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Citi prime services report on liquid alternatives

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Citi prime services report on liquid alternatives

Citi prime services report on liquid alternatives

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  • 1. Citi Prime FinanceThe Rise of Liquid Alternatives &the Changing Dynamics of AlternativeProduct Manufacturing and DistributionMay 2013
  • 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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
  • 32. Rise of Liquid Alternatives Survey | 33Since 2008, Alternative UCITS assets increased by$131 billion, while the combined assets of onshore andoffshore private funds increased by only $37 billion.(MAP assets grew by $17 billion, but this total is notcounted as a separate asset pool in our analysis,because the AUM is already likely to be listed in eitherthe alternative UCITS or onshore private fund figure.)This dramatic swing in flows has significantly changedthe structure of the European marketplace. Chart24 illustrates that the combined pool of alternativeassets in Europe increased from $516 billion at theend of 2008/early 2009 to $684 billion by the end of2012. The share of these assets allocated to privatelyheld hedge funds (both onshore and offshore)declined, however, from 77% to only 64% of assetsduring the corresponding period.In many ways, what has occurred in Europe could bea model for the much larger U.S. market. As will nowbe discussed, U.S. regulatory changes both beforeand after the GFC have worked to flatten differencesbetween privately offered and publically offeredfunds, just like AIFMD has done in regards to UCITS.And, while there is no Solvency II- type imperativehanging over U.S. institutional investors, there hasbeen increased public focus post-GFC on asset/liability management and the high cost of hedgefund fees.Simply having more harmonized policies andoversight, however, may not warrant a shift inallocations. It was a desire for the liquidity benefitsof these new structures that drew Europeaninstitutional investors, but there is not nearly thesame level of concern about this factor from the U.S.institutional audience.What we will explore in coming sections is that thechange in U.S. alternative asset pools is likely to besparked not by traditional institutional buyers, but bythe emergence of a new retail audience.“ Investors are all about transparency. They want managed accounts. In away, it’s back to the future. This used to be the ways that CTAs managedback in the day and then to be cleaner operationally, people went towardco-mingled funds.” — CTA Fund“ We used to want to be highly opportunistic in the market. We haddistressed, middle market and structured credit all in our co-mingledaccount, but now we’ve broken that up into separate sleeves. Meanwhile,our managed accounts are going in the opposite direction and becomingmore custom and mixed in terms of product.” — $10 Billion AUM Hedge Fund“ Managed Account Platforms are a good option because of thetransparency… investments through managed account platforms willincrease and they are also good from a Solvency II perspective.” — Boutique Research and Consultancy Firm“ In Europe right now, managed account platforms have becomebest practice.” — Platform Provider“ AIFMD and Solvency II are pushing Europe toward managed accountplatforms. As the investor, I don’t want to have to go to the pension’sboard and say I am invested in an offshore Cayman fund and I don’t knowwhat it’s invested in.” — ConsultantChart 23: Changes in European AlternativeStructures: 2008 to 2012Chart 23Sources: Citi Prime Finance analysis based onHFI EuroHedge, HFM Week, HFR, Strategic Insight dataChanges in European Alternative Asset Structures:2008 to 2012ManagedAccountPlatformsAlternativeUCITsOnshoreHFsOffshoreHFsBillionsofDollars$17B$131B-$42B$79B$-60$140$80$40$100$-200$120$60$80$-40$37BSubset ofAlternativeUCITS OnshoreFundsThe $37B notation floating ABOVE theright column has no apparent purpose.Please verify need to include.$20
  • 33. Rise of Liquid Alternatives Survey | 34“ We see a real difference between U.S. and European investors. U.S.investors want more long-term returns and they see European allocatorsas more likely to swing into and out of positions.” — $1.0 to 5.0 Billion AUM Hedge Fund“ Europe was always freaked out by liquidity.” — Multi-Family OfficeChart 24: Changing Structure of European Hedge Fund IndustryEnd-2008 / Early-2009: $516B AuM 2012: $684B AuMChart 24-ASources: Citi Prime Finance analysis based onHFI EuroHedge, HFM Week, HFR, Strategic Insight dataOffshore EuropeanHedge Funds$377BChanging Structure of European Hedge FundIndustry: End-2008 / Early-2009: $516B AuM4%23%Onshore EuropeanHedge Funds$22BAlternative UCITS$117B73%ManagedAccountPlatforms$41B8%Chart 24-BSources: Citi Prime Finance analysis based onHFI EuroHedge, HFM Week, HFR, Strategic Insight dataChanging Structure of European Hedge FundIndustry: 2012: $684B AuMOffshore EuropeanHedge Funds$335B15%36%Onshore EuropeanHedge Funds$101BAlternative UCITS$248B49%ManagedAccountPlatforms$58B8%
  • 34. The regulation of ”pooled investment vehicles”,defined under U.S. financial services regulation ascomprising registered investment companies (RICs),business development companies (BDCs) and hedgefunds, and their respective registered investmentadvisers (RIAs), has gone through significant changessince the original incarnations of these rules wereestablished in the 1940’s.Whether or not it was their intention, regulators arehelping to bring marketing, compliance, reportingand many of the operational processes of privatelyoffered funds closer to publically offered fundsand the investment rules, fees and tax treatmentof publically offered funds closer to the privatefund world.Publically and Privately Offered Funds DevelopAlong Parallel PathsThe Investment Company Act of 1940 (the 40 Act)and the supporting Investment Advisers Act (AdvisersAct) of the same year together form the backbone ofU.S. financial regulation, and were originally writtento instill public confidence in the fledging investmentcompany industry following the Wall Street Crash of1929. It was designed to protect the public from anew type of investment vehicle, mutual funds, whichhad been growing in popularity since their creation in1924. The 40 Act applies to all investment companies,but exempts several types of investment companiesfrom its purview. The most common exemptions arefound in Sections 3(c)(1) and 3(c)(7) of the 40 Act andinclude hedge funds.Since the 40 Act was released, the rules andregulations governing non-exempt investmentcompanies (including mutual funds, BDCs, etc.) andexempt investment companies (including hedgefunds) diverged with regards to disclosures, frequencyand transparency of reporting. This divergence alsoaccounted for the types of investment techniquesallowed within the various investment vehicles,principally short selling of shares and use of portfolioleverage to deliver excess returns.The non-exempt mutual fund companies weretraditionally considered ‘long only’ and investedin public securities in the equity and debt markets.Exempt hedge funds could engage in the short sellingof securities through borrowing relationships withbroker-dealers and the use of portfolio leverageabove standard portfolio margin, as defined underthe Federal Reserve Board Regulation T (Reg T).These two parallel worlds, the regulated and publicallyavailable mutual funds and the lightly regulated andonly privately offered hedge fund industries, havegrown in size since the 40 Act to reach $11 trillion and$2.3 Trillion, respectively, in the U.S. A number ofmarket events and rule changes over the past decadehave resulted in the bridging of these two types ofinvestment vehicles, and have consequently erodedthe artificial barrier between publicly offered andprivately offered funds.40 Act Mutual Fund Restrictions Ease,Creating a More Flexible LandscapeThe creation of the Securities Exchange Commission(SEC) and the passing of the Securities Act of 1933 putin place safeguards to protect investors, and requiredall mutual funds to register with the SEC and providedisclosures in the form of a prospectus describing theactivities and investment guidelines for the fund. The40 Act then put in place additional regulations thatrequired further disclosures and sought to minimizeconflicts of interest.Overthepreviousdecade,theSECbegantomodernizeand update the 40 Act regulations that had notsignificantly changed since their original inception. Awhole set of changes took place in the interpretationand implementation of 40 Act regulations for RICs.The SEC adopted changes in July 2006 permittingthese funds to take small positions in an unlimitednumber of funds and affiliated funds of funds. Thesignificance of this regulatory loosening opened upthe ability of closed-end funds to invest in unregulatedhedge funds, as long as the fees were transparentand reported to investors. This marked the first timethat retail investors could access the privately offeredhedge fund products, and began to bridge the public-private boundary for pooled investment companies.Around the same time period (late 2005) an updateto the fee structure for mutual funds includedthe implementation of redemption fees aimed atincreasing the duration of retail investments anddeterring market timing and late trading of mutualSection IV: U.S. Regulations Flatten Barriers BetweenPrivately and Publically Offered Funds
  • 35. Rise of Liquid Alternatives Survey | 36fund listed securities. This seemingly small changeto fee structure began to lengthen the duration ofcapital flows and ease liquidity pressure on mutualfund managers.In 2009, the SEC made changes to the delivery andtransparency requirements for fund prospectuses,allowing funds to provide investors an online summaryprospectus. This automation and streamlining ledto cost savings for fund managers and allowed forstandardized, transparent comparison of funds.In July 2010, further updates to fee structures wereimplemented with the rescission of the Rule 12b-1requirement and its replacement by a standardizedfee of 25 bps, paid annually for the distributionactivities of the fund. This AUM-based fee, chargedon an ongoing basis, began to better align theincentives of the financial adviser and the investorbecause the size and duration of the investmentwere more important than just an initial sale andcommission environment.In December 2010, the U.S. Congress successfullypassed the Regulated Investment CompanyModernization Act of 2010, which was aimed atmaking registered funds more efficient by reducingthe burden arising from amended year-end taxinformation statements. This improved a fund’sability to meet its distribution requirements andamended the tax treatment of investing in a fund offunds structure.All of these changes served to modernize the 40 Actinvestment funds in a way that increased efficiency,reduced turnover, broadened investment guidelineswith the introduction of non-affiliated fund-of-funds,streamlined tax treatment of fund investments andimproved transparency on the $11 trillion U.S. industryAround the same time these regulatory changeswere taking place for the mutual fund industry, U.S.regulators were imposing laws that would significantlyaffect the privately offered fund industry.Dodd-Frank Act Drives Greater Hedge FundTransparency and ComplianceThe GFC also had a dramatic impact on transparencyand compliance culture in the privately offered fundindustry, which until 2010 had avoided increasedregulation and oversight by the SEC. Until theDodd-Frank Act was passed, this industry reliedon Investment Company Act exemptions originallydefined in 1940.Dodd-Frank required that the vast majority ofunregistered advisers to become registered withthe SEC and therefore fall under the oversight ofthe same securities market regulator as registeredfunds and BDCs. This law required private fundmanagers to become RIAs and introduced broadcompliance requirements.Private fund managers with more than $150 millionAUM are now providing an unprecedented degree oftransparency and standard marketing disclosuresto the SEC under the same process as publicallyregistered funds. The new ‘ADV’ form requirementswere considered a significant reporting changefor hedge fund managers, who until this point hadremained unregistered and provided no publicinformation about their investment activities.Investments in compliance programs to meetthe requirements of being an RIA under the SECguidelines were significant across the U.S. hedgefund industry in 2011 and 2012. A dramatic increasein manager registrations took place, identifying thesefirms to the public via the SEC registration process.As part of the RIA guidelines, registered private fundmanagers now had to have a defined complianceprogram and a designated compliance officer whilebecoming subject to SEC reviews and scrutiny.As shown in Chart 25, in October 2012 the SECreported the number of private fund managers nowregistered with the SEC increased to 4,061 during2012, when registration became mandatory. Thisrepresents an increase of 59% over the 2,557 fundsthat had chosen to voluntarily register in previousperiods, and does not include the more than 2,000small funds that were shifted from federal to stateoversight as a result of the Dodd-Frank Act rulechanges. Indeed, many hedge fund managers enacteddual registrations in 2012, choosing to register with“ We felt that the liberalization of the 40 Act around 2007 made it possibleto run a proper strategy. We felt that it would be difficult to raise moneyfor a hedge fund as there were so many hedge funds out there. At onepoint in 2007, the New York Times ran an article saying that the hedgefund industry had run out of Greek and Roman god names.” — $5.0 to $10.0 Billion AUM Liquid Alternatives Manager“ Transparency in hedge funds has created a middle ground where the IFAnetworks can now educate the mass affluent buyer. These buyers arenot worried about the same things as the pension funds. They just wantgood returns.” — Asset Manager
  • 36. Rise of Liquid Alternatives Survey | 37the Commodities Futures Trading Commission (CFTC)in addition to the SEC if their portfolio contained asignificant use of futures and/or options.Beyond registration, there have also been increaseddemands for transparency into the actual hedge fundholdings. Post-GFC, rules emerged that requiredmanagers to disclose their largest short-salepositions. This was followed in 2012 by additionalreporting requirements. A new systemic risk reportknown as ‘Form PF’ (or form private fund) wasintroduced as a reporting requirement by a newlyformed department within the U.S. Treasury calledthe Financial Stability Oversight Council (FSOC).The FSOC was established to monitor systemicmarket risk. To fulfill this mandate, registered hedgefund managers must now provide the FSOC withinformation on a variety of private fund activities thathad until that point remained completely opaque.Such Form PF disclosures include extensiveinformation about their position holdings and riskpractices — data that had rarely been shared withany regularity with investors. The production anddelivery of Form PF prompted widespread industryinvestments in reporting technologies, and resultedin nearly all larger hedge funds having to upgradetheir procedures to aggregate risk information anddetailed fund investment information. These changeshave narrowed the gap between where U.S. hedgefund managers were prior to the GFC and where theystand today vis à vis the mutual fund industry.JOBS Act Proposed Changes Will AllowExpansion of Alternative “Brands”The most recent regulatory change that is servingto blur the boundary between publically offeredand privately offered investment funds is embeddedwithin the Jumpstart Our Business Startups Act(JOBS Act) which was passed in April 2012. TheJOBS Act’s purpose is to encourage funding of smallbusinesses in the U.S. by easing various securitiesregulations.There are two main changes in the JOBS Act affectingpooled investment vehicles, one relating to BDCs andexchange listed closed-end funds, and one relating tothe marketing and advertising of private funds.The JOBS Act proposed relief for certain typesof companies, referred to as ‘emerging growthcompanies’, from specific regulatory and disclosurerequirements in their registration statement that theyfile when they first go public and for the following 5years. This allows new public companies, includingBDCs, to have a longer phase in period to meet thefull requirements of being a public company. Thismakes it easier and less expensive to launch a newclosed-end publically traded investment company.This allows more fund managers to come to marketwith these products in a shorter timeframe.ThemoresignificantchangeproposedwithintheJOBSAct is the lifting of the ban on ‘general solicitation’and advertising of specific types of private placementsecurities, including privately offered hedge fundsor private equity funds, which has been in placesince the original securities acts defined in 1930s.Chart 25Source: Based on information released by the SECin press release dated October 19, 2012.Hedge Private Fund Advisors Registered with SECOnly Shows Managers with More than $100M AuMVoluntary MandatoryNumberofRegisteredPrivateFundAdvisors2,5574,061+59%04,5002,5001,5003,5005001,0003,0002,0004,000Chart 25: Hedge Private Fund AdivsorsRegistered with SEC Only Shows Managers withMore than $100M AuM“Hedge fund managers are becoming regulated on their home turf sogetting more regulated on another turf is not as big a deal.”— $5.0 to $10.0 Billion AUM Hedge Fund“Hedge funds themselves are being subject to much greater regulatoryobligations and their fund operations are now very transparent. Managersare going through a fatigue of going through these regulations and arenow looking to monetize these investments.”— Law Firm Intermediary
  • 37. Rise of Liquid Alternatives Survey | 38If implemented by the SEC this year, the changesmay allow hedge fund managers to promote theirprivately offered hedge funds in the same way that aregistered fund manager can promote a mutual fundby using public media to build a brand and explain thebenefits of their fund products.The ability of these managers to promote their“brand” is especially important as demand forpublically offered alternative 40 Act funds is growingdramatically. Hedge fund firms are deciding whetherto create or sub-advise these vehicles. This willallow managers to discuss their firm and investmentcapabilities with a broader set of financial wealthadvisers and audiences to gauge potential interest.New Rules Erode Barrier between Publicallyand Privately Offered FundsMore than 80 years ago, the paths of registeredinvestment funds and privately offered hedge fundsdiverged along the lines of transparency, oversight,reporting and target audience. We saw the U.S.mutual fund industry explode throughout the 1980sand 1990s while the hedge fund industry remainedthe domain of wealthy investors and large institutions.Those barriers on either side have slowly eroded,but the GFC was the most significant event that hasbought these products closer in line with the roll-outof Dodd-Frank and the subsequent opening up of theprivate fund universe.“ Regardless of the JOBS Act, you can market a 40 Act fund. You can goout and take ads out on television to market a 40 Act fund. As a hedgefund manager, you can’t do that.” — $1.0 to $5.0 Billion AUM Hedge Fund“ The SEC has no idea that over regulation of hedge fund managers hasled to a new audience for these products. Hedge fund law firms arenow desperate for 40 Act lawyers to help managers figure out how toleverage the opportunity.” — Law Firm Intermediary“ We are creating products on the cutting edge of regulatory engineering.” — CTA Fund
  • 38. Foundational changes in the U.S. financial advisormarket have been taking place in parallel to thechanges in U.S. regulations outlined in the previoussection. While regulatory changes structurallyhelped to flatten differences between publicallyand privately regulated funds in the U.S., financialadvisors are driving demand from a completelynew audience for hedge fund-like strategies. Thiscombination of demand from a new source and amore level regulatory playing field are spurring rapidgrowth in U.S. publically offered alternative vehicles.This is a significant development, not only becausefinancial advisors bring a new set of buyers to thetable, but because the U.S. mutual fund and ETFmarket is the largest in the world. Changes in the U.S.are likely to have a ripple effect globally and influencewealth advisory in other regions. Understandingwhat’s occurring in this market is critical in thinkingabout how other markets around the globe maydevelop in the future, which may influence demandfor hedge fund and hedge fund-like strategies.Three-Quarters of U.S. Retail InvestorsDo Not Qualify for Private FundsUnlike the European marketplace that is heavilyweighted to the institutional investor, the U.S. marketis nearly evenly split between institutional andretail buyers. Chart 26 illustrates this breakdown.Institutional investors in 2011 accounted for$14.5 trillion of the total $27.3 trillion market forprofessionally managed assets in the U.S. (53%), andretail investors accounted for $12.8 trillion (47%).Retail investors control a higher share ofprofessionally managed assets in the U.S. becausethe majority of pension and retirement plans aredefined contribution systems, not defined benefitSection V: Changing U.S. Wealth Adviser Dynamics AreDriving New Demand for Alternatives ProductsChart 26Sources: Cerulli Associates citing Department of Labor, ICI, Federal Retirement Thrift Investment Board, PlanSponsor, Insuranceassetmanager.com,The Foundation Center, NACUBO, Insured Retirement Institute, VARDS, Morningstar Direct, Strategic Insight/SIMFUND, SIFMA, Investment News, FinancialPlanning Bank, Insurance Market Research Group, Meridian IQ, SP Capital IQ MMID, The Institute of Management and Administration, Pensions Investments,FDIC, OCC, Barrons, Financial Planning Association, Investment Management Consultants Association.$8,000BillionsofDollars2005 20092001 2011$15,000$13,000$12,000$11,000$9,000$9.9T2003 2007$14.2T$12.8T$8.6T$12.5T$14.5T2004 20082002 2006 2010$14,000Professionally Managed U.S. Assets Under Management: Retail Institutional(Excludes Non-Professionally Managed Assets, Adjust Channels for Double Counting)$10,000RetailInstitutionalChart 26: Professionally Managed U.S. Assets Under Management: Retail Institutional(Excludes Non-Professionally Managed Assets, Adjusts Channels for Double Counting)Chart 26Sources: Cerulli Associates citing Department of Labor, ICI, Federal Retirement Thrift Investment Board, PlanSponsor, Insuranceassetmanager.com,The Foundation Center, NACUBO, Insured Retirement Institute, VARDS, Morningstar Direct, Strategic Insight/SIMFUND, SIFMA, Investment News, FinancialPlanning Bank, Insurance Market Research Group, Meridian IQ, SP Capital IQ MMID, The Institute of Management and Administration, Pensions Investments,FDIC, OCC, Barrons, Financial Planning Association, Investment Management Consultants Association.$8,000BillionsofDollars2005 20092001 2011$15,000$13,000$12,000$11,000$9,000$9.9T2003 2007$14.2T$12.8T$8.6T$12.5T$14.5T2004 20082002 2006 2010$14,000Professionally Managed U.S. Assets Under Management: Retail Institutional(Excludes Non-Professionally Managed Assets, Adjust Channels for Double Counting)$10,000RetailInstitutional
