The figures speak for themselves. Standard Life’s Absolute Return Strategies Fund has raked in over $8 billion now (and is thought to be the second largest UK retail fund overall), while BlackRock’s UK Absolute Alpha fund has just over $3 billion. These are not numbers to be sniffed at.
For managers currently seeking to raise money in the UK, this will provide pause for thought. Some firms will no doubt write retail distribution off automatically; a small boutique is not set up to manage a large retail distribution operation, but then again, is a small boutique ready for the UCITS jungle? For the larger firm, perhaps a multi-manager business with a generous slice of onshore and offshore institutional assets, UCITS may now offer the opportunity to look more closely at the UK retail market.
A changing market for hedge funds?
Deutsche Bank’s recent UCITS III Absolute Return Investment Survey found funds of funds accounting for over 50% of its responses in the UK, followed by wealth managers (17.1%), private banks (8.6%), and investment consultants (7.1%). The UK has seen the most asset flows into UCITS III absolute return funds in the last 18 months, unsurprisingly as it still functions as the fund of funds hub for the European market. Deutsche also pointed to the tax benefits for UK investors, which it said might be a driver behind future allocations.
Due to changes in regulation and the impact of the FSA’s Retail Distribution Review in 2006, Deutsche’s Jonathan Kent, a director in the bank’s ICG sales group, says IFAs in the UK will increasingly pass investment management mandates to UK-based wealth managers. “This allows an IFA to focus on the provision of a wider range of financial services to an individual and passing the risk and responsibility for investment management to specialist wealth managers,” he says.
Currently, however, less than 2% of the total UCITS investment universe polled by Deutsche would describe themselves as an IFA, although nearly 50% of total respondents said they invested on behalf of retail clients. There is plenty of scope for growth here.
“UCITS represents an opportunity to widen distribution, but at the same time you still need to generate alpha,” says Luke Reeves, a director with Matrix Group in London. “You need to be able to show the market that you have very good quality managers running funds that are hard to replicate. In specialised areas, I think absolute return funds will have appeal.”
Matrix has already launched two UCITS hedge funds for which it is raising money in the UK, namely the Matrix Asia Fund, a long/short equity fund managed by Rupert Foster, and the Lazard Credit Opportunities Fund, a multi-strategy vehicle managed by Sean Reynolds. Matrix is prepared to consider other third party funds for its UCITS platform, funds which would have access to its distribution network as well, but Reeves is at pains to emphasise that successful candidates must meet its tough selection criteria.
Multi-manager funds
Blacksquare Capital has been one of the first firms to take a fund of funds strategy into the UK retail space. It has done this by launching a UK Open Ended Investment Company (OEIC) as opposed to the usual Luxembourg SICAV, and pursuing an ultra-conservative strategy when choosing managers for the fund.
According to Brian Raven, a partner at Blacksquare Capital, part of the process has involved travelling the length and breadth of the UK, meeting IFAs and wealth managers, and educating them on the merits of the strategy. “We make it very clear what we can invest in,” he says. “We give them full disclosure every month.”
The fund is available on a number of the main platforms used by UK IFAs to buy and sell funds for their clients, amongst them those offered by Hargreaves Lansdown, James Hay, Nucleus and Ascentric. Procuring a listing on one of these platforms for a hedge fund vehicle is no mean feat, and Raven accepts that the first launch has been “a long and painful” process. Results have varied between platforms, but they have brought in the business.
Blacksquare launched its original product, the IFSR Blacksquare Diversified Absolute Return Fund, as a UCITS for the UK retail market last summer. Since then it has added a second multi-manager fund, the IFSR Multi-manager Absolute Return Fund. Interestingly, while there is no performance fee being levied, there is a 5% ‘front end’ fee which is still the norm for the retail funds market.
“Investment banks have no interest in helping hedge funds to access the retail market,” Raven explains. “Yet IFAs find our fund a very compelling story. We have been talking to the investment directors of IFA communities throughout the country, and we find that they want a turn key solution at the portfolio level. We can deliver this to them in a highly regulated, compliant structure. But we’ve had to earn our stripes. We’ve had literally hundreds of meetings across the country.”
While it takes time to win acceptance to one of the IFA platforms, at the same time, retail investors do not spend six months mulling over whether to make an allocation. Those funds which find they have a large base of retail money will take less notice of the many small investments and redemptions: it will begin to seem like a more solid asset base.
