vanilla creditinto alternative credit—strategies with a degree of shorting in them.We’ve seen some go even further. All the way to reallocating vanillacredit to distressed.” — $10 Billion AUM Hedge Fund
  24. 24. Rise of Liquid Alternatives Survey | 25“ I was shocked at the level of institutional demand I encountered for theseDiversified Growth Funds when I was out visiting Japanese investors.I think that these may end up being the first real publically tradedproduct that has potential to draw off institutional hedge fund demand.” — $5.0-$10.0 Billion AUM Hedge Fund“ I see hedge funds as a bond surrogate, but they’ll perform betterthan bonds.” — Sovereign Wealth FundThese privately offered liquid credit hedge funds,including long/short credit funds, only utilize amanager’s more liquid strategies expressed byinstruments that are readily priced and traded.Because of the more liquid nature of the underlyinginstruments and strategies, these funds can offerprivate investors more frequent redemption terms(i.e., monthly) compared to a hedge fund manager’sflagship funds that may only be redeemed quarterlyor semi-annually. In addition, manager fees on thesefunds are typically lower than a for manager’s mainhedge funds, in an effort to compete more directlywith actively-managed credit funds.This credit product extension is being driven by thesame risk concerns that are prompting allocatorsto place more equity hedge strategies into theirportfolio alongside their actively managed, long-onlyequity allocations. If the credit cycle turns, the samecompanies in this equity risk bucket will be impacted,and having credit hedge strategies in the portfolioalongside investors’ core credit long-only fundsshould help to dampen such exposure. This trendis what is prompting us to widen our description ofthe equity risk bucket to be a broader company riskbucket for 2013 forward. This change is highlightedback in Chart 10.In this year’s survey interviews, it has beeninteresting to note the depth of collaboration takingplace between the large credit hedge fund firmsand their investors in designing these new productsand in determining where they fit in the investors’portfolio. Because of the size of their investmentsand the strategic, longer-term nature of their capital,institutional investors have built deep relationshipswith these managers and are working with them in amore collaborative, advisory manner.This consultative approach with investors partiallyexplains why large and franchise-sized credit firmsare getting larger.Credit Hedge Funds Compete to ProvidePortfolio Insulation with a New Class ofPublically Offered Fund ProductsIn looking to offer downside protection in the corecredit holdings of institutional portfolios, credithedge fund managers have begun to compete headto head with a new class of publically offered fundsthat seek to offer the same portfolio insulation andprotection in periods of market stress. Last year wediscussed how ”All Weather” funds were attractingflows from institutions looking to experiment withrisk parity. This year, we heard more in our interviewsabout similar publically offered multi-strategy fundsthat have a more flexible mandate, and how they aregaining traction with investors.These are broad strategy funds that include somehedging techniques that can be expressed with liquidinstruments. They seek high total return over the longterm that is consistent with prudent risk managementby allocating assets actively across stocks, bonds andshort-term instruments, with the various exposures toeach asset type varying opportunistically in responseto changing market and economic trends.What has been interesting about these publicallyoffered multi-asset funds is that they seem to begaining a degree of traction with the institutionalaudience, while publically offered equity funds witha degree of hedging are not finding this same levelof receptivity.There is expected to be ongoing competition betweenthese products for institutional dollars, particularlyamong investors that are not yet fully developed intheir hedge fund investing programs.“ Being a big franchise sized firm has helped a lot with the bigger pensionsand sovereign wealth funds. People are looking for one-stop solutionsmuch more so now than in the past. The advisory nature of what we offerinvestors is seen as extremely valuable. They say, ‘I want you to tell mewhen I should move into a different segment’. We’re really starting tosee the advisory aspect of the relationship be a real selling point. Oncewe get our foot in the door, our experience has been positive in that therelationship deepens over time.” — $10 Billion AUM Hedge Fund