  • 39. Rise of Liquid Alternatives Survey | 40schemes like in Europe. In a defined contributionplan, individual investors are given control to maketheir own selections around how to invest theirassets rather than turning discretion for managingthose portfolios over to the sponsoring institution.To facilitate such discretionary investing, there isan established market of financial advisers. Thissection will examine trends occurring in that financialadviser landscape.There are multiple categories of retail investors inthe U.S. that break down by their level of wealth.To illustrate points about how demand from theseinvestors may impact the hedge fund industry, wecollapse the upper wealth bands and simply say thatall individual investors with more than $5.0 millionnet worth are considered high net worth. This is animportant cut-off point because all those above thisband are considered a qualified investment purchasesand are able to buy into a private fund vehicle.Our analysis shows that these high net worth investorsrepresent 27% of the total U.S. market of householdinvestable assets. That means that under currentlaw, nearly three-quarters of the retail U.S. investormarket (73%) are not currently wealthy enough toinvest in privately offered hedge fund vehicles.This pool of retail investors with less than $5.0 millionin net worth is split into three segments: affluentinvestors, with $2.0 million to $5.0 million of networth; mass affluent, with $500,000 to $2.0 millionof net worth and retail, with less than $500,000 ofnet worth.For our analysis, we are going to focus primarily onthe affluent and mass affluent categories becausereal estate- and college-related savings take up asmaller portion of these investors’ assets, and theythus have a larger amount of unencumbered capitalto invest.This audience relies heavily on financial advisorsin making investment decisions, often signing overdiscretion for their portfolio and allowing theirfinancial adviser to make investments on theirbehalf. This is a critical point to remember, sincea change in approach adopted by such advisers canbe enacted without having to gain permission fromeach individual they advise. Such a change in adviserthinking and approach occurred post-GFC.Wealth Advisers Move toward a MoreRisk-Aligned Portfolio ApproachIncreasingly, retail wealth advisers in the U.S.operate like Chief Investment Officers (CIOs) chargedwith managing the return stream for a pension,endowment or foundation. To preserve their clients’trust and business, they look to create a stable returninvestment portfolio that, over time, helps theirclients’ assets grow.Not surprisingly, the majority of these advisers reliedon a model portfolio constructed using strategicasset allocation principles to create diversity intheir portfolios. As was the case for institutions,these wealth advisers initially used modern portfoliotheory and the capital asset pricing model to createseemingly diversified holdings.Prior to 2008, wealth advisers were for the mostpart pursuing a capital-weighted model portfoliothat looked very much like the institutional 60%equities/40% bonds portfolio. Within their equitiesportfolio, they would look to diversify holdings acrossvalue and growth stocks of various capitalizations,and in their bond portfolio they would look to diversifyholdings by credit quality and duration. Becausethe majority of their clients were restricted frominvesting in private funds, nearly all of the wealthadvisor portfolios were invested in long-only vehicles.These portfolios took substantial hits in the 2008 GFC.Just as we saw with leading institutions in subsequentyears, there is now a large class of wealth advisers inthe U.S. that are now looking at the allocation of riskin their portfolio as opposed to simply looking at theallocation of capital.“ Alternatives are a major focus of the U.S. retail market as mass affluentinvestors have had 5 years of poor returns in money markets, bonds andequities. This is an economic driven trend that has nothing to do withregulation.” — Asset Manager“ Long investors and their advisers were both unclear on what to do after2008. The way that they had been thinking about their portfolio—valueand growth, credit quality and duration—were not working anymore.Correlations became close to 1 between credit risk and equity risk. Manyof these investors thought they were 60/40 in their portfolio and it turnedout they were 90/10. That’s why these products became appealing fromthe demand side. Advisors wanted to diversify their portfolios to betterspread their clients’ risk.” — Morningstar Alternatives Research Team
  • 40. Rise of Liquid Alternatives Survey | 41As noted earlier, a portfolio with 60% allocatedto equities and 40% allocated to fixed income in2008 was not diversified when viewed from a riskperspective. When the equity markets were down40% to 50% in 2008, this was a major wake-up callto the wealth advisor industry.These investors and advisors responded very muchlike leading institutions and began aggressivelylooking for options to dampen volatility in theirportfolios and create more robust portfolios. Unlikeinstitutional investors, however, clients that are inthe affluent and mass affluent categories do notqualify for investment in the private hedge fundvehicles that are being used to achieve those aims ininstitutional portfolios.To satisfy this need, there has been a dramaticincrease in demand for publically offered alternativestrategies. These publically offered alternativemutual funds and ETFs employ many of the samehedge and investment techniques as for privatefunds, and nearly all of the structures are available tothe full range of clients in the retail category.Tax Reporting for Publically Traded AlternativeFunds Is Seen as SuperiorMany wealth advisers are even promoting theseproducts to clients in their high net worth categorythat may have been put off either by the high feesassociated with hedge funds or by the tax treatmentof private investment vehicles. Investors in the limitedpartnership structures associated with privatelyoffered funds typically get a K-1 tax statement eachyear as opposed to a 1099 form for the vast majorityof publically offered funds.While this may seem like a minor point, it was onewidely cited by survey participants. There arefederal tax rules requiring investment firms to issue1099 statements by the end of January each year. Incontrast, K-1 statements often arrive late in the taxpreparation cycle and force wealthy individuals todelay filings from April to August each season. Forindividuals that have engineered their investmentportfolios in ways to achieve maximum tax savings,this delay in being able to receive tax refunds fromthe government is viewed by some as burdensome.Moreover, there are distribution considerations fora more retail audience. Many of the mutual fundsupermarkets, independent and regional broker-dealer firms are not set up to process K-1s, and willnot accept products on to their platforms that requirethis filing.Achieving the portfolio benefits of alternativestrategies is not only important for clients, but,because of changes in the way that financial advisorsare getting paid, these products are also seen as away to insure a more stable revenue stream for theadvisers themselves.Shift in Wealth Advisor CompensationAlso Drives Alternatives DemandTo qualify to sell securities or funds to a retailaudience, an adviser at a minimum has to be a“registered representative” and for many years thiswas the preferred model in the industry. A registeredrepresentative looks to sell specific financialproducts (securities or funds) to their clients andthey must determine their client’s suitabilityto purchase that product and ensure that theirclient has all required disclosures before allowingthem to engage in a transaction. The registeredrepresentatives were typically paid a commissionwhen such a transaction occurred.A new breed of adviser began to emerge in the earlyto mid-1990s that looked to differentiate themselvesfrom the traditional representative by actuallyregistering as an RIA with the SEC and taking onfiduciary responsibility for their clients’ portfolios.For compensation, these advisors chose to take a feeonly on the assets they managed and to not chargecommissions. They marketed themselves as havinggreater independence as a result of not having topush product, and as promoting better long-term“ What’s driving the emergence of these products is the demand fordownside protection, outsized returns and alpha. The RIA and wirehouse community in gatekeeper positions are really clamoring foralternative products.” — Law Firm“ High net worth investors like these regulated alternative productsbecause they’re so sick of waiting around for K-1s. They like getting the1099s so that they can get their taxes done on time.” — Asset Manager“ There is some interest from the mass affluent for the liquid alternatives.Most importantly, the structure allows them to get a 1099 versus a K-1form. I’ve had direct conversations with the distributors of these liquidalternative products and its puzzling to me that the 1099 issue is such abig deal, but they tell me that no financial advisor wants to be the one tointroduce a K-1 into their client’s portfolio.” — Asset Manager
  • 41. Rise of Liquid Alternatives Survey | 42“ Targeted investor demographics will be a deciding factor since manyretail platforms will not distribute products to their clients that issueK-1s. These platforms’ investor base is not familiar with K-1s so theadvisers need products for their clients that issue 1099s. The moreretail platforms may not even have procedures or systems able toprocess K1s for their clients. Conversely, most accredited investors(and their wealth advisors) are familiar with K-1s so everything elsebeing equal they would be agnostic to whether a fund is structured toissue 1099s or K-1s.” — Law Firm“ Advisers were also pushing for alternative mutual funds and ETFsbecause there had been a shift in adviser’s pay from commission tofee-based. They liked these products because they reduced volatilityin their pay stream.”— Morningstar Alternatives Research Teamreturns by encouraging clients to buy and hold ratherthan move in and out of investments.The traditional brokerage firms resisted this trendtoward fees rather than commissions until just afterthe technology bubble (1999 to 2001). Revenues formany of the brokers at these firms were exceptionallyhigh in those years due to the excessive day-tradingthat was taking place from retail investors. Whenthe market crashed, so too did the compensation formany registered representatives. To keep their mostsuccessful advisers, the traditional broker-dealersmoved to a combined fee and commission model.Chart 27 shows that by 2008, 30% of financialadvisers were compensated solely by fees, and 43%were compensated by a combination of fees andcommissions. The sharp drop in assets that occurredin the GFC hit the wealth adviser community especiallyhard because they saw not only their clients’ assets,but their own compensation, drop precipitously.Since 2008, the trend in the wealth adviser markethas trended towards a combined fee and commissionstructure. By 2012, 60% of advisers were being paidin this manner, and the share of advisers being paidsolely on a fee basis was down to 17%.Alternative mutual funds and ETFs are seen asespecially attractive to financial advisers that are paidon both fees and commissions. As already discussed,the ability of these strategies to offer some volatilitydampening effect, keeping their clients’ portfoliosmore resilient to market corrections, can help tostabilize adviser asset-based fees.These are also the “new” products on the block, andmany are being offered by investment managers thatwere previously unavailable to the retail audience.Chart 27: Shifting Pay Structure for U.S. Wealth Advisors2008 2011Chart 27-ASource: College of Financial Planners11%30%16%CommissionsOnlyFees CommissionsSalary Based Fees Only43%Shifting Pay Structure for U.S. Wealth Advisors2008Chart 27-BSource: College of Financial Planners7%17%15%CommissionsOnlyFees CommissionsSalary BasedFees Only60%Shifting Pay Structure for U.S. Wealth Advisors2011
  • 42. Rise of Liquid Alternatives Survey | 43As a result, these funds are able to commandhigher commissions than the traditional long-onlymutual funds and ETFs, where fees have been undercompression for many years.Change in Distribution Channels CreateReady Market for AlternativesChanging dynamics within retail distributionchannels are also driving interest in publicallyoffered alternatives. Unlike privately offered fundsthat are primarily marketed and distributed by thefirm that manages the product, the dynamics of thewealth adviser market rely predominantly on thirdparties and “affiliates” to promote their funds. Anaffiliate in this sense is a firm that has a distributionarrangement with a product manufacturer to createexclusive products.Chart 28 shows that only 6% of retail products areoffered directly from the product manufacturer,whereas the broker-dealer channel accounts for 62%of retail distribution. According to Cerrulli Associates,assets controlled by the U.S. broker-dealer channelreached a record $11.6 trillion in 2011, surpassing thepre-GFC peak of $11.4 trillion.Within the broker-dealer category, there are anumber of sub-categories. Movement within thesesub-categories has had an important impact on thesourcing of products.The wealth adviser market has been dominated bya handful of powerful wire houses. The term wirehouse dates back to early years when these firmswere expanding their branch network nationally andwould look to connect regional offices to exchangesvia telegraph wires, a technology innovation at thetime. In these organizations, all of the branchesand their representatives have access to a commonset of research, resources and products. Today,the remaining wire houses in the U.S. are MorganStanley’s Smith Barney, Bank of America’s MerrillLynch, Wells Fargo and UBS Wealth Advisors.As a sub-category, wire houses control the largestsingle pool of assets, but their overall holdings andtheir share of market has been falling in recent years.In 2007, according to Cerrulli Associates, wire housescontrolled $5.5 trillion in assets and accounted for48% of the broker-dealer total. By 2011, their assetshad declined to only $4.8 trillion, and their share hadfallen to only 41%.This is a significant development, because the wirehouses sell “dedicated” product. Smith Barneyrepresentatives only sell products on the SmithBarney platform, and the same would hold true forthe other wire houses as well.As Chart 29 shows, a different set of adviserswithin the broker-dealer space has been gainingprominence, and these advisers have a differentproduct distribution model.As noted earlier, RIAs are individuals that haveformally filed with the SEC to have fiduciaryresponsibility over their clients’ portfolios. Many ofthese RIAs also affiliate with an independent broker-dealer to get the advantages of a “branch” networkwithout the restrictions of being on a formal wirehouse platform. These advisors are called “duallyregistered,” since they are both an RIA and registeredrepresentative. Examples of independent broker-dealers include traditional securities brokerage firmslike LPL Financial, Raymond James and AmeripriseFinancial as well as online brokerages like CharlesSchwab, TD Ameritrade and E*Trade.There is a lot of overlap between the independentChart 28* Excludes channel overlap and non-professionally managed assets.Sources: Cerulli Associates citing Department of Labor, ICI, Federal RetirementThrift Investment Board, PlanSponsor, Insuranceassetmanager.com,The Foundation Center,NACUBO, Insured Retirement Institute, VARDS,Morningstar Direct, Strategic Insight/SIMFUND, SIFMA, Investment News,Financial Planning Bank, Insurance Market Research Group, Meridian IQ,SP Capital IQ MMID, The Institute of Management and Administration,Pensions Investments, FDIC, OCC, Barrons, Financial PlanningAssociation, Investment Management Consultants AssociationU.S. Retail Distribution Channels 2011**62%6%14%Broker-DealersDiscount TradingPlatforms SupermarketsPrivate ClientGroups Bank TrustsDirect fromProductManufacturer18%Chart 28: U.S. Retail Distribution Channels 2011*“ The first adopters of alternative mutual funds and ETFs were independentRIAs—maybe 2 years down the road from 2008, the wire houses thenstarted getting involved and putting them into their model portfolios. Sonow, both segments are involved.” — Morningstar Alternatives Research Team
  • 43. Rise of Liquid Alternatives Survey | 44broker-dealers and the regional broker-dealercategory. Regional broker-dealers originally tendedto have operations only in specific areas of thecountry, but today many run national networks. Thetop regional broker-dealers include Legg Mason,Oppenheimer, A.G. Edwards, Robert W. Baird, andEdward Jones.Together, RIAs, independent broker-dealers andregional broker-dealers have been gaining marketshare, rising from $4.9 trillion in assets in 2007 or43% of the broker-dealer total, according to CerrulliAssociates, to $5.8 trillion or 50% of assets in 2011.The majority of RIAs, independent broker-dealers andeven many regional firms have an “open architecture”in that they are product agnostic and can source newfunds from a wide array of manufacturers rather thanbeing locked into selling only sponsored products.Indeed, some have developed a reputation for fundingnew products by putting up money to help launch afund or by coming in early in a fund’s developmentwith a large block purchase in order to qualify for aspecial “adviser” share class.Since these advisors have discretion over theirclient portfolios, they are able to secure a largeblock of shares in a new fund in order to get the feebenefits and then allocate parcels of that purchaseout across their accounts to help their clients realizecost savings.These RIAs, independent broker-dealers and regionalbroker-dealers are proving to be a critical originationpipeline for new alternative fund offerings comingto market. Once these new products begin to gaintraction, they are then able negotiate with the wirehouses and create affiliate deals to offer product onsponsored platforms.Chart 29: Assets Controlled by Broker-Dealers IRAs, IBDs Regional Broker-Dealer Share0$12,000$6,000$4,000$8,000$2,000$10,00042%52%50%51%49%44%45%47%48%46%43%Chart 29* Excludes channel overlap and non-professionally managed assets.Sources: Cerulli Associates citing Department of Labor, ICI, Federal Retirement Thrift Investment Board, PlanSponsor, Insuranceassetmanager.com, The Foundation Center, NACUBO,Insured Retirement Institute, VARDS, Morningstar Direct, Strategic Insight/SIMFUND, SIFMA, Investment News, Financial Planning Bank, Insurance Market Research Group,Meridian IQ, SP Capital IQ MMID, The Institute of Management and Administration, Pensions Investments, FDIC, OCC, Barrons, Financial Planning Association,Investment Management Consultants Association.20092007 2008 2010 2011Assets Controlled by Broker-Dealers RIAs, IBDs Regional Broker-Dealer Share$11.4T$8.9T$11.6T43%$11.4T50%Broker-Dealer Channel Assets Percent Controlled by RIAs, IBDs Regional B/Ds$10.4TBillionsofDollars“The demand from the retail adviser within the wire house was such thatthe distribution side felt that they had to have alternative products.” — Public Fund Packager Distributor“ If you are targeting the wire houses with a registered fund, you still needadvisors to push the product.” — $10 Billion AUM Hedge Fund
  • 44. Rise of Liquid Alternatives Survey | 45Publically Offered Alternative 40 ActMutual Fund ETF Assets SurgeSpurred by each of the factors discussed thus far—wealth advisers becoming more sensitive to riskin client portfolios, more standard tax treatment,changing compensation structures and a shiftingdistribution model-AUM in the publically offeredalternative 40 Act mutual fund and ETF space havesurged, as can be seen in Chart 30. In 2006, therewas a combined AUM of only $50 billion across thetwo product sets; by 2008, that amount had nearlydoubled to $95 billion, with these registered “liquidalternatives” perhaps being the only investmentcategory besides money market funds to see netinflows in that period.The market nearly doubled again between 2008 and2009, rising from $95 billion to $166 billion, and thisrapid growth has been evident since with AUM risingto $305 billion by the end of 2012. To put this figurein perspective, the entire hedge fund industry’s AUMwas $368 billion in 1997, only 15 years ago.While there is no specific audience breakdown forownership of these funds, it is understood that themajority of investment dollars are coming from amore retail audience. Institutional investors andmulti-family office investors we surveyed expressedlittle interest in these products. These investorsbelieve the restrictions imposed on these funds makethem less likely to achieve the returns that the moreflexible, privately offered hedge funds can provide.Also, unlike their European counterparts, the vastmajority of U.S. institutions did not see the liquiditythese products offered as especially attractive.Liquid Alternatives Exceed Hedge Fund Growthin Some CategoriesIn an attempt to evaluate flows into the variouspublically offered liquid alternative strategies, wehave grouped the various offerings to most closelymimic the hedge fund categories. Chart 31 shows0$350$50$150$250$100$200$300Chart 30Source: Morningstar.20052003 2004 2012Publically Offered U.S. Alternative 40 Act Mutual Funds ETFs$95B$166B$305B$239BBillionsofDollars$264B20072006 20092008 20112010$80B$25B$50B$9B $16BChart 30: Publically Offered U.S. Alternative 40 Act Mutual Funds ETFs0$350$50$150$250$100$200$300Chart 30Source: Morningstar.20052003 2004 2012Publically Offered U.S. Alternative 40 Act Mutual Funds ETFs$95B$166B$305B$239BBillionsofDollars$264B20072006 20092008 20112010$80B$25B$50B$9B $16B“ There was a lot of talk about liquid alternatives at an institutionalinvestor conference we were at recently and 75% of the attendees saidthat they would never consider investing in these products.” — Asset Manager“ Liquid alternatives are not really hedge funds, and this messagingneeds to emerge in the future with clients. When converting a hedgefund strategy to a 40 Act product, investors need to haircut theirexpectations.”— Insurance Company
