We’ve heard a lot about the recent stellar rise in demand for the so-called ‘40 Act’ liquid alternatives funds in the US. Well, here is how the trend is playing out in Australia. Surprisingly, big super funds are beneficiaries.
According to David Saunders, the founder and managing director of K2 Advisors, an affiliate of Franklin Templeton Investments, there are two “guaranteed” forces impacting the trend in hedge funds: control over the investment vehicle and better liquidity.
There are other forces, too, such as fees, but those are being subsumed in the wave towards “liquid alts” by not only retail investors but, increasingly, big pension funds. In Australia, about 50% of K2’s A$4 billion under management has already been invested by institutional investors in the latest generation of hedge fund strategies from K2, providing daily liquidity and a multi-manager structure rather than the traditional fund of funds.
Sam Mann, who set up K2 in Australia in 2007 and remains the regional head of what is now FT (Franklin Templeton) Solutions, says his group has been “facilitating” institutional clients into the liquid alternatives space for a couple of years.
For a super fund, it is possible to get set in a multi-manager hedge fund strategy, with daily liquidity, for a total fee of not much more than 100bps. We have come a long way since the 2 and 20 strategies (2 per cent flat management fee, including underlying managers, and 20 per cent performance fee above a hurdle such as the cash rate) of traditional hedge funds of funds.
Saunders, who started K2 as a fund of hedge funds manager back in 1994, says the hedge fund world has bifurcated into the less-liquid opportunities brought about by post-GFC banking regulations, which account for about 20 per cent, and the liquid strategies driven by demand from retail investors, accounting for the other 80 per cent.
Given that most of K2’s US$10.4 billion under management is from institutional investors, the firm has built its latest generation of liquid strategies as institutional grade.
Apart from the lower-than-normal fee structure, the strategies are implemented through a managed fund under the control of the ultimate manager, in this case Franklin Templeton, which also provides trustee and associated protection. This has a lot of advantages over the funds being dispersed into various – typically 30-35 – underlying hedge funds.
One of the advantages is that the investor can get the same sort of strategy diversity with fewer managers. In K2’s case, the main global multi strategy fund has just 11 managers. “We own and control the fund,” Saunders says, “and we price the assets every night. The manager just splits its trades and we settle and clear them. We have our own independent administration and risk aggregation.”
With the bifurcation of hedge fund strategies into, roughly, 20 per cent illiquid and 80 per cent liquid, Saunders believes that the illiquid strategies, which still offer a lot of appeal for big super funds, should get a management fee premium. Their opportunity arises because of the major banks in most countries – probably to a lesser extent in Australia – vacating the middle-range loans market.
“There’s a huge opportunity for hedge fund managers to provide everything to that segment of the market that the banks used to do,” he says. “The cost of capital has gone up so much, because of Basle III and other regulations, that it has squashed their profitability.” Saunders believes there has been at least a hundred funds launched by hedge fund managers in the past couple of years to take advantage of this trend, and perhaps another hundred we don’t know about. “In five years time there will be all sorts of entities making loans which are mostly unlevered,” he says.
For the liquid part, which is growing rapidly, the big hedge fund managers have to participate from a business perspective if they want to continue to grow. The retail liquid alts market demands a total fee of 2 per cent or less, with no performance fee, otherwise it is difficult to get onto the major platforms.
“The next wave of untapped potential in the alternatives market, including private equity and others, is in retail. It’s a much bigger pool of money,” he says. It is also a more stable asset base for managers and provides them with diversification of clients for their business.
Putting some rough numbers to the state of the whole hedge fund world, Saunders says, only about 700 of the estimated 10,000 managers in the world control about 75 per cent of the US$3 trillion in current assets. There are about 200 big “allocators” of assets, such as global pension funds and sovereign wealth funds, and just 40-or-so global multi-asset managers, like Franklin Templeton, with retail distribution. An estimated $350 billion in retail money in liquid alts is predicted to jump to $1 trillion in the next two years.
If a hedge fund manager wants to be in the retail space it will probably have to go through one of those global multi-asset managers, because the cost of retail distribution is prohibitively high for all-but the biggest of firms. In the US, for instance, the big distributors, such as Morgan Stanley and Merrill Lynch have tens of thousands of sales agents, brokers and advisors.
And the final point in his argument concerning these “guaranteed” forces driving the market is performance. Last year, for the first time, many liquid alternatives funds outperformed their illiquid counterparts. Sure, it’s a survey of only one year, but it’s still an interesting development.
* Greg Bright is publisher of Investor Strategy News (Australia)