  25. 25. Rise of Liquid Alternatives Survey | 26In Europe, these funds are known as diversified growthfunds, (DGFs) and they have also seen significantasset growth in recent years. These funds take aflexible approach to asset allocation and offer clientsaccess to equities, bonds, alternative assets and cashwithin certain range limits. This approach allowsthese funds to dynamically switch between defensiveassets, growth assets and diversifier strategies, withthe aim of achieving strong risk-adjusted returns.As shown in Chart 18, DGFs in Europe have raised$37 billion in total assets from 2009 through 2012,moving from $14 billion to $51 billion AUM—a increaseof 270%. This growth is emblematic of a broadertrend in Europe, where traditional private hedgefund allocations from key institutions are beingdriven toward publically offered vehicles in responseto regulatory pressure. Indeed, as we will explore,European regulations that have emerged post-GFCare working to reallocate a significant portion ofprivate fund capital to publically offered vehiclesthat offer lower fixed fees, daily liquidity and morefrequent transparency. This is fundamentally alteringthe structure of the European hedge fund industry.$0$60$40$30$50$10$20Chart 18Source: Citi Prime Finance analysis based on eVestment Data.European Diversified Growth Funds2009-20122009 2012BillionsofDollars$14B$51B+270%Chart 18: European Diversified Growth Funds2009-2012
  26. 26. Across Europe, continued regulatory change anduncertainty, combined with more risk-averse investorsentiment, is encouraging a reallocation of alternativeinvestment dollars away from private hedge fundstoward both alternative UCITS that offer daily orweekly liquidity and separately managed accounts.Shifts in European demand for specific alternativestructures are occurring almost exclusively amongtraditional hedge fund investors—the majority ofwhich are large institutions that have discretion overtheir asset pools, and are highly attuned to bothpublic sentiment and political signals. As such, wesee the changing flows as part of a rebalancing andnot an expansion of the overall European industry.Anticipation of AIFMD Dampens Growth inEuropean Private Hedge FundsPost-GFC, public sentiment in Europe demanded thatmore be done to regulate hedge funds and otherprivate fund vehicles to provide investors betterprotections. The European Commission published itsoriginal draft proposal for the Directive on AlternativeInvestment Fund Managers (AIFMD) on April 30,2009, which was aimed at regulating all private funds.The text for AIFMD was adopted by the EuropeanCouncil and Parliament in May 2011 and came intoforce in July 2011. In December 2012, the EuropeanCommission published its Level 2 DelegatedRegulation. European states will have until July 22,2013 to transpose the rules into their national law asthe first tranche of regulations are due to take effecton that date.The goal of the legislation has been to put hedgefunds and private equity firms under the supervisionof the European Union regulatory body. The rulesfocus on both alternative investment fund managers(AIFMs) and on alternative investment funds (AIFs),and apply to both European Union members and tonon-EU members.The new rules cover a number of elements of anAIFM’s fund operations, spanning across marketing,depositories, risk, remuneration, supervision andreporting. Each of these areas will require significantchanges in the industry. Just how significant is notclear, however, as there continues to be meaningfuldebate regarding the rules, even with the firstimplementation deadline approaching.The scope and scale of pending regulatory changesfor the European industry has been a dampeninginfluence on asset growth for the traditional privatefund industry, especially against the backdrop of aturbulent and often difficult investment environment.This is shown in Chart 19.Indications are that assets held by private funds inEurope have grown by only 9.2% in recent years,rising from $399 billion at the end of 2008 toan estimated $436 billion at the end of 2012. Bycomparison, assets managed in private hedge fundsoutside of Europe grew by 80%, rising from $1.0trillion to $1.8 trillion in a similar timeframe.Section III: European Regulatory Pressures Force aReallocation of Alternative Assets Away fromPrivate Fund StructuresChart 19: European Hedge Fund Industry ChangeOnshore Offshore Private Funds 2008 vs. 20120$450$250$150$350$50$100Chart 19Source: Citi Prime Finance analysis based on HFI HFR data.European Hedge Fund Insutry ChangeOnshore Offshore Private Funds 2008 vs. 2012End-2008 End-2012BillionsofDollars$377B$101B$400$200$300 $355B$436B$399B$22BillionOffshore Onshore