  • 45. Rise of Liquid Alternatives Survey | 46these groupings and flows.Three of the most recognizable strategies withinthe publically offered liquid alternatives space arethose that most closely resemble the “equity hedge”category, as defined by HFR. These strategies arelong/short equity, market neutral and bear marketfunds. Flows into these strategies between 2009 and2012 amounted to $28.9 billion, while during the sameperiod the HFR equity hedge category experiencedoutflows of $57.4 billion.The next publically offered category is non-traditionalbond funds, which include a range of strategies fromunconstrained long, where the investment managercan hold cash, to long-bias, with only a small degreeof hedging or shorting, all the way to liquid go-anywhere long/short credit funds that can spanvarious durations and credit profiles. Flows into thispublically offered liquid alternative category were$53 billion, on par with flows of $57 billion as listedfor HFR’s Relative Value funds—the category thatexperienced the most rapid growth in the same 2009to 2012 period.The third set of publically offered liquid alternativefunds is managed futures and currency funds. Thesefunds most closely align to HFR’s macro category.Because the primary focus of these funds is in futuresmarkets as opposed to securities markets, there areexceptions in the 40 Act rules about how they canoperate. It should be noted that the fees on theseproducts are significantly higher than for the otherpublically offered liquid alternatives that are morefocused in the traditional securities space. Flowsinto these products were only $11 billion compared toflows of $33 billion into HFR’s macro category.The final type of publically offered liquid alternativefund is a multi-alternative or “multi-alt” fund, as theywere commonly referred to in our survey interviews.This is a multi-manager fund structure that can havea mix of different strategies within it, all being sub-advised by different investment managers.While similar in many respects to a multi-strategyfund, there is no direct analogy to the hedge fundindustry, since the sub-advisors within the fund comefrom different firms. Nor is it like a traditional fundof hedge fund offering, because the sub-advisers areset up as separately managed accounts within thefund and do not incur an additional layer of fees. Thefund manager can add a new sub-adviser or removea sub-advisor from the fund at their discretion asoutlined in the prospectus. Flows into multi-alts in2012 were $13.4 billion, but that figure is likely tospike in 2013 because there are many new multi-altfunds currently in the product development pipelinethat will launch this year.Having introduced these emerging products and theinvestor audience driving their demand, we will nowtry and assess their impact on the overall hedge fundindustry’s future profile.Chart 31Source: Morningstar.Investor Flows into Publically Offered U.S.Alternative Funds by Strategy: 2009-2012Long/ShortEquity,MarketNeutral Bear MarketNon-TraditionalBondManagedFeatures CurrencyMulti-AlternativeBillionsofDollars$28.9B$53B$13.4B$11.4B0$60$40$30$50$10$20Chart 31: Investor Flows into Publically OfferedU.S. Alternative Funds by Strategy: 2009-2012Chart 31Source: Morningstar.Investor Flows into Publically Offered U.S.Alternative Funds by Strategy: 2009-2012Long/ShortEquity,MarketNeutral Bear MarketNon-TraditionalBondManagedFeatures CurrencyMulti-AlternativeBillionsofDollars$28.9B$53B$13.4B$11.4B0$60$40$30$50$10$20“ When you look at Marketfield taking in $2.8 billion in flows in January2013 and $1.8 billion February, it’s hard to ignore the potential of the 40Act liquid alternatives space.” — Asset Manager“ If alternative mutual funds are the only access point for an investor, theyare a better option than most long-only funds.” — Multi-Family Office
  • 46. While the emergence and subsequent surge in demandfor publically available liquid alternatives has alreadyhad a noticeable impact on the hedge fund industry,we are only in the early stages of growth. As theseproducts become more widely accepted, we expect tosee a widening gap between privately offered hedgefunds that will become increasingly institutional anda middle tier of publically offered alternative funds.These emerging “liquid alternatives” have alreadycaptured a portion of the assets from traditionalhigh net worth hedge fund buyers, as well as someinstitutional interest from organizations that weremandated (or came under constituent pressure)to invest in lower fee, higher liquidity products intheir portfolios. Our analysis shows that 10% of theassets eligible for privately offered hedge funds havealready moved into these publically offered products.Going forward we expect that share to remain steady,rising to approximately 12% over the coming years.Growth in liquid alternatives is expected to come froma broadening set of retail investors. In the U.S., theinvestor base is expanding from mutual funds intoretirement funds. Over time, we anticipate this spurin demand for similar products in wealth centers inEurope, Asia and Latin America. These represent acompletely new pool of buyers that will be additive toexisting hedge fund industry assets.Privately Offered Fund Industry Will BecomeIncreasingly InstitutionalInstitutional investors have had a marked impacton the hedge fund industry over the past decade.Collectively, pension plans, sovereign wealth fundsand EFs became the dominant investing class in2008, marking a pivotal point in the industry asinterest from this segment surpassed traditionalHNW/FOIs.Throughout our interviews in this year’s survey,we looked to gain insight into investors’ intentionsfor future hedge fund allocations. Thematically,most indicated that increased inflows are likely; onthe other hand, many also commented that 2013may be “Darwinian” for managers unable to showperformance after 2 years of mediocre returns.Rather than withdraw allocations, however, investorsindicated that they would shift assets to higherperforming managers while keeping their overallcommitment to hedge funds steady.Relative to their total pool of investable assets,institutions continue to channel only a small portionof their overall holdings to the hedge fund industry.Chart 32 shows that, globally, institutional assetsmanaged by pensions, sovereign wealth funds andEFs increased 23% between 2007 and 2012, risingfrom $29.1 trillion to $35.7 trillion. Based on that5-year rate of change, we forecast that this pool willrise to $44.0 trillion by 2017.Institutional allocations to the broad alternativescategory that includes hedge funds, privateequity, mezzanine financing, real estate and otherinvestments rose from 18% in 2007 to 22% in 2012.We project that growth to continue, with alternativesincreasing to 27% by 2017. We predict institutionswill continue to allocate assets to long-terminvestments in illiquid holdings, where they cantake advantage of this historically low interest rateenvironment. They will also look to forge partnershipswith firms that sit on the cusp of the hedge fund andprivate equity worlds.Hedge funds as a sub-set of alternatives accountedfor 17% of allocations in 2007, rising to 19% in 2012.We conservatively project that share to rise to 20%of alternative allocations in 2017. This implies thathedge funds as a percentage of global institutionalassets will reach to 5.3% by 2017, compared to just4.2% in 2012 and 3.0% in 2007.The impact of this increase in allocations is illustratedin Chart 33. As shown, institutional assets investedSection VI: Overall Industry Assets to Rise as HedgeFunds Become More Institutional Liquid AlternativesDraw a New Audience“ Our long-only managers outperformed the markets by 6% in 2012 andI’m overall happy with our hedge fund managers. I’m little disappointedby some hedge fund performance last year but our managers still beattheir peers.” — Endowment
  • 47. Rise of Liquid Alternatives Survey | 48in privately offered hedge funds are expected toincrease to $2.3 trillion by 2017, up from $1.5 trillionin 2012 and $878 billion in 2007.Had we projected the growth of institutional assets inprivately offered hedge funds using a straightforward5-year average, it would have indicated $2.6 trillioninstead of $2.3 trillion. The reason for this slightdownward adjustment is that we re-categorized $220billion in AUM for 2012, shifting those assets into anew designation of publically offered liquid alternativefunds owned by institutional investors or QIPs. Suchpublically offered funds include alternative UCITS,alternative 40 Act mutual funds and ETFs—a categorythat we broadly classify as liquid alternatives. Bycarving out this pool, we can forecast how growthin liquid alternatives is likely to be driven by thetraditional hedge fund buying audience or reflect newdemand from a previously untapped retail audience.To complete our estimation for the privately offeredhedge fund industry, we used a 3-year average rateof growth from high net worth and family officeinvestors. It was not possible to use a 5-year average,TOTALASSETSBiLLIONS US $ALTERNATIVESAS % OFTOTAL ASSETSALTERNATIVEASSETSBiLLIONS US $HEDGE FUNDSAS % OFALTERNATIVESHEDGE FUNDASSETSBiLLIONS US $HEDGE FUNDSAS % OFTOTAL ASSETSGLOBAL PENSION FUNDS2007 $24,932 16.0% $3,989 15.0% $598 2.4%2012 $29,754 18.0% $5,356 16.8% $900 3.0%2017E $35,509 23.0% $8,167 17.1% $1,397 3.9%SOVERIGN WEALTH FUNDS2007 $3,737 25.0% $934 18.0% $168 4.5%2012 $5,184 40.0% $2,074 22.0% 456 8.8%2017E $7,191 40.0% $2,876 24.0% 690 9.6%ENDOWMENTS FOUNDATIONS2007 $440 39.0% $172 60.0% $103 23.4%2012 752 52.0% $391 33.0% $129 17.2%2017E $1,286 52.0% $669 34.0% $227 17.7%TOTAL INSTITUTIONAL2007 $29,109 18%.0 $5,095 17.1% $869 3.0%2012 $35,690 22.0% $7,820 19.0% $1,485 4.2%2017E $43,986 27.0% $11,712 19.8% $2,314 5.3%Sources: Citi Prime Finance analysis based on Towers Watson Global Pension Studies, SWF Institute, NACUBO Commonfund Studies.Assumptions:1. U.S. Canadian endowments foundations estimated at 70% of global EF assets2. Alternative percentage of global pension funds based on top 7 nations’ share of global assets3. Sovereign wealth fund allocation to alternatives hedge funds estimated based on Citi Prime Finance interviews4. EF share of alternatives hedge funds based on NACUBO Endowment Study Commonfund estimatesChart 32: Institutional Investment in Hedge Funds by Segment
  • 48. Rise of Liquid Alternatives Survey | 49as the drop in assets experienced in 2008 was stillsufficiently large as to keep that number negative;our interviews showed stable, not declining, interest.As shown in Chart 33, we see growth resuming for theHNW/FOI audience with assets projected to increasefrom $766 billion in 2012 to $932 billion in 2017. Thoseflows, however, will not be sufficient to maintain theircurrent market share due to the significant increasein allocations from institutional investors. We seeassets from the HNW/FOI category falling from 34%to 29% of total privately offered hedge fund AUM—thus extending the institutional nature of the industry.In total, we expect hedge fund industry assets toreach $3.25 trillion by 2017, an increase of about44% from 2012 or a CAGR of 7.6%. This is on par withrecent growth trends, as assets under managementgrew at a CAGR of 7.1% from March 2010 to March2013, according to data from eVestment.U.S. Retail Demand to Drive AlternativeMutual Fund ETF AUMAs noted in Section IV, 73% of retail investors in theU.S. are not eligible to invest in privately offered funds.Only those individuals that meet the threshold ofbeing a QIP with greater than $5 million of investableassets are eligible to purchase such offerings.According to Cerulli Associates, over the past severaldecades this limited the potential individual investoraudience for hedge funds to approximately 600,000households in the U.S.The introduction of liquid alternatives in publicallyoffered fund vehicles has created a new opportunityfor these previously ineligible buyers to add hedgefund-like strategies to their portfolios. This retailinvestor group collectively holds $20 trillion ininvestable wealth, of which nearly $8 trillion isheld in mutual funds and retirement accounts. AsChart 34 shows, the result is a far larger audiencefor alternatives in the U.S., and a tremendousopportunity for hedge fund managers to reach a newinvestor segment.Chart 33: Hedge Fund Industry Assets by Investor Type: Forecast to 2017Chart 33Sources: Citi Prime Finance analysis based on HFR data and outputs from our institutional audience modeling.0MillionsofDollars‘05 ‘09‘02 ‘17E$2,500,000$1,500,000$1,000,000$990B53%‘03 ‘07$1.5T66%$932B29%$878B47%$766B34%$2.3T71%‘04 ‘08‘06 ‘16E$2,000,000Hedge Fund Industry Assets by Investor Type: Forecast to 2017$500,000‘12‘10 ‘14E‘11 ‘15E‘13EHigh Net Worth Family OfficesInstitutional Clients:Pension Funds,Soverign Wealth Funds,Endowments FoundationsChart 33Sources: Citi Prime Finance analysis based on HFR data and outputs from our institutional audience modeling.0MillionsofDollars‘05 ‘09‘02 ‘17E$2,500,000$1,500,000$1,000,000$990B53%‘03 ‘07$1.5T66%$932B29%$878B47%$766B34%$2.3T71%‘04 ‘08‘06 ‘16E$2,000,000Hedge Fund Industry Assets by Investor Type: Forecast to 2017$500,000‘12‘10 ‘14E‘11 ‘15E‘13EHigh Net Worth Family OfficesInstitutional Clients:Pension Funds,Soverign Wealth Funds,Endowments Foundations“ 2013isgoingtobeknownastheyearwhenDarwinismredefinedtheactivefund management industry. There is nowhere to hide poor performanceand investors have no patience for down months or quarters. Thisindustry does not suffer fools and those that do not perform will becomeextinct. This will introduce more risk taking and leverage and with arising equity market, this is going to be a tough competitive landscapefor active fund managers irrespective of strategy.” — Third Party Marketing Intermediary
  • 49. Rise of Liquid Alternatives Survey | 50Currently the alternative mutual fund and ETFuniverse stands at $305 billion in AUM, as reportedby Morningstar. We see retail investors with lessthan $5.0 million net worth accounting for 85%, or$259 billion, while institutions and qualified buyersrepresent only $46 billion.Approximately half the total holdings ($151 billion)are in alternative mutual funds, a figure representingapproximately 1.9% of the total mutual fund industryin the U.S. The remaining $154 billion is held inalternative ETFs.According to the Investment Company Institute,an estimated 3.5 million U.S. households held ETFsin 2011. Of households that owned mutual funds, anestimated 6 percent also owned ETFs. ETF-owninghouseholds tended to originate from the moreaffluent, experienced investors who owned a range ofequity and fixed-income investments.As previously discussed, leading RIAs, IFAs and duallyregistered advisors are seeking publically offeredalternative product and looking to expand theirdistribution efforts to further engage the affluent,mass affluent and retail audience in order to bettertarget that audiences’ $8 trillion in retirement andmutual fund investments. These advisors are pullingother retail sales channels in their wake, and interestfrom the segment overall still has substantial roomto grow. Cerulli Associates estimates that as of2012, less than one-third of financial advisers usealternative mutual funds or ETFs in constructing theirclient portfolios.Over the past 4 years there has been prolific growthin the number of these funds launching; more than207 have been created since 2008, bringing thecurrent total to over 350. Interviewees noted thatthese figures are likely to jump sharply in 2013, as awave of new offerings is reportedly in the pipeline.As marketing and distribution picks up steam,understanding and uptake of the new vehicles islikely to rise. Our moderate growth scenario seesthe liquid alternative share of mutual fund holdingsincreasing from the current 1.9% share to capture10% of mutual fund assets overall and 5% to10% of retirement assets depending on thewealth segment by 2017. This is illustrated inChart 35.Chart 34Alternatives Audience Expansion in the U.S.Source: Citi Prime Finance.PublicFundEligibleInstitutionalPrivateFundEligibleTraditionalAlternativesAudienceEmergingUSAudienceSWFsPensionFundsEndowments FoundationsHigh Net Worth Family OfficesAffluentMass AffluentRetailChart 34: Alternatives Audience Expansion in the U.S.Source: Citi Prime Finance.PublicFundEligibleInstitutionalPrivateFundEligibleffices“ The next step for alternative mutual funds is the 401(k) market. There isgoing to be tremendous pressure to put alternative product on the plansfor retail investors.” — Law Firm
  • 50. Rise of Liquid Alternatives Survey | 51Our projection is for the share of households owningalternative ETFs to double for the affluent andmass affluent segments, reaching 12% of totalhouseholds that also own alternative mutual funds,and the more retail audience is likely to reach thesame 6% threshold currently seen by their morewealthy counterparts.Together, we see retail assets for alternative mutualfunds and ETFs growing from $259 billion to $772billion in the U.S. Our forecast based on our interviewsis for the institutional share of this market to remainflat Those institutions mandated or inclined to shiftfrom privately offered to publically offered fundshave already been moving capital into these vehicles,and most institutions expressed a preference toremain in a manager’s private fund offering that wasseen delivering superior returns. We see institutionaldemand rising from $46 billion in 2012 to $136 billionin 2017, remaining at 15% of total market share.This could boost the total asset pool for alternativemutual funds and ETFs to $908 billion by 2017. Thisis illustrated in Chart 36.This projection for growth may prove to be overlycautious, since we are not assuming any expansion inthe overall mutual fund and retirement account assetpool and instead are projecting based solely on shiftsand reallocations within the current figures. Thetrend, however, is clear. Demand for these productsfrom a completely new audience is expected to risesharply. Given the role of the U.S. in the global wealthmarkets, there is a significant likelihood that demandfrom wealthy individuals that do not currently qualifyto purchase privately offered funds elsewhere in theworld may begin to follow suit.“ Hedge funds are likely to move into the direct lending market and thelarge managers are going to start looking like the investment banks did15 years ago. There is a re-shaping of the financing market shaking outand banks can’t extend the credit they did before the crisis. The largeprivate equity/hedge fund shops are well placed to step into this gap andprovide corporate financing.” — $1.0 to $5.0 Billion AUM Hedge Fund10% of MutualFunds 5% ofRetirementAccounts – 6%of those HouseholdsAlso OwningAlternative ETFsChart 35Sources: Citi Prime Finance assumptions based on Federal Reserve, Current Populations Survey, Cerulli Associates, Deloitte Center for Financial ServicesU.S. Households Investable Assets by Wealth Category Share of Target Audience Assets Heldin Mutual Retirement FundsHigh Net Worth Ultra High Net Worth$5.0 Million$7.39TAffluent$2.0 - $5.0 Million$8.12TMass Affluent$500,000 - $2.0 Million$5.75TRetail$500,000$6.18T0$5$10$15$20$25$302011$13.87T10% of MutualFunds RetirementAccounts – 12%of those HouseholdsAlso OwningAlternative ETFsReal Estate OtherMutual Funds Retirement Accounts$0.17T$4.04T$1.97T$8.07T$1.47T$4.33TTrillionsofDollars2017Assumptions10% of MutualFunds 5% ofRetirementAccounts – 6%of those HouseholdsAlso OwningAlternative ETFsChart 35Sources: Citi Prime Finance assumptions based on Federal Reserve, Current Populations Survey, Cerulli Associates, Deloitte Center for Financial ServicesU.S. Households Investable Assets by Wealth Category Share of Target Audience Assets Heldin Mutual Retirement FundsHigh Net Worth Ultra High Net Worth$5.0 Million$7.39TAffluent$2.0 - $5.0 Million$8.12TMass Affluent$500,000 - $2.0 Million$5.75TRetail$500,000$6.18T0$5$10$15$20$25$302011$13.87T10% of MutualFunds RetirementAccounts – 12%of those HouseholdsAlso OwningAlternative ETFsReal Estate OtherMutual Funds Retirement Accounts$0.17T$4.04T$1.97T$8.07T$1.47T$4.33TTrillionsofDollars2017AssumptionsChart 35: U.S. Households Investable by Wealth Category Share of Target Audience Assets Heldin Mututal Retirement Funds