“This is a market that builds over time,” says Luke Reeves at Matrix. “It has a snowball effect. Retail is a slow build – ultimately, you’re up against beta. The barriers to entry are big, and you will need plenty of strong support, particularly on the fund of funds side.”
Many long only funds of funds have been able to accumulate in excess of £1 billion in the UK retail sector, and there seems to be no real reason why a fund of UCITS hedge funds, with the right structure, can’t do the same. But brand still plays a big role. The larger funds in this space already have strong retail brands, and a solid range of long only products. This has to give them an edge against less well-known hedge fund names.
“It is the brands that people are familiar with that are succeeding,” says Julian Rogers-Coltman, CEO at Fleming Family & Partners Capital Management. “The brand counts: it has to. Performance is not everything.”
He sees hedge funds occupying the middle ground in the retail space, between passive, index-based funds like ETFs on the one hand, and the long only brigade on the other.
Education
Everyone interviewed for this article agreed that more education is required if the UK IFA sector is going to embrace UCITS hedge funds. Although hedge funds considering the retail distribution channel have been kicked around for some years now, the relatively low penetration, if Deutsche’s numbers are to be believed, points to a lack of traction with brokers.
It is also noticeable that successful distributors are not referring to their funds as ‘hedge’ funds per se, but rather as absolute return funds. They may meet the classical definition of a hedge fund, but the term is gradually being expunged from marketing literature in the retail space. Investors can understand the idea of managing a fund using cash as a benchmark, but they read about hedge funds being associated with high risk, controversial deals in the newspapers. The two pictures don’t match up. It is possible that hedge funds continue to suffer from reputational issues at the retail level, and the best way to address this is via a subtle ‘rebranding’ exercise.
Luke Reeves at Matrix sees the UK retail market splitting up into sophisticated and unsophisticated tiers, and feels there is still a strong role for funds of funds to play for investors with less than £10,000 to allocate to hedge funds. He emphasises the need for funds to provide stability, both in terms of returns and in terms of their ability to cope with a diverse dealer base. Fund managers who succeed in the retail space need to be able to demonstrate they have an edge, and that they are actively managing their fund. Whether it will be possible to sell some of the lower volatility, systematic, futures-based strategies into this space remains an open question, but their return profiles certainly seem to fit the bill. Helping the IFA explain them to investors is another challenge entirely.
Fees
One of the big concerns many hedge funds will have with the retail market is fees. Ultimately, a 2/20 fee structure will be a hard sell. At Blacksquare, the firm waived its performance fee in order to get traction with IFAs. “I don’t think you can justify it in this market,” says Raven.
At Matrix, Luke Reeves says he has seen little ‘push back’ on performance fees. He sees no reason why funds should not charge one, but warns that “if you’re going to charge a performance fee, you need to be able to back that up.”
The challenge, according to one third party marketer who asked not to be named, is how to compete against some of the more successful players out there that have already waived their performance fee. In addition, there is the ongoing risk of cannibalising offshore funds that are still charging one. “If you look at the UK market right now, you can see some big [hedge] funds that have succeeded on the strength of brand recognition and competitive pricing,” he notes. “In the wealth management market, the brand may not be as important, but size certainly is. There is a general sense that investors want to be with investment pedigree and longevity. Private banks want to see multi-fund shops and platforms with which they can sign a global distribution agreement.”
Conclusion
Blacksquare says it has no plans to market its fund outside the UK, despite its UCITS status. “This is a green field site,” explains Raven. “The percentage in model portfolios currently allocated to alternatives is virtually zero.” On top of that, thanks to their high profile in the retail sector, the Blacksquare fund is now attracting institutional interest, including from insurance companies that are liquidating portfolio allocations with stock exchange-listed hedge fund vehicles to go down the UCITS route.
The increasing scrutiny on new UCITS hedge fund launches by regulators could also have significant consequences for what can, and cannot, be offered in the retail segment. It is entirely possible that the more sophisticated strategies will be kept out of this sector by higher minimum investment levels.
The barriers to entry in the UK retail market are high, there is no doubt of that, and it is probably not the place for a start up to cut its teeth. But having said that, there are plenty of assets to go for. Success requires brand awareness, a decent product, and the performance to back it up. Those firms that have something new to offer this market may find that they can raise considerably more money than they thought at first. They just have to be prepared to travel beyond the M25 on a regular basis.