  27. 27. Rise of Liquid Alternatives Survey | 28AIFMD Marketing Considerations Draw MoreFunds OnshoreAIFMD does not have a specific requirement forfunds to be registered onshore in Europe. However,the spirit of the directive has encouraged manymanagers to assess whether their offering couldbe seen as more attractive if it were registered ordomiciled onshore in Europe.Specifically, European AIFMs with a European AIFwill have access to a marketing passport that allowsthem to promote their fund across all the memberstates, starting in July 2013. It is envisaged that allother fund managers will still be able to distributetheir funds in Europe from July 2013 to July 2015,but they must do so under country-specific privateplacement regimes that require certain transparencyand controlling interest requirements. In additionto the added complexity of complying with multiplecountry-specific guidelines, the full scale of how andwhen these private placement regimes may change isstill unclear.Starting in July 2015, European AIFMs with non-European AIFs—and all other non-European AIFMswho market their products to European investors—will also be able to apply for a marketing passport.On the other hand, the ability of non-European AIFMswith European AIFs to continue offering their fundsunder the private placement regime will lapse. Atthat point, all European AIFs must be part of thepassport system, and the AIFMs offering these fundsmust be in full compliance with the regulations. Ascurrently envisioned, all private placement optionswill be gradually phased out; starting in July 2018,any AIFM marketing an AIF in Europe will need to havea passport and be in compliance with the directives.Rising Scrutiny of Institutional Investors LimitsInterest in Private FundsIn addition to regulatory uncertainty aboutthe impacts of AIFMD and a turbulent marketenvironment, increased regulation and scrutiny ofkey institutional investors has also worked to limitgrowth in private funds in Europe. Chart 20 shows“ There are not enough asset raising opportunities in Europe right now sobright people won’t be launching new hedge funds. The European hedgefund industry is very flat. I am not seeing anything exciting at this time.” — UCITS Platform Intermediary“ We view AIFMD as a major opportunity for a firm of our brand and scale.We already have a $65 billion long only UCITS business in Luxembourgwhich is distributed throughout Europe and Asia. We see the addition ofboth alternative UCITS and AIFMD compliant hedge funds as a naturalextension of our platform.” — Asset ManagerChart 20Source: EFAMABreakdown of European Investment Landscapes by Participant Type2011: €13.8 Trillion42%31%27%Retail€4.28TAlternative UCITS€9.52T69%31%InsuranceCompaniesPensionsBanks OthersChart 20: Breakdown of European Investment Landscapes by Participant Type, 2011: €13.8 Trillion
  28. 28. Rise of Liquid Alternatives Survey | 29the current breakdown of the European investor base.As shown, European investment is heavily skewedtoward institutions as opposed to a retail audience.European institutions account for 69%, or €9.6trillion, of the region’s overall €13.8 trillion in assets,while retail investors account for only 31%, or €4.3trillion, according to EAFMA.This allocation of capital reflects the strong role thatEuropean institutions play in managing capital onbehalf of their constituents. Unlike the U.S. market(discussed in Section IV), where retail clients exercisesubstantial control over their savings and investmentportfolios, the European asset management industryis largely defined by discretionary institutionalasset allocations.Political pressure on these organizations to limittheir investment in private funds has grown post-GFC. Large pension funds have been especiallyscrutinized, as sponsors are focused on fallingasset/liability ratios, the need for greater corporategovernance at