  • 51. Rise of Liquid Alternatives Survey | 52U.S. Retail Demand Could Spark Similar Interestfrom Other Global InvestorsAs we look more broadly at the potential audience forpublically offered alternative products, it’s importantto understand the current balance of investmentfund asset distribution across the globe. In their 2012study, the European Fund and Asset ManagementAssociation (EFAMA) puts global investment fundassets at €20.8 trillion. Of this total, the U.S. accountsfor 48.9%, followed by Europe with 28.6%. This isillustrated in Chart 37.It is interesting to note that asset trends in theEuropean UCITS market appear to correlate withgrowth patterns in the U.S. market. This is illustratedin Chart 38. Assets in the two regions tend to riseand fall in parallel. EFAMA estimates that from 1991 to2011, net assets held in U.S. mutual funds have risenby a CAGR of 11.2%, while assets held in EuropeanUCITS have increased by a CAGR of 11.0% in thesame period. If liquid alternatives begin to accountfor a rising share of total U.S. mutual fund AUM, itis reasonable to expect that investors in the nextlargest investment region might experience similardemand and begin to mimic this trend.0$1,000$100$300$700$200$500$900Chart 36Sources: Citi Prime Finance assumptions based on Morningstar, ICI, Federal Reserve, Current Populations Survey, Cerulli Associates, Deloitte Center for Financial Services.20092007 2008 2017ERegulated U.S. Alternative 40 Act Mutual Funds ETFs Forecast on Assets to 2017$908BBillionsofDollars20112010 2013E2012 2015E2014E$305B$80B2016E$600$400$800+198%0$1,000$100$300$700$200$500$900Chart 36Sources: Citi Prime Finance assumptions based on Morningstar, ICI, Federal Reserve, Current Populations Survey, Cerulli Associates, Deloitte Center for Financial Services.20092007 2008 2017ERegulated U.S. Alternative 40 Act Mutual Funds ETFs Forecast on Assets to 2017$908BBillionsofDollars20112010 2013E2012 2015E2014E$305B$80B2016E$600$400$800+198%Chart 36: Regulated U.S. Alternative 40 Act Mutual Funds ETFs Forecast on Assets to 2017“ When you look at where traditional portfolio manager products are andwhat investors are going to have to do to achieve a higher yield, they aregoing to have to use alternatives. It’s hard to guess what the market sizewill be, but you know it’s going to be huge.” — Asset ManagerChart 37Global Investment Fund AssetsQ1 2012: €20.8 TrillionSource: EFAMA48.9%5.5%5.9%United StatesEuropeBrazilAustraliaJapan3.7%Canada3.6%China1.2%Other3.0%28.6%Chart 37Global Investment Fund AssetsQ1 2012: €20.8 TrillionSource: EFAMA48.9%5.5%5.9%United StatesEuropeBrazilAustraliaJapan3.7%Canada3.6%China1.2%Other3.0%28.6%Chart 37: Global Investment Fund AssetsQ1 2012: €20.8 Trillion
  • 52. Rise of Liquid Alternatives Survey | 53While U.S. tax requirements can often dissuadeforeign buyers from purchasing U.S. mutual funds,the European UCITS framework is one that has beenadopted widely by other countries for establishingfunds to be distributed to their local investors andin the global marketplace. According to Lipper forInvestment Management data, as of July 2012, 11.1% ofall UCITS fund registrations originated from countriesoutside Europe, thus allowing their native investorsaccess to product with recognized internationalregulatory oversight.As discussed in Section III, retail demand foralternative UCITS products has been fairly muted inrecent years, with institutional investors accountingfor the large majority of AUM. There was someuptick in retail interest during 2012, however,according to HFI, and this may be a harbinger of moredemand to come.If the U.S. alternative mutual fund and ETF marketsurges as we anticipate, many other nations in theworld may look to promote publically offered liquidalternatives to their own wealth segments thatare ineligible for privately offered funds. Given itsflexibility for allowing foreign managers to createfunds, we think it likely that many such firms lookingto create liquid alternative product may look firstto the UCITS framework as a potential vehicle forexpressing that interest. As such, there may bepotential to reinvigorate the alternative UCITSmarket with new demand from retail participants incoming years.“ Alternatives are a natural evolution for U.S. retail investing. We startedwith U.S. equities in the 1970s, then moved to global equities and thenmoved to bonds. Now we’re moving into long/short products with morejuice in the return stream.” — Asset ManagerChart 38: Comparison of U.S. Mutual Funds UCITS GrowthChart 380‘96 ‘11$14,000$10,000$6,000‘93‘91 ‘94‘92 ‘10Comparison of U.S. Mutual Funds UCITS Growth$2,000‘02‘98 ‘06‘00 ‘07‘04$12,000$4,000$8,000Source: EFAMA‘03‘99‘95 ‘01‘97 ‘05 ‘08 ‘09UCITS net assets (EURbn) US mutual funds net asssets (US$bn)CAGR 11.0%CAGR 11.2%BillionsofDollarsChart 380‘96 ‘11$14,000$10,000$6,000‘93‘91 ‘94‘92 ‘10Comparison of U.S. Mutual Funds UCITS Growth$2,000‘02‘98 ‘06‘00 ‘07‘04$12,000$4,000$8,000Source: EFAMA‘03‘99‘95 ‘01‘97 ‘05 ‘08 ‘09UCITS net assets (EURbn) US mutual funds net asssets (US$bn)CAGR 11.0%CAGR 11.2%BillionsofDollars
  • 53. Rise of Liquid Alternatives Survey | 54Alternative UCITS Likely to BecomeIncreasingly Retail in Coming YearsUsing the average annual growth rate of 11% from2007 to 2012 as a baseline, we project alternativeUCITS growth of 68% from $248 billion at the endof 2012, to $417 billion in 2017. This projection isdetailed in Chart 39.In trying to extrapolate the appetite for retailinvestment in alternative UCITS, we analyzed theglobal trends in retail-focused asset management,and incorporated related insights from hedge fundmanagers we spoke with that are launching newalternative UCITS products.As more U.S.-based hedge fund managers expandinto alternative mutual fund products, we predictsome will also look to create UCITS offerings, whileEuropean based hedge fund managers and managersfrom other regions looking to leverage the UCITSframework may concurrently follow this trend andextend their offerings as well.In short, the broader acceptance of retail-focusedalternatives in the U.S. is likely to have a follow-oneffect in other regions. Our projections for alternativeUCITS show retail investment growing at a CAGRof 17.7% from $74 billion at the end of 2012 to $167billion in 2017.Such growth would shift the mix of ownership inalternative UCITS with retail buyers ineligible topurchase privately offered funds rising from 30%to 40% of the total asset pool, and institutions andother buyers eligible to purchase privately offeredfunds falling from 70% to 60% of the market.$0$450,000$50,000$150,000$350,000$100,000$250,000Chart 39Source: Citi Prime Finance analysis based on Morningstar data.20092007 2008 2017EAlternative UCITS Assets Under Management Forecast to 2017$417B20112010 2013E2012 2015E2014E$248B$217B2016E$300,000$200,000$400,000+68%Average Annual Growth, 11%MillionsofDollars$0$450,000$50,000$150,000$350,000$100,000$250,000Chart 39Source: Citi Prime Finance analysis based on Morningstar data.20092007 2008 2017EAlternative UCITS Assets Under Management Forecast to 2017$417B20112010 2013E2012 2015E2014E$248B$217B2016E$300,000$200,000$400,000+68%Average Annual Growth, 11%MillionsofDollarsChart 39: Alternative UCITS Assets Under Management Forecast to 2017“ At the moment, the liquid alternatives space is a U.S. story, but I seethe rest of the world catching up quickly once they realize that you canmake good returns on a mid-fee product. They all claim they see thestory in the U.S., but they are underestimating it in the rest of the world,particularly if there is another problem in the hedge fund industry thatundermines confidence or if we go through another couple years ofmediocre returns.”— $5.0 to $10.0 Billion AUM Hedge Fund
  • 54. Rise of Liquid Alternatives Survey | 55Retail Audience Projected to Reach 21% ofIndustry Assets by 2017Taken collectively, the global opportunities for bothalternative UCITS and 40 Act regulated alternativeproductsoverthenext5yearsisextremelysignificant,and will be an increasingly important part of theinvestor set for hedge fund managers extending theirtraditional individual investor base further down thewealth spectrum.Our projection for the combined pool of assets inalternative UCITS and 40 Act alternative funds showsAUM growing to $1.325 trillion by 2017 comparedto $553 billion today, an increase of 140% over thenext 5 years. This would bring the liquid alternativeuniverse up to nearly the same size as the entirehedge fund industry was in the wake of the 2008GFC. This is illustrated in Chart 41.Of that total, we see a $939 billion opportunity inliquid alternatives for buyers that are not eligiblefor privately offered funds. That compares to thepresent $333 billion market size for that retailinvestor audience.$0$300,000$50,000$150,000$100,000$250,000Chart 40Source: Citi Prime Finance analysis based on Morningstar data.2009 2017EAlternative UCITS Interest by Audience Forecast to 2017$250B20112010 2013E2012 2015E2014E$173B$124B2016E$200,000Institutional Audience Retail Audience$167B$74B$41BMillionsofDollarsChart 40: Alternative UCITS Interest by Audience Forecast to 2017“ Our European business isn’t huge to begin with. We’ve long looked atthe UCITS markets, but we don’t have any of these products currentlybecause there are a lot of restrictions on what you can trade. With therise of the alternative 40 Act funds, however, we rethinking our decision.” — Asset Manager“ Our original UCITS that has a long track record went retail to mom andpop in the U.K. market.” — Asset Manager$0$300,000$50,000$150,000$100,000$250,000Chart 40Source: Citi Prime Finance analysis based on Morningstar data.2009 2017EAlternative UCITS Interest by Audience Forecast to 2017$250B20112010 2013E2012 2015E2014E$173B$124B2016E$200,000Institutional Audience Retail Audience$167B$74B$41BMillionsofDollars
  • 55. Rise of Liquid Alternatives Survey | 56What is important to note is that, proportionately,growth in liquid alternatives is likely to lag for thoseaudiences that would qualify for privately offeredfunds—namely, institutional investors and HNW/FOIs.Their share of the liquid alternatives is seen decliningfrom 40% to only 29% of the total market. Thisreflects our view that for these investors, their abilityto invest in privately offered funds, whether throughco-mingled vehicles, SMAs or funds of one, is goingto be seen as preferable to publically offered funds.As noted earlier, our view is that by 2012, thisaudience had already shifted $220 billion, or 10% oftheir assets, from privately offered hedge funds topublically offered alternative vehicles in the yearspost-GFC, often keeping those assets with the samehedge fund manager, but in a different structure.“ It just makes sense for today’s hedge fund manager to try and usetheirintellectual capital in ways to reach the trillion of dollars ofretail investors.” — Asset Manager“ There is a whole new universe of retail investors that want to getexposure to any hedge fund and not necessarily discerning about whichhedge fund. And it is a quick way to raise a lot of capital.” — Multi-Family OfficeChart 41: Combined Outlook for Both Alternative UCITS 40 Act Alternative Funds Forecast to2017 by Audience0$1,400$800$600$1,000$200$1,20040%75%70%65%45%55%60%50%Chart 41Sources: Citi Prime Finance assumptions based on Morningstar, SEI/Strategic Insight data Federal Reserve,Current Populations Survey, Cerulli Associates, Deloitte Center for Financial Services.2007 2017ECombined Outlook for Both Alternative UCITS 40 Act Alternative Funds Forecast to 2017 by Audience$292B$553B$127B43%$333B60%$1.325T$40020092008 2016E20122010 2014E2011 2015E2013E$939B71%RetailAudiencetoPurchaseHedgeFundsAlternative40ActUCITSFunds
  • 56. Rise of Liquid Alternatives Survey | 57Going forward, we see little additional impetus forthis audience to move. By 2017, our view is that 12%of privately eligible funds will be trading in publicallyoffered vehicles versus 10% today. This is highlightedin Chart 42.Our outlook for the entire industry’s growth istherefore quite positive based on the exploration oftrends in this year’s survey. From today’s combinedasset figure of $2.61 trillion, we anticipate the overallpool of AUM to grow 77% to $4.18 trillion by 2017.Privately offered hedge funds will rise from $2.03 to$3.25 trillion—an increase of 60%. Publically offeredliquid alternative funds held by institutions or QIPswill increase from $220 billion to $386 billion, but byfar the largest pool of growth will occur in publicallyoffered liquid alternatives held by retail investors thatare not eligible to purchase private funds today. Weforecast this pool of assets moving from 13% of thecombined market today to 21% by 2017.Competition to access that new pool of investors islikely to be intense and have a profound effect on howalternative product manufacturing and distributionchanges in the coming years. We are already seeingsome major industry partnerships, acquisitionsand expansions emerge. The following sections ofthis year’s report will focus on how various sets ofinvestment managers, from traditional long-onlyasset managers to hedge funds to private equity firms,are positioning themselves, and where each of thesetypes of managers is likely to be most successful.“ Our wealth management group that focuses on high net worth andultra-high net worth clients has developed a Wealth Management Selectplatform of mutual fund wrappers for alternatives from which it offersclient access to single managers.” — Insurance CompanyChart 42-AHedge Fund Liquid Alternatives Market Outlook2012: Total $2,608 BillionSources: Citi Prime Finance assumptions based onMorningstar, SEI/Strategic Insight data FederalReserve, Current Populations Survey, CerulliAssociates, Deloitte Center for Financial ServicesPublically Offered LiquidAlternatives Retail Audience$2,032B79%$333B13%$220B9%Privately OfferedHedge FundsPublically OfferedLiquid AlternativesInstitutional QIPAudienceChart 42-BHedge Fund Liquid Alternatives Market Outlook2012: Total $4,184 BillionSources: Citi Prime Finance assumptions based onMorningstar, SEI/Strategic Insight data FederalReserve, Current Populations Survey, CerulliAssociates, Deloitte Center for Financial ServicesPublically Offered LiquidAlternatives Retail Audience$3,246B71%$939B21%$386B8%Privately OfferedHedge FundsPublically OfferedLiquid AlternativesInstitutional QIPAudienceChart 42: Hedge Funds Liquid Alternatives Market Outlook2012: Total $2,608 Billion 2012: Total $4,184 Billion
  • 57. Expectations for continued strong demand forprivately offered hedge fund product from theinstitutional audience and emerging demand from anew retail audience for publically offered alternativestrategies are pushing the boundaries on whatinvestors consider to be active management, andexposing a desire on the part of all investors to havemanagers with a broader set of skills in their portfolio.The traditional view of active management as beinga fund’s ability to post positive tracking error relativeto a benchmark is fading, and a more expansive viewis emerging that evaluates a manager on how muchof a market’s opportunity they can capture and withwhat volatility and risk profile. As this new viewtakes hold, the way in which managers discuss theirproduct is changing.A whole new set of vehicles is emerging that fallunder an “actively managed” mandate. The majorityof these products are available in either a publicallyor a privately offered fund structure, marking theculmination of convergence trends of recent yearsand the erosion of boundaries between previouslydistinct investment segments.Distinctions between Various InvestmentSegments ErodeAs recently as the late 1990s, investors viewedlong-only asset managers, hedge funds and privateequity firms as belonging in separate spheres witheach type of portfolio manager possessing a uniqueskill set, having distinct products and commandinga specific compensation model. As discussed atlength in our report last year, a number of driversemerged that began to blur those product boundariesand create convergence zones across variousaudiences. We will briefly revisit those drivers in thissection, but recommend reading last year’s surveyfor a more in-depth analysis of the factors drivingproduct convergence.Chart 43 illustrates the drivers of change and showshow those drivers caused asset managers, hedgefunds and private equity firms to shift from theirtraditional positioning within the transparency andliquidity spectrum.Asset managers traditionally offer a set of highlyliquid, long-only products that provide position leveltransparency in the publically offered fund space.Portfolio managers tend to invest the majority oftheir funds’ cash in the markets, fully paying for mostsecurities. For many years, institutional portfolioswere composed almost exclusively of these long-onlyproducts and evaluated their performance relative toa specific benchmark. A growing desire on the partof institutional investors to diversify their portfoliosand seek an illiquidity premium after the technologybubble burst, and a shift in investor thinking towardisolating beta with passive investment products,both began to threaten the franchises these assetmanagers had built up in the early 2000s. Theyresponded by creating new fund offerings that movedout of their traditional comfort zone.New products emerging from asset managerorganizations began to free long-only portfolioSection VII: Expanding View on Active Fund ManagementEncourages New Product OpportunitiesChart 43Source: Citi Prime Finance.Factors Driving Convergence Through 2012High Transparency LowLiquidityIlliquidLiquidPublic Funds Private FundsAccess Larger Capital Pool Diversify Investor BaseHedge Fund ManagersCreate Liquidity Diversify Investor BasePrivate Equity FirmsTraditional Asset ManagersProtect ActiveManagement FranchiseChart 43: Factors Driving ConvergenceThrough 2012
  • 58. Rise of Liquid Alternatives Survey | 59managers from benchmark constraints, allowingthem to use an expanded set of investmenttechniques, some of which mirrored those being usedby managers in the privately offered fund space. Newofferings that emerged to compete with hedge fundswere typically less liquid than the asset managers’traditional offerings. They also commanded a higherfee than the manager’s traditional long-only product.Meanwhile,hedgefundmanagershadlostasignificantshare of their assets in the GFC and realized that theyhad been overly concentrated with fund of hedgefund investors. In order to diversify their investorbase, they began to forge relationships directly withlarge institutional investors and the consultants thatwere advising those participants.In response to demands from this new audience,hedge funds began to offer greater transparencyinto their portfolio holdings and their tradingapproach (i.e., their use of leverage, determinationof risk and method for controlling volatility). Therewas also a widespread push in the industry tobetter align liquidity terms to the assets beingheld in the portfolio, with those managers in highlyliquid strategies often accepting fee concessions tomaintain their allocations.As discussed in previous sections of this paper,investor views about different hedge fund strategiesbecame more nuanced, with recognition of thedifferent characteristics of each strategy in buildingbetter diversified and more resilient portfolios. Theywere also able to better evaluate their hedge fundChart 44: Convergence in 2012Chart 44Convergence in 2012Source: Citi Prime Finance.Transparency LowLiquidityLiquidHighIlliquidPublic Funds Private FundsTraditional Asset Managers Hedge Fund Managers Private Equity FirmsBenchmarkedLong OnlyPassive ETF Index FundsPrivateEquityUnconstrainedLongUCITS RegulatedAlternativeFundsDirectionalNon-DistressedMacroAbsoluteReturnCONVERGENCEDistressedCashPlus AlphaCONVERGENCEChart 44Convergence in 2012Source: Citi Prime Finance.Transparency LowLiquidityLiquidHighIlliquidPublic Funds Private FundsTraditional Asset Managers Hedge Fund Managers Private Equity FirmsBenchmarkedLong OnlyPassive ETF Index FundsPrivateEquityUnconstrainedLongUCITS RegulatedAlternativeFundsDirectionalNon-DistressedMacroAbsoluteReturnCONVERGENCEDistressedCashPlus AlphaCONVERGENCE“ The concept of long and long/short is disappearing and we are movingto an active versus passive market where we will only pay high feesfor true alpha. This is going to be how investors all see the world in 5years’ time.” — European Fund of Fund
  • 59. Rise of Liquid Alternatives Survey | 60managers’ positions in conjunction with their long-only manager positions and gain insight into theirconsolidated exposures, thus allowing them to focusmore carefully on the risk factors in their portfolio.The impact of these two trends is illustrated by thelarge ‘convergence zone’ highlighted in Chart 44.Both asset managers and hedge funds began to offera similar set of products that spanned both sidesof the publically offered and privately offered funddividing line.A similar pattern was taking place at the less liquidend of the spectrum. Hedge fund managers wereable to step into funding gaps left in the wake ofthe GFC and begin to engineer less liquid productswith associated cash flows that looked much morelike traditional private equity investments. These“cash + alpha” products proved very attractive toan institutional audience that was in search of yield,given record low interest rates.During the same time, private equity firms werecoming under pressure from their investor base forbeing under-invested and sitting on too much cash intheir portfolios. They began to look for more liquidinvestment opportunities and to expand their setof product offerings. The result was a smaller, butequally important, convergence zone that is alsohighlighted in Chart 44.Factors Driving Convergence Shift fromDefensive to OffensiveUp until 2012, much of what was driving productconvergence were defensive reactions to ongoingmarket developments. Asset managers had toprotect their franchise[s?], hedge fund managers hadto regain assets lost in the GFC and diversify theirinvestor base and private equity firms had to provethey could effectively deploy their capital. A morepositive set of drivers has emerged in the past 12months, and firms in each investment managementsegment are taking a more offensive posture inpursuing new opportunities.Chart 45 highlights these new drivers. Assetmanagers are beginning to think more holisticallyabouttheirinstitutionalinvestmentaudience.Toretaininvestor allocations, managers need to offer holisticsolutions that can span a broad liquidity spectrumincluding products with an inherent illiquiditypremium. This move demonstrates recognition onthe part of asset managers that the time horizon andreturn requirements of large institutional investorsare more complex than in previous years, and thatthey need to be able to offer a range of investmentoptions in order to be a long-term strategic partner.“ We use active management allocations for more concentrated fundsthat have higher volatility but not necessarily higher risk. We viewhedge funds as a compensation scheme and they are the epitome ofactive management.”— Full Service Consultant“ When we think about traditional active management, that’s a businessthat’s going to be challenged.”— Asset Manager“ The private equity companies have been under drawn and this is causingLPs to move away from the larger asset gathering firms who cannotdeploy their capital.”— Third Party Marketing IntermediaryChart 45Source: Citi Prime Finance.Factors Driving Convergence in 2013 BeyondHigh Transparency LowLiquidityIlliquidLiquidPublic Funds Private FundsPrivate Equity FirmsLeverage Investment Expertise Brand to Build Broad Capital Base Create Liquidity Diversify Investor BaseTraditional Asset ManagersHedge Fund ManagersCreate More Stable Capital Recapture Illiquidity PremiumsCreate Institutional Solutions Preserve Client BaseProtect ActiveManagement FranchiseAccess Larger Capital Pool Diversify Investor BaseChart 45Source: Citi Prime Finance.Factors Driving Convergence in 2013 BeyondHigh Transparency LowLiquidityIlliquidLiquidPublic Funds Private FundsPrivate Equity FirmsLeverage Investment Expertise Brand to Build Broad Capital Base Create Liquidity Diversify Investor BaseTraditional Asset ManagersHedge Fund ManagersCreate More Stable Capital Recapture Illiquidity PremiumsCreate Institutional Solutions Preserve Client BaseProtect ActiveManagement FranchiseAccess Larger Capital Pool Diversify Investor BaseChart 45: Factors Driving Convergencein 2013 and Beyond
  • 60. Rise of Liquid Alternatives Survey | 61Hedge fund managers had already begun to leveragetheir expertise in more liquid offerings in orderto access larger capital pools. Now they are alsopursuing an expanded set of partnerships and usingtheir expertise at managing distressed or illiquidassets with a trading component as opposed to aninvesting mindset, creating the longer duration fundsdiscussed in Section II and forming new partnershipswith reinsurance companies, MLPs, infrastructure,real estate and other types of firms. New insurance-linked security funds in catastrophe bonds and fundsthat provide investors cash flow from a unique incomestream are the result of this product innovation.Finally, private equity firms are looking to significantlychange their profile and leverage their brand inthe liquid trading space. These firms are offeringlong-only mutual funds in some instances, andan entire range of products that fit into publicallyoffered alternatives.Convergence Trend Culminates inNew Market ConfigurationThe result of more offensive strategies and productcreation from each type of investment manager hassignificantly changed the industry model for 2013and beyond. In many ways, these changes markthe culmination of the convergence trend and theestablishment of a new norm. This is illustrated inChart 46.Several features are immediately evident in looking atthis new model. Previously, there were two separateconvergence zones, one between asset managersand hedge funds and another between private equity“ Long-only money is so big that hedge fund managers cannot ignore it.Just look at AQR.”— Insurance CompanyChart 46Convergence in 2013 BeyondSource: Citi Prime Finance.Transparency LowLiquidityLiquidHighIlliquidPublic Funds Private FundsPublic Private OverlapTraditional Asset Managers Hedge Fund Managers Private Equity FirmsBenchmarkedLong OnlyPassive ETF Index FundsPrivateEquityUnconstrainedLongHedged Long ActivelyManaged Futures(Alternative Beta)LiquidLong / ShortLong / ShortOpportunisticReal Assets Long DurationCONVERGENCEAsset Managers, Hedge Funds Private Equity FirmsMore Liquid Less LiquidChart 46Convergence in 2013 BeyondSource: Citi Prime Finance.Transparency LowLiquidityLiquidHighIlliquidPublic Funds Private FundsPublic Private OverlapTraditional Asset Managers Hedge Fund Managers Private Equity FirmsBenchmarkedLong OnlyPassive ETF Index FundsPrivateEquityUnconstrainedLongHedged Long ActivelyManaged Futures(Alternative Beta)LiquidLong / ShortLong / ShortOpportunisticReal Assets Long DurationCONVERGENCEAsset Managers, Hedge Funds Private Equity FirmsMore Liquid Less LiquidChart 46: Convergence in 2013 BeyondChart 46Convergence in 2013 BeyondSource: Citi Prime Finance.Transparency LowLiquidityLiquidHighIlliquidPublic Funds Private FundsPublic Private OverlapTraditional Asset Managers Hedge Fund Managers Private Equity FirmsBenchmarkedLong OnlyPassive ETF Index FundsPrivateEquityUnconstrainedLongHedged Long ActivelyManaged Futures(Alternative Beta)LiquidLong / ShortLong / ShortOpportunisticReal Assets Long DurationCONVERGENCEAsset Managers, Hedge Funds Private Equity FirmsMore Liquid Less Liquid
  • 61. Rise of Liquid Alternatives Survey | 62firms and hedge funds. Now, there is an uninterruptedarea of overlap where offerings from all three typesof market participants can be found.Another major change over the past few years,discussed throughout this report, has been theerosion of a hard boundary between publically andprivately offered products. There is now an extensivezone in which investors can source a virtually identicalstrategy in either a publically or a privately offeredvehicle. Not surprisingly, all of the more liquid tradingstrategies are contained within this zone.The third important change is that there has beena simplification in the industry’s presentation ofdifferent strategy types. The overlap in productshas become extensive enough that we can nowcollapse down different types of strategies andregroup them. In our new convergence model, wehave opted to classify strategies by the type ofinvestment approach they use to produce excessreturns. Rather than there being a string of productswith varying degrees of liquidity and transparency,as we saw in last year’s convergence model, thisyear we see only five main types of strategies.We see three types of strategies in the moreliquid convergence space—unconstrained long,which encompasses all unbenchmarked long-onlystrategies; hedged long and actively managedfutures (both of which can also be termed alternativebeta strategies) and liquid long/short strategies,either in equities or credit.In the less liquid convergence space, we see twoadditional types of strategies. The first is a set oflong/short opportunistic funds that encompassmany special situational and less liquid event-drivenstrategies, as well as relative value and credit fundsthat can move fluidly between durations. The secondare real-asset and long-duration funds that arelooking to realize returns over an extended periodof time and often require investors to agree tomulti-year lock-ups.As will be discussed, the reason we have chosen togroup the strategies within the convergence zone inthis way is because each offering employs a slightlydifferent set of skills in realizing their investmentgoals, and the techniques required to manage thestrategies become increasingly more sophisticatedas the liquidity of the offering diminishes.“ For hedge funds, diversifying into long only can be equated to investingin dividend/coupon paying instrument; it’s a much more steady revenuestream; plus long only investors can be more stable so from a businessbuilding perspective the long only business can be a good thing.”— Asset Manager“ Our liquid credit strategy is hedged, but it is not a hedge fund. We’rewinning assets from the bigger part of the allocator’s pool. Fixed incomeis usually 30% of the pension’s overall pool. We’re getting these flows.We’re seeing a migration toward more traditional high yield product withsome downside protection.”— $10 Billion AUM Hedge Fund“ We are working on a legal funds claims product that focuses on therecovery of hard assets through the courts. We are underwriting aclaims product which is also structured as a private equity vehicle. Youcommit capital for 3-5 years and as assets are recovered, the dividend ispaid out to investors.”— Third Party Marketing Intermediary“ Forget about the assumptions you made before Dodd-Frank and revisitthe legal structure for offering your strategy. It is now a Chinese menuof options for offering your products to new audiences. You need to ask,‘how liquid is your strategy?’ If you have no more than 15% in illiquidsecurities then you need to think about a mutual fund.”— Law Firm
  • 62. Rise of Liquid Alternatives Survey | 63Convergence Zone Products Span a BroadRange of Active Trading SkillsIn the traditional definition of active management,the only investment technique available to aportfolio manager to realize positive returns relativeto their benchmark was to over- or under-weighttheir positions. As the industry is moving away fromstrict benchmarking, there are an increasing varietyof ways for the portfolio manager to outperform andobtain alpha in their portfolio.Chart 47 provides a listing of the most commonlyused trading skills employed in the strategies withinour new convergence zone.Unconstrained long funds, the most liquid andtransparent within the convergence zone, employ thefewest number of skills. Managers in these strategiesare able to hold cash and choose only a limited set ofsecurities to purchase rather than always needing tobe fully invested. They can stay long only, or they havethe option to “over-bet” on certain long securitiesby using proceeds generated through short sales topurchase additional longs. Sometimes the managerswill purchase longs in an amount proportional to theirshort proceeds, like in the 130/30 strategies that roseto prominence a few years ago. Other unconstrainedlong strategies run in a range, typically between 80%and 120% net long.The same core skills are used to support the nextconvergence product, but additional techniques areutilized that completely change the profile of howthe strategy is realized. Hedged long strategiestypically have a lower net long position than withunconstrained long funds, and can go all the way tomarket neutral. The majority of managers in thesechoose some instrument to “hedge” their longsecurities exposure, typically sticking with a liquidexchange traded product or a custom swap to realizethe hedge. Occasionally, these managers may choose“ More and more over time, we see investors’ portfolios bar-bellingbetween cheap beta and then a whole variety of options for alpha.”— Asset Manager“ The future of active fund management will all be about the disaggregationof risk and packaging of products around a specific profile. Transparencyand technology are allowing us to offer private and public products thathave similar characteristics and can appeal to different audiences.”— Asset ManagerUNCONSTRAINEDLONGHEDGEDLONGLIQUIDLONG / SHORTOPPORTUNISITICLONG / SHORTREAL ASSETS LONG DURATIONActively Participate inManagement of Company/Asset PManage Illiquid or DistressedPools of Assets P PExamine Capital Structure Identify Relative Value P P PFinance Portfolio LeverageLong Positions P P PIdentify Short Alpha on SingleSecurities P P P PHedge Long Positions w/ETFs,Indices, Futures or Swaps P P P POver bet on Long PositionsUsing Short Proceeds P P P PHold Cash Buy Only SelectOpportunities P P P PChart 47: Investment Skills Required to Support Convergence ProductsSource: Citi Prime Finance.
  • 63. Rise of Liquid Alternatives Survey | 64a single security short for the portfolio, but that is arare occurrence and, if pursued, there will typicallyonly be a limited number of such positions held in theportfolio. For actively managed futures, currencyfunds and CTAs, the fund can use either long orshort positions or some combination across differentmarkets, but all of the products are exchange tradedor highly liquid.The pursuit of short alpha through the use of singlesecurity shorts is a dividing line in many investors’minds between a hedged long and a true long/short strategy. Using short positions to hedge longsecurities is distinct from choosing a security to shortin order to capture alpha. Investors have consistentlycited an ability to identify alpha on the short side asa highly prized, capacity-constrained and difficult tolearn skill. The other hallmark of liquid long/shortproducts is an ability to finance the portfolio andlever the long position.As we move from the liquid to the less liquidconvergence zone products, the skill set againevolves. Managing an illiquid or distressed set ofsecurities requires a different mindset and riskdiscipline than working in a more liquid set of holdings.Similarly, being able to fully realize the benefit oflong-duration or real-asset strategies requires that aportfolio manager be able to actively participate inthe management of that asset or company.This idea of layering on an increasingly sophisticatedset of trading techniques to realize alpha is at the heartof the expanding definition of active management.Understanding how different types of investmentfirms in the convergence zone are able to bring thoseskills into their product offering is at the heart of howalternative product manufacturing is changing.“ If I did do a liquid alternatives product, I wouldn’t do a lot of what I doin the hedge fund. The most notable solution is not to do any individualshorts. I would probably just use ETFs.”— Asset Manager“ For traditional asset managers, learning how to short from both aninvestment and operational perspective is a steep learning curve.”— $1.0 to 5.0B AUM Hedge Fund“ Each of the sleeves in our alternative 40 Act product runs at 8-10%volatility, but when you put the sleeves together they net out to 5%volatility. That’s good for a regulated product. Then we’ll seed a privateplacement version of the fund that we’ll run at 2x which gets us uptoward our desired 10-12% volatility for private placement products.”— Asset Manager
  • 64. Although asset managers, hedge funds and privateequity firms are competing for allocations within theconvergence zone, this does not imply that they areall equally well positioned to do so. Each investmentsegment has a different core competency that hasbeen established for some time in investors’ minds.By focusing on their respective skill sets, firms mayfind launching products much easier than overcomingsome of these embedded industry biases.The experience of the past few years has shown thatit is much easier for an asset manager to leverage itsrecognized skills to create a new offering as opposedto adding new skills that stretch investor confidenceAsset Managers Encounter ResistanceMoving Up the Skills SpectrumTraditional asset managers’ core competencyhas been in identifying and investing in fully paidfor long securities. In the equities space, theirexpertise is in assessing securities along a value togrowth continuum and doing so in within variouscapitalization bands. In bonds, they assess the creditquality of relative instruments across a broad set ofdurations.In looking to participate in product creation withinthe convergence zone, these managers are able toextend that core skill set in only a limited way, as theirbackground has not established them as expertsin trading techniques with investors, but ratheras experts in having investment opinions. This isillustrated in Chart 48.Portfolio managers hailing from a traditional long-only background are able to most easily pursueunconstrained long strategies that allow themhold back cash and only purchase select securitiesbecause this technique aligns most closely to the“value” mindset that investors expect from thistype of manager. They have also been able in someinstances to use short proceeds to over-bet on longpositions, but their use of that technique can bringforward questions about their experience, as manylong-only managers had problems with this approachin 130/30 strategies they had launched pre-GFC.More often, these long-only managers are able towin investor confidence by choosing to hedge theirlong positions with ETFs, indices, futures or swaps,as they can hire traders that can follow the portfoliomanager’s guidance and manage these positions ontheir behalf. As a result, traditional asset managers’skills are aligned to offer hedged long strategieswithin the convergence zone as well.Beyond those two more liquid offerings, however,traditional asset managers run into a credibility gap.Only a select group of these portfolio managers havebeen able to convince investors that they are able toidentify short alpha on single securities, but, eventhen, there is not a sense that these managers areexperienced in using long leverage or in any of theother more sophisticated investment techniques.This makes it difficult for these managers to crediblyextend much further in the convergence zone beyondthe most liquid product offerings. This is illustratedin Chart 49.Section VIII: Market Players Face Differing CredibilityGaps in Trying to Extend into New ProductsFUNDLIQUIDITYlessliquidCOREINVESTMENTSKILLSTRADITIONALASSETMANAGERSActively Participate inManagement ofCompany/AssetManage Illiquid orDistressed Pools of AssetsExamine Capital Structure Identify Relative ValueFinance Portfolio Leverage Long PositionsIdentify Short Alpha onSingle SecuritiesHedge Long Positionsw/ ETFs, Indices, Futuresor SwapsOver bet on Long PositionsUsing Short ProceedsHold Cash Buy OnlySelect OpportunitiesmoreliquidChart 48: Areas of Core Competency forTraditional Asset ManagersSource: Citi Prime Finance
  • 65. Rise of Liquid Alternatives Survey | 66As a traditional long-only portfolio manager triesto extend into less liquid, higher fee products thatrequire a more sophisticated set of investment skills,they run into a credibility gap that often limits theirability to launch and grow these offerings. Manyasset managers we interviewed as part of this year’ssurvey noted that they had a number of small hedgefund offerings, many of which were below $100million AUM and most of which were under the $500million threshold that would be considered necessaryto be seen as institutionally viable for an independenthedge fund manager.Because these long-only portfolio managers do notneed to live off the proceeds of these hedge funds, butrather view them as supplementary to their existingincome, these small funds can persist for extendedperiods of time without raising additional assets. Thethinking in most asset manager organizations is thatthese small hedge funds can establish long enoughtrack records over time to convince investors aboutthe manager’s skill.Hedge Funds Are Viewed as More Credible forUsing Fewer Skills to Create ProductChart 50 illustrates that hedge fund managers havebuilt their businesses around being able to leveragea substantially broader set of investment techniques.Indeed, many of the portfolio managers at these firmsoriginated from proprietary trading desks on the sell-side, where being able to use a range of investmenttechniques to make profits as market conditionsevolved lay at the core of their daily activities.That is not to say that hedge fund managers only havea trading as opposed to investing mindset. Surveyparticipants expressed the view that most hedgefund managers can deploy the same skills that assetmanagers possess in terms of being able to identifyvalue in running the long side of their portfolio, butthey are also able to do more.They cited an ability of hedge fund managers toleverage their long portfolios in the right conditionsto amplify their bets. They also noted that hedgeChart 49: Ability of Traditional Asset Managersto Extend Their Core CompetencyChart 49Source: Citi Prime Finance.Ability of Traditional Asset Managers to ExtendTheir Core CompetencyInvestmentSkillsRequiredLessSophisticatedMoreSophisticatedCredibilityBarrierFeesLowHighMore Liquidity LessTraditionalAssetManagersChart 49Source: Citi Prime Finance.Ability of Traditional Asset Managers to ExtendTheir Core CompetencyInvestmentSkillsRequiredLessSophisticatedMoreSophisticatedCredibilityBarrierFeesLowHighMore Liquidity LessTraditionalAssetManagersCOREINVESTMENTSKILLSTRADITIONALASSETMANAGERSHEDGEFUNDSActively Participatein Management ofCompany/AssetManage Illiquidor DistressedPools of AssetsExamine CapitalStructure IdentifyRelative ValueFinance Portfolio LeverageLong PositionsIdentify ShortAlpha onSingle SecuritiesHedge LongPositions w/ETFs,Indices, Futures orSwapsOver bet on LongPositions UsingShort ProceedsHold Cash Buy Only SelectOpportunitiesChart 50: Areas of Core Competency forTraditional Asset Managers Hedge FundsFUNDLIQUIDITYmoreliquidlessliquidSources: Citi Prime Finance
  • 66. Rise of Liquid Alternatives Survey | 67Chart 51Source: Citi Prime Finance.Ability of Traditional Asset Managers vs. Hedge Funds to Extend Their Core CompetencyInvestmentSkillsRequiredMoreSophisticatedMore Liquidity LessFeesLowHighLessSophisticatedCredibilityBarrierTraditionalAssetManagersCredibilityBarrierCredibilityBarrierMore LiquidHedge FundsLess LiquidHedge FundsChart 51Source: Citi Prime Finance.Ability of Traditional Asset Managers vs. Hedge Funds to Extend Their Core CompetencyInvestmentSkillsRequiredMoreSophisticatedMore Liquidity LessFeesLowHighLessSophisticatedCredibilityBarrierTraditionalAssetManagersCredibilityBarrierCredibilityBarrierMore LiquidHedge FundsLess LiquidHedge FundsChart 51: Ability of Traditional Asset Managers vs. Hedge Funds to Extend Their Core Competencyfund managers often have multiple ideas workingin parallel in their portfolios, so that they can beinvesting for value with some portion of their assetsand pursuing other goals such as mean reversion,arbitrage or capturing relative value across a capitalstructure with other portions of their trading book,thus enabling them to have multiple return streamswithin the same portfolio.Chart 51 illustrates that hedge fund managers arethus seen as more credible when trying to launchproducts within the convergence zone. As shown,they are able to pare back on their trading and utilizea sub-set of their skills to offer less liquid strategies,but that the trade-off for these managers in launchingthese products is that they have to accept lower feesfor doing so.As illustrated in Chart 51, there is also a perceiveddifference in the ability of various types of hedgefund managers to extend their skills. Managers thatfocus on the more liquid products, including themajority of equity hedge fund managers, describeda typical set of fees that were lower for hedged longand unconstrained long strategies than those beingrealized by hedge fund managers originating fromless liquid strategies.Equity hedge fund managers were able to demand atbest a 1% management fee and 10% incentive fee inprivately offered structures and usually only 50 to75 bps on publically offered vehicles. By contrast,credit hedge fund managers offering similar productswere indicating that they were obtaining a 1.5%management fee and up to a 15% incentive fee abovea returns hurdle for privately offered funds, and thatthey were able to obtain a full 1% management fee inpublically offered vehicles.In either instance, it is clear that hedge fundmanagers are finding it easier to convince investorsof their ability to employ a smaller set of skills thanasset managers are finding it to convince investorsof the opposite.Source: Citi Prime Finance.