fund managers and the high feescharged by private vehicles.For insurance companies, the largest Europeaninstitutional segment, new rules being discussedwould actually apply punitive charges to firmsinvesting in private hedge fund offerings; an exceptionwould be made when a private fund provides completetransparency to the underlying assets.Insurance companies account for 42% of Europeaninstitutional assets. Since the 1970s, insurancecompanies in Europe have been operating under aset of regulations broadly referred to as Solvency I.Solvency I focused primarily on the capital adequacyof insurers and required little in terms of riskmanagement and governance. This framework isset to be updated in 2014, with a new regime calledSolvency II. Among other requirements, Solvency IIprovides minimum levels for an insurance company’srisk-based capital.Pillar 1 of the proposed Solvency II rules requires thatinsurers hold sufficient capital to ensure a 99.5%probability of meeting obligations to policyholdersover a 1-year period. To meet this goal, the standardformula proposed in the directive sets a sliding scaleof capital charges against a portfolio’s assets. Themost punitive capital charges are reserved for hedgefunds and private equity funds, which are classifiedas “other equities” and assessed with a 49%capital charge.Although Solvency II rules are still not in effect, thetone of public discourse in Europe has made it difficultfor insurance companies and other institutions toinvest as freely in private fund vehicles. The resulthas been a reallocation of investment dollars to moreheavily regulated and transparent structures in thealternatives marketplace.Alternative UCITS Draw Increased Flows fromEuropean InstitutionsAll publically offered fund structures in Europefall under the auspice of a set of laws known asthe Undertakings for Collective Investment inTransferrable Securities (UCITS). In 2003, a thirditeration of the UCITS rules was released that allowedfor the expanded use of exchange traded and over-the-counter derivatives. It also introduced a commonprospectus and marketing “passport” that provideddistributors access to all of the EU countries andeliminated previous costly and disparate privateplacement regimes. These key changes openedthe door for the first wave of publically offeredalternatives—or alternative UCITS—vehicles.Asset managers, who saw alternative UCITS as anexpansion of their unconstrained long productsand were able to leverage existing marketing anddistribution organizations, accounted for the initialwave of alternative UCITS offerings launched in theyears pre-GFC. Hedge funds initially avoided creatingalternative UCITS funds due to the perceived productconstraints, costs of daily reporting and fear ofcannibalizing their higher-fee private fund offerings.Although UCITS III envisioned a product for retailinvestors offering daily, weekly or monthly liquidity,interest in alternative UCITS came predominantlyfrom institutions that faced restrictions on theirability to invest in private fund vehicles.By 2007, according to SEI/Strategic Insights,alternative UCITS AUM had reached $212 billion.These assets proved fleeting, however, as AUM fellby 55% in the GFC to only $117 billion, as shown in“ Pension funds are reconsidering hedge fund investments because ofliquidity issues and fees. Some of them are annoyed due to the lockupsand high fees.” — Boutique Research and Consultancy Firm“ For some insurance companies in Europe, there are rules that they caninvest only in UCITS.” — Boutique Research and Consultancy Firm
  29. 29. Rise of Liquid Alternatives Survey | 30Chart 21.Post-GFC, the entire investor community, andinvestors in Europe in particular, had a severe backlashagainst liquidity issues that emerged during the crisis.Institutional investors that had been prevented fromaccessing their privately placed capital throughoutthe crisis due to lock=ups and fund gates wereattracted to the daily, weekly or monthly liquidityprovisions of alternative UCITS. These institutionssought approval from—and were encouraged by—their constituents to reallocate assets to productsthat offered greater regulation, public oversight anddisclosure requirements.In the immediate wake of the GFC, the launch ofseveral UCITS platforms provided an access pointfor institutional investors to make allocations intoa range of alternative UCITS funds. Further, theseplatforms