  • 67. Rise of Liquid Alternatives Survey | 68Private Equity Managers Struggle to MoveBeyond Perceived Banking SkillsPrivate equity firms are seen as being value investors,much like asset managers, but the skill set theyuse to realize that value is quite different. Surveyparticipants cited private equity firms as having a“deal” mentality in terms of thinking deeply aboutone specific company or asset and envisioning howto create value with that investment. Rarely do theythink broadly across an entire industry or sector.The techniques used for realizing value in privateequity investments can include participating inthe management of that asset or company andrestructuring their capital. Oftentimes, privateequity firms get involved when the asset is in distressor is privately held and thus illiquid. Their mindsetin looking at a company or asset is also muchlonger term, and they do not look to insulate theirinvestments to interim market movements. Instead,they focus on finding a long-term exit plan that allowsthe private equity manager and their investors torealize a profit.As Chart 52 shows, these skills overlap in somesense with similar hedge fund manager skills, butthe mindset and the manner that private equityfirms execute is quite different. Indeed, most marketparticipants felt that private equity firms offered askill set more akin to the banking industry than to thetrading community.COREINVESTMENT SKILLSTRADITIONALASSET MANAGERSHEDGEFUNDSPRIVATEEQUITY FIRMSActively Participate in Management of Company/AssetManage Illiquid or Distressed Pools of AssetsExamine Capital Structure Identify Relative ValueFinance Portfolio Leverage Long PositionsIdentify Short Alpha on Single SecuritiesHedge Long Positions w/ETFs, Indices,Futures or SwapsOver bet on Long Positions Using Short ProceedsHold Cash Buy Only Select OpportunitiesChart 52: Areas of Core Competency for Traditional Asset Managers, Hedge Funds Private Equity FirmsFUNDLIQUIDITYmoreliquidlessliquidSource: Citi Prime Finance.
  • 68. Rise of Liquid Alternatives Survey | 69Private equity firms have nonetheless been tryingto deploy capital into more liquid investments, asdiscussed in Section VII. Their ability to do so withtheir existing skills is limited, however, as they, too,run into a credibility gap. Long-duration products,where they compete head-to-head with credit hedgefunds for investor capital, are the area where theyhave the most credibility, since these are in essenceshorter-dated private equity funds. Getting intomore opportunistic or liquid long/short strategies orhedged strategies is difficult for them as they struggleto convince investors about their competency.This is illustrated in Chart 53.Recently, we have seen several private equity firmslaunch publically offered, unconstrained long fundsthat seek to leverage their brand for identifying valuewith a retail audience. This strategy for the most partrelies on an investor set that may be less attuned tothe nuance of how private equity investors pursuetheir investment goals and how this differs from atypical asset manager.Chart 51Source: Citi Prime Finance.Ability of Traditional Asset Managers vs. Hedge Funds to Extend Their Core CompetencyInvestmentSkillsRequiredMoreSophisticatedMore Liquidity LessFeesLowHighLessSophisticatedCredibilityBarrierTraditionalAssetManagersCredibilityBarrierCredibilityBarrierMore LiquidHedge FundsLess LiquidHedge FundsChart 53: Ability of Each Type of Market to Extend Their Core CompetencyChart 53Source: Citi Prime Finance.Ability of Each Type of Market Participant to Extend Their Core CompetencyInvestmentSkillsRequiredMoreSophisticatedMore Liquidity LessFeesLowHighLessSophisticatedCredibilityBarrierTraditionalAssetManagersCredibilityBarrierCredibilityBarrierCredibilityBarrierMore LiquidHedge FundsLess LiquidHedge FundsPrivate EquityFirmsSource: Citi Prime Finance.
  • 69. Privateequityfirmsandtraditionalassetmanagersarerethinking their approach to product manufacturingin the convergence zone. This is due to perceivedcredibility barriers and their experience of onlybeing able to achieve a limited degree of successin building expanded offerings organically. Bothsegments appear to recognize that a more optimalsolution is to acquire hedge fund talent to bridge theirskills gap in this product space.This is not a new idea, particularly for the traditionalasset manager community. There have been manyhigh-profile mergers attempted in the past that raninto integration issues that ended up limiting theeffectiveness of this strategy. As a result, there hasbeen a subtle shift in approach; organizations arelooking to acquire hedge fund talent, not necessarilyhedge fund firms. The struggling fund of hedgefund industry has proven ripe ground from whichto source such talent, as have smaller hedge fundfirms struggling to raise assets in an environment ofrising costs.On the private equity side, managers have useda variety of approaches that focus on creating abetter alignment of skills that look at similar types ofopportunities as the core private equity investmentteams, but from a trading as opposed to bankingmentality. A new model is emerging where the privateequity firm buys minority stakes in hedge fundmanagers in order to get exposure to a portfolio ofhedge fund return streams.Asset Managers Build Hedge FundsOrganically with Internal TalentAsset managers have pursued several models intheir quest to build hedge fund capabilities. We willlook at each of those models in the coming sections,including the newest model that focuses on acquiringfund of hedge fund talent. The first model we willexamine is when asset managers look to grow hedgefund product organically.Section IX: Traditional Asset Managers and Private EquityFirms Look to Hedge Fund Talent for Product CreationCHART 54 Organic Growth Asset Manager ModelUnconstrained Long Unconstrained LongLong/Short FundBenchmarkedLong Only FundBenchmarkedLong Only FundBenchmarkedLong Only FundRESEARCH TEAMAnalystAnalystAnalystAnalystPortfolio Manager Portfolio Manager Portfolio ManagerVALUESENIORITYChart 54: Organic Growth Asset Manager Model
  • 70. Rise of Liquid Alternatives Survey | 71A number of brand-name asset managers began toexpand into long/short products in the late 1990s. Themodel they developed has been widely followed byother asset managers in subsequent years. The assetmanager allows a top portfolio manager to launchand develop their fund internally with firm or partnercapital. These internal long/short funds develop atrack record until a point where the organizationbelieves it will be able to successfully attract outsidemoney. At that time, the fund begins to be marketedand becomes part of the asset manager’s privatelyoffered product suite. This organic growth model ishighlighted in Chart 54.Firms adopting this model typically do so in order tokeep talented individuals within the firm and allowthem to participate in higher fee products as theyprove their seniority in the organization. Allowingexisting managers to expand their span of controlis less disruptive than bringing in outside managersand, in turn, allows these organizations to bettercontrol and preserve their culture.At its foundation, this approach reflects a beliefthat the skill set required for unconstrained long,hedged long and hedge fund strategies is primarilyan extension of the long-only, value-driven skill set,and that the same manager can use its convictions tooversee a variety of fund vehicles.The most common critique of this approach is that thelong-only manager is unable to run a long-only and ahedge fund strategy without experiencing a conflictof interest between the objectives of each type ofportfolio. The bulk of the manager’s money will be inits long-only product, but it will have the opportunityto collect more fees if it were to generate profits intheir hedge fund products.The mechanics of running funds with significantlydifferent size pools of assets is also a challenge. Theskills, expertise and time it takes to establish positionsin large, long-only funds are at odds with the nimble,often small positions that portfolio managers seek toestablish in hedge fund vehicles.How managers identify and handle the short side oftheir portfolio is another area that draws skepticism.Long-only managers typically over-weight the stocksthey like the most and under-weight the stocks theylike the least in their value portfolios. Choosingto short a stock they like less is not the same aschoosing to short a stock in which they see defineddownside potential. Moreover, because they overseelong-only and long/short portfolios, the managermay under-weight securities in some portfolios andoutright short in others. This is why many of the assetmanager products prefer to use ETFs or indices onthe short side, thus placing them in our hedged longcategory as opposed to a true long/short offering.Several asset managers have built up multi-billionAUM hedge fund franchises pursuing the organicgrowth strategy, but those assets typically accountfor no more than 10% to 15% of the traditional assetmanager’s total AUM, a factor which often givesinstitutional investors pause in thinking about theirinherent skills and commitment to the space.Many of the asset managers with successful hedgefund franchises today focus more on their traditionalset of wealthy investors that would be more apt torecognize the brand value of having a leading long-only manager overseeing their hedge fund assets.Merger and Acquisition Approach CreatesCultural Integration ChallengesThe second model being used to obtain the rightskill set to effectively offer hedge fund product is topurchase or merge with an established hedge fundmanager and leverage their brand and capabilities.Asset managers following this model had a differentviewpoint about the skills required to offer hedgefund products. Whereas in the organic model thehypothesis was that research teams and portfoliomanagers could take their proven fundamentalapproach and use different fund vehicles to expresstheir views, those organizations following themerger and acquisition (MA) approach believedthe opposite.These asset managers expressed their belief thatto effectively offer hedge fund or hedge fund-likeproducts, they required teams that have honed theirskills to think about portfolio construction as a multi-dimensional money-making opportunity across thelong side, the short side and even potentially thehedge portion of a trade. Their view was that thereis a certain ‘DNA’ to a hedge fund portfolio manager.Since portfolios managers and analysts emergingfrom the long only world have not been steeped inthis mindset, traditional asset managers pursuing theMA model feel that they must go outside the wallsof their current organization to access the requiredskills. This is illustrated in Chart 55.There have been many high-profile examples ofthis approach both, before and after the 2008GFC, including the Morgan Stanley InvestmentManagement’s purchase of Frontpoint in 2006,JP Morgan Investment Management’s purchaseof Highbridge Capital in 2006 and subsequentlyGavea Asset Management in 2011 and the BlackRockacquisition of Barclay’s BGI unit in 2009. Other firmsknown for their acquisition strategy include LeggMason, Lord Abbott and Guggenheim.
  • 71. Rise of Liquid Alternatives Survey | 72The most substantial benefit of this approach is thatthe asset manager immediately has a market-readyoffering. There is no need to create and incubate aproduct and build a credible track record. There isan existing product that has immediate credibilitywith the asset manager’s client base and that bringswith it a new client base of hedge fund investors. Thiscan speed the organization’s ability to cross-pollinatetheir funds across these two audience sets.Experience has shown, however, that there areseveral concerns that are unique to the MA model,each of which relates in some way to the challengesof integrating two financial firms of very differentscale and focus.Relative pay between the “real money” and hedgeside of the organizations is a major point of concern.Asset managers purchasing these hedge fund unitshave typically not previously dealt with the collectionand allocation of incentive fees. The relative poolsof money that are available to distribute across theinvestment teams on the long-only side versus thehedge fund side can be extremely divergent. This canlead to resentment within the organization and makefor an uneasy management environment.The level of bureaucracy within most assetmanagement firms can also be a challenge for thehedge fund team. From a scale perspective, thenumber of employees in each unit is likely to be highlyskewed toward the asset manager. Most hedge fundshave fewer than 100 employees, and even some of thevery largest tend to operate with just a few hundred.This compares to asset managers that can havethousands of employees. Processes, controls andpolicies that work for large organizations can be seenas stifling for smaller hedge fund teams. Conversely,hedge fund controls can be seen as lacking whenviewed against the culture of oversight demandedby traditional asset managers that operate in thepublic domain.Talent retention thus becomes a real concern. Insome of the highest profile mergers, the key researchand trading talent from the hedge fund side has leftwithin a relatively short period of time after joiningthe broader asset manager organization. This dilutesthe value of the hedge fund acquisition and causesquestions about the investment skill set to re-emerge.Emphasis Shifts from Acquiring Hedge FundFirms to Acquiring TeamsAfter many years of trial and error, both the organicand the MA model seem to be giving way to anew trend toward targeted talent acquisition anddevelopment. In this model, the asset manager keepsa hard separation between their privately offeredfund product and their publically offered fund productREGULATED FUND DIVISION PRIVATE FUND DIVISIONCHART 55 - MA approach to building hedge fund capabilitiesUnconstrained LongBenchmarkedLong Only FundBenchmarkedLong Only FundASSET MANAGER RESEARCH TEAMAnalystAnalystAnalystPortfolio Manager Portfolio ManagerHEDGE FUND RESEARCH TEAMAnalystAnalystHedge FundHedge Fund ManagerChart 55: MA Approach to Building Hedge Fund Capabilities“ The largest asset management firms are starting to position themselvesto be major players in the alternatives space.”— Public Pension
  • 72. Rise of Liquid Alternatives Survey | 73(as was the case in the MA model), but they do soorganically by allowing a select number of resourcesto “cross the line’ into the private fund division andby hiring select hedge fund talent directly into thatpart of the organization so that they bring withthem the required hedge fund ‘DNA’. The firm thenbuilds dedicated hedge fund product around theseindividuals which they market separately and apartfrom their long-only funds.This approach addresses concerns about alignmentby requiring that portfolio managers that wish tomove in this direction give up their long-only funds,and it further addresses concerns about the hedgefund skill set by finding candidates with deep hedgefund backgrounds that can be integrated into theprivate fund organization individually rather thanas part of a firm acquisition so that the impact isminimized. This model is illustrated in Chart 56.Finding a good fit of individuals is critical to thisapproach. Internally, the number of candidateswishing to move into the hedge fund space is likely tobe much more limited. When faced with the decisionto give up their long-only fund, only those portfoliomanagers with a true passion for managing a hedgefund portfolio are likely to want to make the move.Externally, the goal is to find the right individualsthat will integrate with the asset manager’s existingculture. Identifying hedge fund managers willing tomake such a move is becoming somewhat easier asthe cost of running a hedge fund has been going updue to regulatory pressures and the requirement forinstitutional levels of operational controls. As notedin our December 2012 benchmark survey, a smallhedge fund manager needs to have between $280million and $350 million in AUM just to break even offtheir management fees. Given this backdrop, thereis a broadening set of hedge fund teams that may beREGULATED FUND PRIVATE FUNDCHART 56 Talent Acquisition Approach to Building Hedge Fund CapabilitiesUnconstrained LongVALUE, DOWNSIDE STRUCTUREAnalystAnalystAnalystVALUEAnalystAnalystBenchmarkedLong Only FundPortfolio ManagerVALUE DOWNSIDEAnalystAnalystBenchmarkedLong Only FundPortfolio ManagerLong/Short FundPortfolio ManagerHedge FundHedge Fund ManagerSENIORITYRESEARCH ORGANIZATIONChart 56: Talent Acquisition Approach to Building Hedge Fund Capabilities“ I don’t see the asset managers really gaining a foothold in the liquidalternatives space. Their managers grew up with a very specific mindsetand they simply don’t understand why you go short. If you go short onvalue, you get killed. If you go short on consensus you get killed. Evenif they start bringing in hedge fund guys to build products, it’s going tobe tough for them. If you’re good at shorting, you are likely to be pickingholes in the very securities that are attracting the most long flows forthe organization. It’s very hard for an asset manager not to get in theirown way because of their capital structure being primarily long.”— $5.0 to $10.0 Billion AUM Hedge Fund
  • 73. Rise of Liquid Alternatives Survey | 74willing to consider the benefits of re-launching theirfunds on a more robust managed account platform.Hedge fund managers entering these organizationsare able to concentrate solely on their investmentprocess. They are able to leave behind the businessdemands that they had to juggle as independententities and can forego capital-raising efforts andfocus on building their investment track record.The odds of hedge fund talent staying with the assetmanagement firm are also higher than in the MAmodel. New hedge fund product is built specificallyaround the individual that has been brought in to thehedge fund side and the asset management firm isusing their brand and distribution network to buildthat manager’s persona in the same way as they dofor their long-only portfolio managers. This differsfrom having a known hedge fund product broughtonto the asset management platform with its ownreputation and brand that has been pre-established.The cultural impact of this approach is dampened.The asset manager is evolving, not changing theirculture. They are finding ways to accommodate newskills and new products, but the shift happens slowlyover time as key individuals are brought in to act asagents for change.The final factor that firms pursuing this modelmust realize is that their hedge fund product is goingto be built out very opportunistically. It may be sometime before the asset manager has a full platformof hedge fund products. The number of internalmanagers apt to make a move will be very limited if itinvolves giving up their long-only funds. Identifying,vetting and bringing hedge fund talent onto theplatform and building a new fund offering aroundthose individuals is going to take time and a strongorganizational commitment.“ The large asset managers have not done well historically. Ideally, youneed a more specialized board and specialized service providers. Bigfirms try to launch alternatives but they feel watered down. The largeasset managers added the products to offer the strategy, but they didnot have the same expertise as the hedge funds. Compliance and legaland investment decisions are all very slow in a large asset manager. Youneed to acquire a firm or run a separate unit.”— Law FirmFund ofFundExpertiseChart 57Source: Citi Prime Finance.Ability of Each Type of Market Participant to Extend Their Core CompetencyInvestmentSkillsRequiredMoreSophisticatedMore Liquidity LessFeesLowHighLessSophisticatedCredibilityBarrierTraditionalAssetManagersCredibilityBarrierCredibilityBarrierCredibilityBarrierMore LiquidHedge FundsLess LiquidHedge FundsPrivate EquityFirmsChart 51Source: Citi Prime Finance.Ability of Traditional Asset Managers vs. Hedge Funds to Extend Their Core CompetencyInvestmentSkillsRequiredMoreSophisticatedMore Liquidity LessFeesLowHighLessSophisticatedCredibilityBarrierTraditionalAssetManagersCredibilityBarrierCredibilityBarrierMore LiquidHedge FundsLess LiquidHedge FundsChart 57: Ability of Each Type of Market to Extend Their Core Competency
  • 74. Rise of Liquid Alternatives Survey | 75Acquiring Funds of Hedge Funds Emergesas a New ApproachAn alternate approach that has gained traction sincelast year’s survey is the acquisition of independentfund of hedge fund businesses by traditional assetmanagers, in an effort to accelerate their hedge fundproduct offerings. This route to market providesasset managers access to hedge fund products thatthey can distribute to their client bases. Chart 57shows that fund of hedge funds have a recognizedexpertise in selecting both liquid and illiquid hedgefund managers to create co-mingled and customportfolios. Applying these skills and re-packagingthem to suit a broader audience is a new route tomarket for these participants in both the traditionalprivately offered fund space and increasingly throughnew publically offered vehicles.Fund of hedge funds have been struggling post-GFCand losing both assets and market share, as discussedearlier. They have been looking for new ways toleverage their infrastructure and their core skill set.Because fund of fund managers are compensatedon their skill in selecting managers, and not on theiractual investing expertise, there are fewer integrationand cultural conflicts for a traditional asset managerto manage in forging partnerships with these entities.There have been numerous high-profile acquisitionsand partnerships announced in the last 12 monthsincluding Franklin Templeton’s acquisition of K2in October 2012, Legg Mason’s Permal Fundsbusiness acquiring Fauchier Partners Managementin December 2012, and Wells Fargo acquiring a 35%stake in Rock Creek’s fund-of-hedge-fund business,also in December 2012.A new partnership between Fidelity Investmentsand Arden Asset Management to offer hedgefund products to retail investors via a mutual fundstructure was also announced in December,highlighting how these acquisitions are likely to beutilized in 2013. Indeed, not only those funds of fundsinvolved in public deals with asset managers, butmost of the leading independent funds of funds arelooking at the publically offered fund space as a ripeopportunity set.These examples in 2012 all highlight a continuedfocus from the traditional asset manager communityon developing hedge fund product.Private Equity Firms Use a Blend ofThese Models under an Umbrella BrandPrivate equity firms are looking to leverage theirstrong “private fund” reputation to set up a broadrange of products under their umbrella brand. Theirapproach has been a blend of several of the modelsexplored in the asset manager world.Bain Capital chose to grow their hedge fundorganization organically, allowing several partnersto set up affiliated firms focused in the moreliquid hedge fund trading space—Brookside,Absolute Return Capital and Sankaty all originatedfrom this model.Other firms have followed the MA approach. Earlyin 2012, Apollo Global Management acquired StoneTower Capital, a large fixed- income, relative valuehedge fund; a product with clear adjacency to theprivate equity fund management discipline that iscore to the Apollo business. This adjacency was alsohighlighted in Carlyle’s earlier acquisition of thehedge fund Claren Road in December 2010.“ Big guys like us have enough infrastructure and capability to dosomething in the liquid alternatives space. For mid-sized guys, it’smore work and they may be hesitant to do this. Small guys are just sodesperate to raise money they’d do anything.”— Asset Manager“ When we think about launching an alternative 40 Act product, the goodnews is that we already run a lot of 40 Act money so we know what we’regetting into with daily NAV.”— Asset Manager“It takes 3 years of track record to get your Morningstar rating, but as weare a recognized brand, we should start to see real AUM growth soonerthan a 3-year horizon.”— Asset Manager“ Everyone is trying to explore marketing alternatives to the retail market,but many do not have the brand to build a big business in this market.We see the private bank platforms actually consolidating their providersof product and we think that this plays to the larger asset managementfirms with a strong brand.”— Asset Manager
  • 75. Rise of Liquid Alternatives Survey | 76There have also been examples of the private equityfirms bringing on specific hedge fund talent andbuilding out product around those individuals. KKRbrought on a set of Goldman Sachs proprietarytraders at the end of 2010, and recently Blackstoneannounced that they have hired the head of Barclay’sinvestment banking unit for the purpose of setting up afund that takes minority stakes in a portfolio of hedgefund firms to obtain a portion of the managementfees as well as the funds’ return streams.Blackstone set up its own fund of funds model manyyears ago and has been extending that productrecently, filing with the SEC their intent to registeran open-end, multi-alternative product that isexpected to launch in June 2013. In June 2012, KKRannounced that they would acquire a majority stakein Prisma Capital Partners LP, a leading fund of hedgefunds provider founded in 2004 by partners fromGoldman Sachs.In Asia, survey participants also noted an emergenceof this theme. A number of Chinese private equityfirms have been jumping on the hedge fundbandwagon, typically at the behest of existing privateequity investors. As an example, SAIF Partners, oneof the PRC’s largest homegrown private equity firms,is planning to launch a Greater China hedge fund thisyear. Others have already launched such vehicles tovarying degrees of success. Conversely, some Asia-based hedge fund firms have launched or are planningto launch private equity vehicles, too.The unifying theme to the majority of these assetmanager and private equity firm moves has beenthe need to go to the hedge fund industry to sourcethe unique skill sets required in order to offer morecredible hedge fund products.Hedge fund managers are also examining theirproduct and assessing their franchise at strategicgrowth points as will be discussed in the next section.“ The big private equity guys are still raising billions and billions but do nothave the investment opportunities to source.”— Third Party Marketing Intermediary“ The PE guys are getting dragged into hedge because they don’t haveenough places to put the incoming allocations. The cash on the sidelinesneeds to be deployed so this is leading to business expansion and growthof the huge firms like KKR, Apollo, and Blackstone.”— $1.0 Billion AUM Hedge Fund“ We are already seeing private equity firms become competitors, butthey’re coming at it from a very different way than we look at it. We seeit as a look through to a pool of assets and then what structures do youwant to have in place to create good convexity and return stream. Thetype of return a private equity firm purports to achieve is going to bevery different. We are looking to protect on both sides.”— $10 Billion AUM Hedge Fund
  • 76. Despite the majority of retail investors being ineligibleto purchase privately offered hedge fund products,hedge fund skills and managers are at the core ofthe unfolding evolution of alternative 40 Act- andUCITS-compliant funds. This is creating morestrategic paths for a hedge fund manager to consider,and a chance to diversify revenue streams for its coreproducts. However, it must first decide whether it isinterested in pursuing these lower fee asset pools,and then how much engagement they want to havewith this audience.In our 2011 report, entitled Global Pension andSovereign Wealth Fund Investment in Hedge Funds:The Growth and Impact of Direct Investing, weidentified two critical inflection points in a hedgefund’s development. The first was when its AUMreached $500 million to $1.0 billion, as that wasthe point at which it became sufficiently large toabsorb institutional tickets without having a singleinvestor account for too large a share of its totalassets. The second was between $3.0 billion and$5.0 billion, where the industry tended to bifurcate—some managers choosing to limit additional capitalraising because of capacity considerations, and othermanagers deciding to continue to build their assetsand their franchise.In this year’s survey, we have now identified and addeda third inflection point in a hedge fund’s strategicdevelopment. As assets reach the $8.0 billion to$10.0 billion threshold, managers must make one ofthree determinations about their future direction.They must choose whether to 1) keep their franchisesolely focused in the privately offered funds spaceor 2) cross over into publically offered fund spacein a limited capacity as a sub-adviser or 3) expandtheir organizational mandate and directly offer amix of publically and privately offered funds. As theretail market opportunity expands, more and morehedge fund managers will face this decision asthey reach what we are now referring to as the“trifurcation” zone.However,beforeexploringtheconceptofatrifurcationfor the largest hedge fund managers, it is importantto understand the impact these industry trends arehaving on small and emerging hedge fund managers,and their path to the institutional allocations thatfacilitate their growth progression to and above$1.0 billion AUM.Small and Emerging Hedge Funds Struggle toSurvive in the Post-GFC EnvironmentSeveral factors have made raising assets particularlydifficult for small and emerging hedge funds post-GFC, and the shifting audience base in the industryhas for the most part worked against smallerhedge funds.Small and emerging managers look to quicklyestablish a track record in order to attract assets.To get onto investors’ radars, they need impressiveperformance, and to achieve such outsized returnsthey will often use more leverage and demonstratehigher volatility than more established managers.This behavior remains attractive to HNW/FOIslooking for such outperformance, but is not asattractive to large institutional investors seekingmore stability in their portfolios.The shift toward institutions directly allocating theirown capital, rather than relying on a fund of hedgefund manager to allocate that capital on their behalf,has also reduced flows. Fund of hedge funds werethe primary source of assets for emerging managers,and since fund of funds made allocations from a co-mingled vehicle, they could afford to write a largenumber of small $5 million to $10 million ticketsand spread their bets. In going direct, institutionstypically write significantly larger tickets of$50million to $100 million each, and this makesit nearly impossible for them to consider smallmanagers, as their investment would represent toolarge a share of that manager’s total assets, thuscreating concentration risk for the institution.The shift in thinking about where hedge funds fit inan investor’s portfolio is also adversely impactingsmall managers. In the new risk-aligned allocationapproach outlined in Section I, institutional investorsSection X: Hedge Fund Managers Face More Choices onHow to Evolve Their Firm and Product Offering“ I see the line between long only and alternatives blurring and we are onlya small boutique player at one end of the spectrum which means we arecompeting with a wider set of asset managers.”— $1.0 Billion AUM Hedge Fund
  • 77. Rise of Liquid Alternatives Survey | 78are moving away from having a dedicated alternativesallocation bucket and are instead viewing differenttypes of hedge funds as belonging in differentportions of their portfolio. This shift means thatinstitutions are no longer looking to diversify by size,strategy and region within an alternatives categoryand instead are looking to invest by risk/return andasset class profile. This has had a noticeable impacton managers in Asia, as they tend to be localizedand much smaller than managers elsewhere in theworld, making it much harder for them to participateas tools within the risk-aligned investment portfoliosbeing constructed.Meanwhile, the costs of running a hedge fundhave been increasing. Not only are institutionalinvestors looking for higher standards of operationalexcellence and well-established controls, regulators,too, are requiring more managers to register theirfunds, create robust compliance programs andadhere to new types of reporting that are strainingthe infrastructure of small managers.All of this has led to a challenging environment forsmall hedge funds. This is illustrated in Chart 58.As shown, industry-wide assets were $194 billion formanagers under the $1.0 billion threshold at the endof 2008. That figure recovered modestly over thenext 2 years, rising 23% to $239 billion, but additionalgains have not been forthcoming. Between 2010 and2012, there was no growth in assets from managersunder the $1.0 billion threshold.This has led to increased churn in the industry.According to HFR, there were 1.3 hedge fund launchesper hedge fund liquidation in the industry during thefirst 9 months of 2012. This compares to a launch/liquidation ratio of 2.1 back in 2007.“ Control and transparency are driving demand for boutique productstowards Managed Account Platforms, particularly for European clients.You need to understand the threshold requirements imposed by theplatforms but we think our products would fit.”— $1.0 Billion AUM Hedge Fund“ Most of this money comes with a demand for an SMA. We do not seeinterest in co-mingled vehicles in the current environment.”— $1.0 B AUM Hedge Fund“ We have had questions from FoF clients who are looking for sub-advisersfor their products. It requires SEC registration and we have reached thathurdle. It is unclear whether the investment staff need to be in the US.”— $1.0 Billion AUM Hedge FundChart 58Data reflects assets as of end of Q4.Source: Citi Prime Finance Analysis based on HFR data.Total Assets for Hedge Fund FirmsWith Less than $1.0 Billion in AuM2008 2010 2012MillionsofDollars2,557+23%+0%$0$100,000$200,000$300,000$400,000$500,000$600,000$700,000$800,000$900,000$1,000,000$194B$239B $240BChart 58: Total Assets for Hedge Fund FirmsWith Less than $1.0 Billion in AuMData reflects assets as of end of Q4.Source: Citi Prime Finance Analysis based on HFR data.
  • 78. Rise of Liquid Alternatives Survey | 79The Search for Hedge Fund Talent OffersSmall Managers a New DirectionRegardless of the factors limiting their growth, manysmall hedge funds have niche investment productsand demonstrate strong performance in their earlyyears. There are starting to be a growing numberof paths open to such managers that struggle tooperate as an independent firm but nonetheless wishto remain in the fund management arena.Many of the large multi-manager hedge fundplatforms have been growing through the acquisitionof small hedge funds. Rather than setting any typeof valuation on the small hedge fund manager’sfirm, these platforms are attracting managers bypromising them larger sums of capital to manage outof the gate by having them operate as a single unitwithin a broader umbrella fund, thus allowing them tokeep the majority of their management and incentivefees after an allocation for costs.The rise of liquid alternative products and theexpansion of strategies being offered by traditionalasset managers and private equity firms withinthe convergence zone, are also providing anotheroption for these firms. We have witnessed examplesin the last 12 months where a portfolio managerhas negotiated a “team” acquisition, whereby itbring its research team and traders to the neworganization. These “team” acquisitions are becomingincreasingly popular, and there are a growingnumber of introductions being made between smallerhedge funds and large asset management or privateequity organizations.The past 12 months has also witnessed a continueddemand for SMAs and the continued growth of MAPs.This trend, in particular in the European market whereinvestor control and transparency are becoming keyrequirements, is presenting another option for smallermanagers to offer and distribute their product. Theability to support MAPs and relationships with theMAP providers requires a significant investment bythe fund manager, but the outcome can be worth theeffort. Chart 22 in Section II of the report providesa list of the 10 largest MAPs that offer exposure tomanagers of all sizes, including small and emergingfund firms.The final development offering potential for smallhedge funds in the last 12 months has been theemergence of the “multi-alt” mutual funds in the U.S.that are creating an opportunity for some smallerhedge funds to sub-advise a sleeve of a publicallyoffered 40 Act product and raise assets from retailinvestors through this structure. There is also asimilar opportunity in the alternative UCITS fundof fund structure in Europe, where the sub-adviserperformance can be replicated using a total returnswap product. We are even starting to see this trendemerge in Asia. where select hedge fund managershave been approached to sub-advise on 40 Act funds.Small and emerging hedge funds are thereforebecoming more creative in how they target growth,with the realization that the chances of survival aregreatly increased upon reaching the $500 millionthreshold and then growing to the key milestonesize of $1.0 billion AUM, a level defined in our modelas the institutional threshold. Merging with a largerplatform, joining a large asset manager looking forhedge fund talent, accepting SMAs or distributingvia a MAP, sub-advising a publicly offered multi-altproduct in a UCITS fund or mutual fund, can all offerpathways for a small manager to evolve and developtheir product.There is an acute understanding by smaller fundmanagers that all options need to be explored. Ourinterviews this year revealed a level of urgencyamong the small manager community to understandthe advantages and challenges associated with eachpotential option discussed above.Managers in Direct Allocators’ Sweet SpotFocus on Core BusinessHedge funds that do reach the institutional thresholdof $1.0 billion AUM continue to experience anexpansion in their investor audience as they comeonto the radar of pension funds, insurance companiesand other institutional participants with directallocation programs. These organizations tend towork with a more niche set of alternative industryconsultants that perform due diligence on managersand maintain an “approved list” of funds that aredeemed to be attractive investment targets for theirclient mandates. Getting onto these approved listsand directly engaging with the institutional audiencecan result in managers seeing a major acceleration intheir capital raising.“ Somebody approached us about starting a $100M 40 act fund where wewould be one of 10 sub advisors so essentially we would manage $10M ofcapital for 75bps, which is not worth it to us. Unless you think they cangrow to $1B pretty quickly it’s not something we want to participate inbecause we can earn more in our HF product with a smaller asset base.We have been doing a break-even analysis on this product to see if it’sworth it.”— $1.0 Billion AUM Hedge Fund
  • 79. Rise of Liquid Alternatives Survey | 80According to Absolute Return magazine’s GlobalBillion Dollar Plus list, as of Q1 2013 there wereapproximately 369 hedge fund managers withassets greater than $1.0 billion. Managers above thisthreshold have demonstrated a significantly differenttrend in their asset growth as compared to the smallmanagers cited in Chart 58.Chart 59 shows that at the end of 2008, assets forhedge fund managers with more than $1.0 billionAUM stood at $1.2 trillion, according to HFR. Thatfigure rose 38% in the next 2 years, to $1.9 trillion.By comparison, small hedge funds increased theirAUM only 23% in the same period, and this gainwas coming off a far smaller asset base. Between2010 and 2012, large hedge funds continued to gainassets, with their AUM increasing another 20% to$2.01 billion at a time when growth for smallermanagers was flat.These figures illustrate how significant the $1.0 billionthreshold has become. This shift toward allocatorsfavoring larger funds has hit the Asian hedge fundindustry particularly hard. Some of our Asian surveyparticipants emphasized that their pension planshave been more aggressive in allocating capital tohedge fund managers as they struggle with a rapidlyaging population in many developed Asian countries.Yet, few of the Asian pension funds allocate asaggressively to hedge funds as U.S. pension funds do;and, when they do make such allocations, they aretypically to the larger global franchises. This perhapsexplains why Asian hedge funds only account for2.5% of the Global Billion Dollar Plus list.As discussed in the findings of our 2011 survey, directinstitutional allocators like to identify managers justas they surpass the $1.0 billion threshold, and theycontinue to lock in capacity with these managers solong as their assets remain in the $1.0billion to $3.0billion AUM range. Direct allocators indicated thatmanagers within these bands were seen as sufficientlylarge to absorb their ticket sizes, but were also stillnimble and able to most effectively deploy capital. Anearly allocation to these funds guaranteed investorsa slot in the event a manager decided to limit or closecapacity. Moreover, direct allocators indicated thatthey had a greater ability to influence managers inthis band in terms of shaping their reporting, theirlevel of transparency and their frequency of contact.In short, direct allocators felt that they could betterforge a relationship with managers in the $1.0 billionto $3.0 billion AUM zone than with many of theirlarger hedge fund counterparts. It is for this reasonthat we deemed hedge funds falling within this AUMzone as being in the direct allocators’ “sweet spot”.Chart 60 below illustrates this pathway to the directallocators’ sweet spot, which we believe is still animportant evolutionary decision point and has notsignificantly changed since our report in 2011.In this year’s survey, hedge funds with AUM in the lowbillion dollar region expressed little interest in theoptions smaller managers were exploring in terms ofjoining multi-manager platforms, moving onto assetmanager or private equity platforms, distributing viaMAPs, or looking to sub-advise within the publicallyoffered liquid alternatives space. Most stated thatthey wanted their investors to know that the managerwas focused solely on their privately offered hedgefund product.When a hedge fund manager’s AUM nears the top ofthis band, they start to reassess their options as they“ We think our strategy only works on $4.0 billion and we already have$3.3 billion. We’d like to make the rest through appreciation. If we goabove the $4.0 billion threshold, we’d distribute profits.” — $1.0 Billion AUM Hedge FundChart 59Data reflects assets as of end of Q4.Source: Citi Prime Finance Analysis based on HFR data.Total Assets for Hedge Fund FirmsWith More than $1.0 Billion in AuM2008 2010 2012MillionsofDollars+38%+20%$0$100,000$300,000$600,000$900,000$1,200,000$1,500,000$1,800,000$2,100,000$1,213B$1,678B $2.012BChart 59: Asset Growth in Hedge Funds withGreater than $1.0BData reflects assets as of end of Q4.Source: Citi Prime Finance Analysis based on HFR data.
  • 80. Rise of Liquid Alternatives Survey | 81hit the first of two major inflection points where theyneed to make important strategic decisions abouttheir future direction.Managers Assess Capacity and IndustryBifurcates Near $5.0 Billion AUMIn our 2011 report, we identified a bifurcation zonefor more mature hedge funds at the top of the directallocators’ sweet spot. As managers neared the $3.0to $5.0 billion AUM region, many began to assesswhether their strategy could maintain the same levelof performance if new capital continued to flow intothe fund.Many managers’ strategies are realized in less liquidmarkets, where it becomes difficult to find sufficientinventory at a reasonable price as their transactionsize grows. Sometimes, managers decide to limittheir size, maintaining smaller, more entrepreneurialorganizations rather than extend their headcount andbuild additional infrastructure to manage increasedassets, especially once they have reached a sizewhere the main partners are realizing substantialpersonal wealth.Managers that fall into these categories oftenchoose to either soft or hard close their fund in“ We have had several fund of funds approach us to sub-advise a 40 Actfund but the major issue is how to replicate our structure of 2/20 intoa zero performance and daily liquidity vehicle. This is just not possible.Our compensation structure is based on the performance fee and if wego down the 40 Act route this will create a lot of conflict.”— $5.0 to $10.0 Billion AUM Hedge FundChart 60: Traditional Hedge Fund MaturationTraditionalConsultants’Sweet SpotChart 60Traditional Hedge Fund Industry MaturationSource: Citi Prime Finance Analysis.AuMHighLow$10.0B$5.0B$3.0B$1.0B$500MSeeders,Day One Early StageInvestorsHNW, Family Office ExperiencedInstitutional Hedge FundInvestorsPrivate Fund AudienceBank Platforms Less ExperiencedInstitutional HedgeFund InvestorsHNW,Family Office,Emerging ManagerFundsDirectAllocatorsSweet SpotBifurcationDecision ZoneInstitutional ThresholdAlternativeConsultants’Sweet SpotSource: Citi Prime Finance Analysis.