helped facilitate this trend by reducing thecosts for hedge fund managers looking to set up anddistribute an alternative UCITS product.The result was a rapid recovery in alternativeUCITS AUM. As noted in Chart 21, alternative UCITSproducts had recouped almost all of their pre-GFCcapital by 2010.The caliber of firms willing to launch alternativeUCITS products was one factor helping to speed thisrecovery. Previously, the products had been emergingprimarily from asset manager organizations; the waveof launches post-GFC were coming from recognizednames in the hedge fund industry. Indeed, SEI/Strategic Insight notes that alternative UCITS fundslaunched post-2007 garnered 70% of incoming flowsin the 2 years immediately following the GFC.“ We were approached by an existing investor that had been in oursovereign debt fund for 6-7 years. They are an insurer and becauseof Solvency II, they have to come out of unregulated hedge funds andinto the registered space. They have said that they are willing to seed aUCITS fund and that they don’t mind setting it up as a sole investor.”— $1.0 to 5.0 Billion AUM Hedge Fund“ Our current UCITS fund is on [a bank] platform. We have used it as ameans of gaining access to European investors who can only invest viaUCITS vehicles.” — $1.0 AUM Billion Hedge Fund“ We are thinking about UCITS again and would explore going on to aplatform as we see this as cost efficiency. Our Long bias product is easyto put into the UCITS wrapper.” — $1.0 Billion AUM Hedge FunChart 21Source: SEI/Strategic Insight data.0$250,000$200,000$100,000$150,000$50,0002008 2009 2010 2011 YTD11/2012Changes in Alternative UCITS AuM:2008-November 2012MillionsofDollarsChart 21: Changes in Alternative UCITS AuM:2008-November 2012
  30. 30. Rise of Liquid Alternatives Survey | 31Alternative UCITS Investment LimitationsSlow Growth Post-2010Institutional enthusiasm for alternative UCITS peakedin the immediate aftermath of the GFC. As Chart 21illustrates, assets grew 89% between 2008 and 2010,but have only been able to gain an additional 19% sincethat time. Slowing interest in the product reflectsincreased awareness on the part of institutionalinvestors about the limitations of these products interms of replicating private fund strategies.According to survey participants, most of theinstitutional assets that have shifted to alternativeUCITS have been focused in a highly liquid sub-set of strategies. Those strategies requiring moreilliquid assets have been difficult to duplicate inUCITS structures. Consequently, optimism aboutcontinued institutional interest in these products ismuted at best.Indeed, Eurohedge’s 2012 UCITS survey attributesthe jump in alternative UCITS AUM in 2012 to asurge in demand from retail buyers; the retail shareof alternative UCITS ownership is cited as havingincreased from 25% to 38% in just the past year.Our observation has been that institutional investorsthat have already rebalanced the more liquid portionof their alternatives allocation, and are thereforemore likely to turn to managed accounts for thetransparency and liquidity benefits they require inmore complex strategies.Separately Managed Accounts Gain Assets,but at Extensive CostsSimilar to regulated alternatives, separately managedaccounts (SMAs) can provide improved governanceand control, greater transparency, enhanced liquidityterms, and reduced capital charges under the look-through provision of Solvency II. SMAs also benefitfrom broader investment flexibility and, for thelargest institutional investors, customized terms andfee structures.Institutions with the means and willingness to allocatea large enough ticket are, for all purposes, able to hirea fund manager to run a customized strategy. This isbecoming increasingly common as investors look tomold strategies and acquire specific exposures to filla particular niche in their portfolio.Costs associated with running an SMA are notinconsequential, however. In many ways, the SMAbears the same expenses as a pooled vehicle; but withan SMA, those costs are borne by one investor andoften represent a larger portion of the account’s orfund’s assets.The investor also assumes the counterparty creditrisk when the account trades derivatives or usesfinancing, and investors must negotiate theirown credit risk and ISDA documents, as well as PBagreements. Operationally, it is difficult for manyinstitutional investors to oversee and manage theseprocesses without sufficient scale.Managed Account Platforms OfferConvenience, but at a CostInstitutions looking to streamline the operationalburden of a managed account platform (MAP)can outsource the set-up and administration to aplatform provider.The top MAPs have been attracting an increasedflow of assets in recent years. Overall assets haveincreased from $41 billion in March 2009 to $57.7billion at the end of 2012. Competition for assetsacross the top platforms is steep, but confined to asmall set of firms. As Chart 22 shows, 9 of the top10 MAP providers in the post-crisis period remain inthe top slots today.