  • 81. Rise of Liquid Alternatives Survey | 82this $3.0 billion to $5.0 billion region, and allow forthe organic realization of additional asset growththrough performance rather than the addition ofnew capital. These managers are seen as havingmore of a boutique business model. They are likely toreplace an investor if one chooses to leave the fund,but they typically reduce their marketing effortsand focus more on investor relations with theirexistingclients.Theleanoperationsandinfrastructurethat these funds can typically have also reduce theirneed for additional income streams outside of theircore products.The bifurcation occurs as other hedge funds seecontinued opportunities to grow their assets withoutsacrificing performance, and they accept the needto expand their headcount and infrastructure toachieve this goal. If their performance stays strong,these managers will continue to draw interest fromthe alternative consulting community, and oftencan experience a second burst of growth as theycome onto the radar of more traditional full-serviceconsulting firms. These full-service consultants oftendeal with less experienced institutional investorsand, as such, they are looking for hedge fundmanagers that present a more professional profile.The addition of infrastructure and more specializedteams overseeing daily operations gives thesetraditional full-service consultants confidence in the“institutional” quality of the hedge fund managers’organization, thus leading many in the industry to saythat these consultants equate ‘big’ with ‘safe’.Hedge funds that move beyond the $5.0 billionthreshold begin to think about ways to expand theirfranchise that allows them to continue to deployincoming capital and raise revenues to pay for anexpanding infrastructure. These managers begin tohave more options about their future direction. By thetime firms reach the $8.0 to $10.0 billion AUM zone,they encounter another strategic inflection point.In addition to choices they can make to grow theirprivately offered fund franchise, these managersalso will have come to the attention of intermediarieslooking to create publically offered product forthe liquid alternatives space. This increases thenumber of choices for the manager to consider, andintroduces a menu of new options for structuringand distributing a range of hedge fund products. Assuch, we are calling this strategic inflection pointbetween the $5.0 to $8.0 billion AUM threshold the“trifurcation zone”.“ We have had several fund of funds approach us to sub-advise a 40 Actfund but the major issue is how to replicate our structure of 2/20 intoa zero performance and daily liquidity vehicle. This is just not possible.Our compensation structure is based on the performance fee and if wego down the 40 Act route this will create a lot of conflict.”— $5.0 to $10.0 Billion AUM Hedge Fund
  • 82. Rise of Liquid Alternatives Survey | 83Franchise-Sized Firms Decide Whether toCross into Public FundsThis new trifurcation zone is illustrated in Chart 61.As shown, there are three paths that branch out fromthis zone, each representing a different strategicchoice about the hedge fund manager’s futuredirection. The three paths that we are now observingin the industry are laid out following Chart 61 and willbe explained in the following paragraphs.Path 1: Hedge Funds Focused Solely on PrivatelyOffered Alternative ProductThis remains the traditional hedge fund path,and there are a number of approaches that weobserved managers pursing at this juncture in theirdevelopment.Many firms are choosing to bring on more resourcesthat will allow them to generate a broader set oftrading signals. In the quantitative or systematicfunds, this is achieved by extending the research teamand challenging them to identify new market patternsor a broader opportunity set to apply models against.In more fundamental and discretionary strategies,this same objective is achieved by bringing on moreportfolio managers to serve under the CIO, eitherwithin the same core mandate as the main fund or in“ Conversion of existing HF strategies into 40 Acts very much depends onliquidity of strategy. For example some our funds are only 10% differentthan the reference fund, but other may be 50% different. Our offshoreEM ELS fund was closed for capacity. But we assessed the 40 signalsand found that 15 of them were not capacity constrained so we packagedthem into a 40 Act fund.”— $10 Billion AUM Hedge Fund“ You can’t always just repackage existing HF into a 40 Act wrapper. Ourcredit long/short fund had to be redesigned from scratch to get into aregistered fund wrapper.”— $10 Billion AUM Hedge FundChart 61: Emerging Hedge Fund Industry MaturationTraditionalConsultantSweet SpotChart 61Emerging Hedge Fund Industry MaturationSource: Citi Prime Finance Analysis.AuMHighLow$20.0B$10.0B$8.0B$5.0B$3.0B$1.0B$500MPrivate Fund Audience Public Fund AudienceDirectAllocatorsSweet SpotTrifurcationDecision ZoneBifurcationDecision ZoneInstitutional ThresholdAlternativeConsultantSweet SpotAlternativeAssetManagersSub-Advisory123Source: Citi Prime Finance Analysis.
  • 83. Rise of Liquid Alternatives Survey | 84new sleeves that can attract differentiated flows. Thistalent acquisition is also being fueled by the churnin the smaller managers looking for more stableinfrastructures to potentially join.The other option is to create another master fund tobe run by a new portfolio manager who is typicallya trusted associate that has proven its strengthswithin the original master fund construct. Creatinga secondary master fund, sometimes referred to asa ‘satellite fund’, around this individual allows thehedge fund to retain this individual, and is viewedpositively by investors worried that most hedgefunds fail to become multi-generational. Havinga secondary master fund also allows investors toevaluate the performance of a potential successorto the original CIO over time, which can make forsmoother transitions.The common traits of this traditional growth path area belief in the success of the privately offered 2/20hedge fund model and an aversion to risking thealpha potential of their strategy by entering intothe public space. Fund managers we interviewedon this path all highlighted potential “cannibalization”of the 2/20 income in that a lower fee-based,publically available product would alienate theircurrent investors.Path 2: To Sub-Advise or Not to Sub-Advise?That is the New Question.The new dynamic that has emerged in the last 12months and creates the core of our trifurcationargument is being driven by the acceleration indemand for hedge fund products in retail structures.Fund of funds, asset managers and private equityfirms are all exploring the ‘multi-alt mutual fundstructure, which allows a hedge fund manager tobecome a sub-adviser to a sleeve of capital within thepublically offered fund.The managers entering the trifurcation zone haveall proven their caliber as hedge fund managers,developed their own unique brand within the privatefunds industry and have just gone through a hugewave of regulatory transparency with the Dodd-Frank, and now AIFMD, requirements. These traitsand experiences are attracting the interest of anew group of intermediaries that are developinghedge fund products for retail distribution channelsand their end clients. Such packagers can hail froma traditional institutional background such as aninsurance company, whereas others may representa completely new class of counterpart whoseentire business model is set up for this purpose.Understanding the trade-offs and implicationsof these new relationships and products is a keydiscussion playing out in the industry with newpartnerships and alliances developing in real-time.Some of the challenges and concerns emerging withthese multi-strategy mutual funds include how tobalance those multiple strategies to stay within theleverage and short sale restrictions inherent in 40Act structures and how to ensure that overall fundliquidity stays above 85% when multiple managersare sub-advising the same pool of investments.The concern around cannibalization identified bymanagers in path 1 still needs to be addressed as thesesub-adviser relationships are discussed along withtheir approach to managing private fund investorsin a parallel relationship. Meanwhile, investors needto assess whether the investment proposition of thehedge fund strategy can be effectively executed in amore restricted sleeve of capital.The majority of interviewees stressed that to besuccessful in expanding their investor base withoutundermining their flagship product, they needed todevelop a new product description to differentiatehow they traded in each type of vehicle. Managersfrequently discussed the number of opportunities orsignals they pursue in their privately offered fund andthen explained how they isolate a sub-set of the moreliquid opportunities to offer in a publically tradedfund. That way, investors eligible for the privatelyoffered fund option feel that they are getting access“ We have created a sub-advisor relationship with a product packagerin the 40 Act space. They had approached us and wanted somethingdifferentiated to offer their clients. They are marketing it and pushingit out to their audience. We view them more as a partnership. From ourside, this investment looks like a managed account.” — $1.0 to $5.0 Billion AUM Hedge Fund“ We have $6.4 billion in our onshore 40 Act fund. We’ve been raising about$1.0 billion a month since launching our sub-advised 40 Act product inOctober 2012 with our distribution partner.” — $5.0 to$10.0 Billion AUM Hedge Fund“ One of the reasons hedge funds are looking at the 40 Act space is that it’sgetting harder to raise money in the private hedge fund space. Also, theylook at a mutual fund manager with $7.0 billion in their fund and they lookat their own hedge fund with $1.0 billion and they think, ‘I’m smarter thanthis guy’. You have to be careful though. It’s a mindset issue you have todeal with. You have to be more humble as a mutual fund manager. Youneed the wholesalers to sell your product for you.” — $5.0 to $10.0 Billion AUM Hedge Fund
  • 84. Rise of Liquid Alternatives Survey | 85to a superior product offering enhanced alpha overthe public version.For the majority of the equity-focused strategies(unconstrained long, hedged long, market neutraland long/short), these constraints do not introducesignificant issues and the products are easy topackage within a public product. However, for thefixed-income and relative-value strategies investing incorporate capital structures using cash securities andrelated derivatives, the fit can be more problematic.If a hedge fund manager determines that its strategycan be successfully realized within the constraints ofa public structure liquid alternative and that it canadequately differentiate its offering from its corehedge fund product, it then must decide whetherthere is a significant enough fee opportunity topursue the new audience. The multi-alt mutual fundsprohibit managers from collecting performance fees,and because the manager is sub-advising, it can onlyexpect to collect a portion of the management fee.The invitation to sub-advise a public product typicallycomes with a request to accept a management fee inthe range indicated by interviewees of between 70-100-bps, which represents a significant step-down interms of fee income potential for the strategy.Testing the water in a sub-advisory relationship wasmost often described as a manager agreeing to be oneof several sleeves in a multi-alternative fund offering.Initialallocationsinthesestructurescanbequitesmall(in the $10 million to $20 million AUM range), but overtime, as the fund grows, the size of the sub-adviser’sallocation can grow proportionately. What is mostappealing to many hedge fund managers exploringthis arrangement is that they do not directly offera vehicle that their investors can access, but ratheronly provide a slice in a bigger pie, thus creating somedistance from the manager’s core product.A good example of these new emerging multi-altproducts is the Arden Alternative Strategies Fund(ARDNX) that launched in Q4 2012 and is sub-advised by a number of brand name hedge fundsincluding CQS, York Capital, JANA and BabsonCapital Management. This fund co-mingles event-driven, equity hedge, global macro, and relative-value strategies in a single multi-strategy productthat offers a broad exposure and diversification toretail investors. Other examples include the PrincipalGlobal Multi-Strategy Fund (PSMIX), which is sub-advised by AQR, PIMCO, Wellington, LA Capital andLoomis Sayles, and the Altegris Equity Long ShortFund (ELSAX), which is sub-advised by Visium AssetManagement, Harvest Capital Strategies, and OMTCapital Management.The other sub-advisory model involves launching asingle manager fund where the hedge fund managerhas an exclusive relationship with the fund sponsorand receives all of the capital being raised into themutual fund. We have witnessed some specificexamples in the last 12 months that have highlightedthe upside potential of this model and make for aninteresting case studies on how to accelerate growthby developing these new retail channels.One such example is Marketfield Asset Management,an equity long/short hedge fund manager with aglobal macro focus that, in addition to its privatehedge fund offering, acts as a sub-adviser to theNew York Life Mainstay Marketfield mutual fund(MFADX). Marketfield launched its own mutual fund inparallel with a private fund in late 2007 (the privatefund launched early in 2008), but did not begintheir relationship with New York Life until Q4 2012.At this point, they chose to transfer to a sub-adviserrelationship in exchange for accessing the New YorkLife distribution network, and have seen assetsincrease significantly since that point. This examplehighlights a dramatic acceleration from being aninstitutional hedge fund to being a significant mutualfund sub-adviser in a very short period of time, whichis possible with the right distribution partnership.“ Hedge funds themselves are being subject to much greater regulatoryobligations and their fund operations are now very transparent.Managers are going through a fatigue of going through these regulationsand are now looking to monetize these investments.”— Law Firm“ We have taken a subset of the ideas we have within our event drivenfund and created an account with an asset manager. We are one of thesub-advisors on their newest alternative mutual fund. The 40 Act fundis a regular mutual fund and will issue investors a 1099 at the end of theyear. We are not willing to put out into the market any access, even ifco-mingled, to our regular private fund offering without receiving ourfull fees.”— $1.0 to$5.0 Billion AUM Hedge Fund“ There are not many ‘multi-alts’ yet, but they will come quickly. It is easierfor an IFA to recommend a product that is sub-advised by many hedgefund managers as the risk is spread and they are effectively offering amulti-strategy hedge fund to a retail audience.”— Asset Manager
  • 85. Rise of Liquid Alternatives Survey | 86Whether a hedge fund manager that opts to sub-advise in the publically offered fund space can achievethe type of success Marketfield has demonstratedor whether it chooses to accept fewer assets forless access, it is clear that the sub-advisory pathoutlined by path 2 in the trifurcation zone offers asignificant opportunity for a manager to grow assetsand diversify income streams outside of their privatefund products.We expect that the majority of the 360 hedge funds$1.0 billion AUM will be approached to sub-advisemutual fund products being constructed by the fundof funds, private equity and large asset managers,and this year we are already seeing a strongpipeline of products coming to market. One ofthe most anticipated launches is the BlackstoneAlternative Multi-Manager Fund (BAMMF), whichis expected to launch in June of this year, with thesub-advisers not yet finalized but eagerly awaited.These new multi- and single-manager funds will likelycome to market more quickly for the more liquidhedge fund strategies focused on equities,commodities and global macro investment themes.We are seeing the fixed-income, relative-valuestrategies emerge, and within the boundaries beingexplored, we predict that the majority of the inboundflows will be in liquid alternatives.Path 3: The Final Path Sees the Emergenceof the Alternative Asset ManagersA small universe of now very large hedge fundmanagers have fully crossed the line between privateand public and broadened their businesses to become“alternative asset managers”. These firms originatedas hedge funds, but have developed distinct productsand distribution strategies that are designed to appealto a much broader audience of investors and now lookvery similar to that of the traditional asset managerorganizations. Their split of capital between privatelyoffered versus publically offered funds comes muchcloser to being 50/50 than to the 15/85 noted witheven the most successful traditional asset managers.These firms are therefore competing directly with theasset managers and the large private equity firmsdiscussed in Section IX.Since these firms have developed publically offeredfund vehicles alongside their private hedge fundofferings, they are already out marketing themselvesto retail investors, and although these managerscannot discuss their private fund performance,they can talk about their firm and their investmentprocess and how this informs the creation of theirpublically offered fund vehicles. This is helping tocreate a certain brand appeal and perception ofexpertise around these firms that many traditionalasset managers are hard pressed to match. It is alsogiving these firms a first mover’s advantage overtheir peers in the traditional hedge fund universe thathave stayed solely in the privately offered fund spaceawaiting clarification on JOBS Act rules-makingbefore launching any brand-building campaigns oftheir own.AQR is one of the standout alternative asset managersthat have successfully created both traditional andalternative mutual funds. It is recognized as a pioneerin product innovation, having established the model ofscaling back signals to create different fund vehicleswith different risk/return profiles. It has, however,chosen initially to distribute its publically offeredfunds only to institutional investors or throughfinancial advisors, and does not allow direct retailaccess. Nevertheless, it has been able to increaseits assets more than four-fold since 2009, and it hasestablished its brand in advance of the wave of retailcapital we are predicting.There is likely to be another handful of large hedgefund firms that grow organically out of the privatelyoffered fund space to compete more directly withtraditional asset managers, and there could be more“ Wecomefrom ahedge funds backgroundversus someofourcompetitors.Long-only managers entering the alternative market now is difficult.They need to have alpha generators within the firm to create theproduct around.”— $10 Billion AUM Hedge Fund“ We think the more established firms with brand recognition includingthe biggest mutual fund providers with be successful in launching retailalternative funds, not boutique firms.”— $10 Billion AUM Hedge Fund“ Our retail alternatives push is a bright spot on our firm’s platform.We raised $1bn in 2012 for alternative registered funds from ourvarious strategies. With the existing hedge fund teams, we justchanged the portfolio characteristics, models and signals to fit into‘40 Act requirements.”— $10 Billion AUM Hedge Fund“ The ‘40 Act risk parity products are growing extremely fast with AQRleading the way. They got out early and are gaining market share quickly.We expect Bridgewater to follow suit and file for a ‘40 Act product soon.”— Asset Manager
  • 86. Rise of Liquid Alternatives Survey | 87mergers along the lines of BlackRock/BGI that createa similar profile alternative asset management firm.BlackRock has a broad platform of portfolio managersand fund strategies, and can therefore choose topackage a variety of different products for a broadinvestor audience. Their DNA as a hedge fund, andtheir significant brand value, put them in a categorywith AQR that is likely to be very compelling to theretail distribution channels and end retail investor.Unlike those traditional asset manager firms thathave had to fill credibility gaps to extend theirproducts into hedge funds, these alternative assetmanagers, hailing from the traditional hedge fundspace, will have a unique marketing angle that shouldposition them well in pursuit of the $1.3 trillion inliquid alternatives we highlighted in Section VI andpotentially for the broader pool of actively managedlong-only assets.The new pathway for hedge fund managers thatwe have introduced in the 2013 outlook survey, andthe trifurcation argument about a firm’s strategicdevelopment, marks a watershed moment in thestory of the development of the private and publicfunds industries in both the largest market in theworld— the U.S.— and its counterparts in Europeand Asia.The crossing of the line between private and publichas been the result of numerous economic boom-and-bust cycles and their related regulatory responses,and we are now seeing the removal of barriers thathave existed since the early stage development ofthe securities and investment funds industries in the1940s. It was clear from our interview and analysisthat the opportunity for hedge fund talent and hedgefund managers is significant, and the pathways andhurdles need to be evaluated and understood.ConclusionAs we examine shifts in the hedge fund industry’sevolution through these annual surveys, we typicallypick up on nuanced changes that happen graduallyover time. These reports attempt to be forward-looking and consider where the industry is headedbased on where it’s been and how participants viewcurrent challenges and opportunities. Occasionally,our line of inquiry uncovers an abrupt and moredisruptive shift. Such was the case with thisyear’s report.Interest in understanding the dynamics andmechanics of the liquid alternatives space, invitationsto sub-advise publically offered funds, acquisitions orpartnerships between traditional asset managementand private equity firms of hedge fund teams andfund of hedge fund talent, announcements about newlaunches offering access to a widening set of well-recognized hedge fund names and debate about theappeal and potential performance of these productsthat use a sub-set of skills pursued in privately offeredfund structures, were all happening in real- time anddiscussed in nearly every interview we conducted.In dissecting the root causes of this surging interest,we were able to recognize many trends that havecome together in the post-GFC world. That analysisformed the basis of this report and foundation for ourforecasts on how the total alternative pie and relativeshare of publically offered and privately offered fundAUM is likely to grow.Citi Prime Finance is committed to helping ourclients understand these unfolding dynamics andmake necessary changes to their own organizationsto be best positioned to take advantage of theemerging trends.A detailed overview of the sub-advised mutual fundproducts is being published as Citi Prime Financeprimer in Q2 2013 and is available by contactingprime.advisory@citi.com“ We have looked closely at Alternative 40 Act funds and we think therewill be growth in the 40 Act market. The growth will take away assetsfrom mutual funds and not from traditional alternative allocations,”— Multi-family Office“ Smart hedge fund managers should look at creating product forretail distribution. If the strategy is not capacity constrained, theyshould consider creating all versions of their fund including 150/50,UCITS, etc,” — $10 Billion AUM Hedge Fund“ AQR did a great job differentiating their customer base between their2/20 product and ’40 Act offering. Being quantitative shop, their corebusiness was set up to grow regulated product. They essentially tookthe flagship fund, decreased leverage and increased liquidity to createa ’40 Act offering with lower fees. From a scaling perspective, this fundwould still be quite profitable. Even with low expense ratios, when youfactor in the assets being raised they are still collecting similar feescompared to their hedged product.”— Morningstar Alternatives Research Team
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