“ The perception from some pension funds about UCITS is that theproducts being offered are not great. If the strategy is in a UCITS format,it is not the same strategy as a private fund and it would not have thesame performance.” — UCITS Platform Intermediary“ We thought for a few days about doing a UCITS fund. We quickly decidedthat the things that made it attractive would make it unattractive…ourmost liquid fund is quarterly on 90. If you shorten that, you’d have tokeep too much liquid capital…and that sacrifices returns.” — $10 Billion AUM Hedge Fund“ If you look at the rules you have to follow in UCITS, it’s really a longonly strategy…The bulk of UCITS funds say that they are total return orabsolute return and they charge fees at that side of the scale, but whenyou look at them they have 2 short positions.” — $1.0-5.0 Billion AUM Hedge Fund“ All of our UCITS fund of hedge fund products are overall long bias innature. We view UCITS as necessary to keep them in business, a wayto appeal to investors nervous about the Madoff experience whenconsidering investing in Alternatives.” — Fund of Hedge Funds
  31. 31. Rise of Liquid Alternatives Survey | 32For investors, the platforms identify, complete duediligence on and provide access to a set of managersthat have already agreed to offer SMAs. In manyinstances, the platform has pre-negotiated termswith the SMA manager. A platform that representsthe potential assets of a number of investors maybe able to negotiate for more attractive terms thana single institution could otherwise achieve. Wherean institution has a series of SMAs, the platform alsoprovides consolidated reporting.Investors working with bank-sponsored MAPs canalso explore financing and structuring opportunities.Such offerings could include negotiating a “maximumdrawdown” threshold, below which the bank sponsorwill hedge off additional losses.The convenience of these platforms cannot bedisputed, but there is little cost savings involved,as the platforms charge substantial fees for theirservices. Even in cases where a platform negotiatesreduced management and performance fees with anunderlying account manager, those savings are notnecessarily passed on to the investor.New Balance of Alternative Asset StructuresEmerges in EuropeWhen all of these different pools of alternative hedgefund strategy assets are considered together, itbecomes clear that emerging regulations in Europeare working to redirect the industry from privatelyoffered hedge funds to either publically offeredalternative UCITS or SMAs. This is illustrated inChart 23.“ Managed accounts are a reflection that investor power is growing andthey are calling the shots. We had a raise in January and at the lastminute, the investor dictated the exact term sheet with fees, liquidityprovisions, key man risk and insurance. It was inconceivable to theinvestor that they would go into a co-mingled fund.” — Third Party Marketing Intermediary“ If we are establishing a long-term relationship with a manager we willinvest in large size via SMAs which allow us to negotiate lower fees andprovide us better access to the managers along with daily transparency.” — Insurance Company+40.6%$41.0 Bn AuM $57.7 Bn AuMMANAGED ACCOUNT PLATFORMSAuM AS OFMARCH 2009(Bn, USD)AuM 2012(Bn, USD)NUMBER OF FUNDSON PLATFORM(March 2009)NUMBER OF FUNDSON PLATFORM(2012)Deutsche Bank 8.00 12.40 136 223Lyxor Asset Management 10.50 11.80 113 121Man Group 7.0 8.0 70 80AlphaMetrix 2.10 6.90 66 150Lighthouse Partners 2.90 4.80 82 90Goldman Sachs 3.20 3.50 20 54HFR Asset Management 1.79 3.10 75 78UBS N/A 2.50 N/A 30Innocap 2.00 2.40 59 48Amundi 1.79 2.30 54 31Guggenheim 1.75 N/A 38 N/AChart 22: Assets Managed on 10 Largest Managed Account PlatformsSource: HFMWeek

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