When I started, hedge funds were leveraged. Now they are hedged. In the past, managers were traders from brokerage houses; today, they have MBAs. They were willing to bet the ranch and investors were willing to tolerate a drawdown of anything up to a third of NAV. No investor today would tolerate anything like that level of volatility.”

These are the recollections of the late Georges Karlweis, the legendary Edmond de Rothschild banker who gave George Soros’s Quantum its start, and who founded one of the early FoHFs, Leveraged Capital Holdings.

“Investors understood that their managers were taking risks. [During an] exceptional crisis, I remember one manager [turning their] 400 long currency, gold and stocks into the equivalent short position,” Karlweis recalled.

“Today, I still own hedge funds, but I have reduced my return objectives… quite dramatically.”

Karlweis was retired in the Bahamas when he gave HFM InvestHedge this somewhat melancholy interview in 2002, reflecting on what had changed since he started out in the 1960s. His descriptions don’t seem radically out of place today.

Of course, plenty has changed in the last 20 years, from the underlying investor base and due diligence practices to strategy appetite and the way investors engage with hedge funds.

In 1998, family offices and HNWIs made up almost two-thirds of the industry’s assets globally, while FoHFs made up another 24%.

Far less concerned about month-to-month liquidity and volatility, the nimble HNWIs and entrepreneurial family offices were an ideal match for Europe’s fledgling managers, who were, in Karlweis’s words, willing to “bet the ranch”.

An HFM InvestHedge survey in May 2002 of nearly 50 managers, of which 21 were European, revealed that pension funds and insurance companies accounted for only 4% of small start-ups, 5% of medium-sized funds and 12% of larger, hard-closed funds.

Even when institutional investors made larger forays into hedge funds, they did so mostly through FoHFs.

An early mover in the UK was the Railways Pension Scheme, which started exploring the space in 2001.

The then-$30bn scheme didn’t deploy any capital until 2004, when it split a $1bn mandate between US groups Blackstone, the Rock Creek Group and Grosvenor Capital Management. Investment director Brendan Reville explained at the time that they selected US firms simply because there was more choice, and because European FoHFs were not as mature.

The road to transparency
The financial crisis and the years that ensued were seminal for European hedge funds and their investors.

The scale of Bernie Madoff’s $65bn fraud was revealed and its impact was far-reaching, explains Kevin Gundle, CEO of Aurum Research.

“Madoff really put a shot across most investors’ bows even if they did not have exposure to Madoff (which was the majority). There was a sense that there was a risk that they could become contaminated by an industry that clearly had problems.”

Following that and other crisis-related revelations around redemption terms and side pockets, investors realised that much more focus on operational due diligence was needed, ushering in expanded roles for specialist and generalist consultants.

That also coincided with the start of a continued contraction among FoHFs.

Many larger institutional investors making their hedge fund debuts after the crisis bypassed FoHFs in favour of making direct allocations with the help of consultants, including the UK’s pension fund for Royal Mail postal workers.

“If you look back perhaps 10 to 15 years, most UK pension schemes that bothered investing in hedge funds, which wasn’t many, used FoHFs and of course with that, they were paying an extra layer of fees,” explains CIO Ian McKnight.

He says the board considered fees, transparency and liquidity and concluded that making direct investments was preferable, with the caveat that internal governance needed to be robust to manage a portfolio well.
“We wanted low correlations to equity, credit or anything else we held in our return-seeking assets and [the portfolio] to have low volatility, which hedge funds should be and generally are. We wanted to get away from this perception that [hedge funds] are all very risky investments.

On the internal governance front, Royal Mail hired Bev Durston, the former head of alternative investments at British Airways Pensions, to lead its implementation in 2013.

They initially split $100m between Halcyon Asset Management, MKP Capital, Swiss commodity specialist Krom River, Elementum and Pacific Alliance Asia Opportunity Fund. Krom was dropped the following year, with Brevan Howard, Och-Ziff and Taconic Capital Advisors added instead.

Today, the hedge fund portfolio of the £10bn-plus pension fund is worth just under $500m, although that could double over the next few years, McKnight says. Brevan Howard remains the only European manager on the roster.

“We’re not bothered where [managers] are based, if they’ve got the characteristics we want and the opportunity set is better, it’s more [about] looking at whether it’s an event or macro or commodity hedge fund, that’s a more important decision in terms of relative difference than exactly where they are running that strategy,” he says.

Other institutional allocators agree.

“We have a mixture of managers and strategies, we don’t select by geography,” explains Claudia Stanghellini, head of external management at SEK 351.1bn ($39.5bn) Swedish pension fund AP3, although she adds that they find managers in Europe and the US to be more institutional and able to cater to its needs than Asian ones.

“We started our portfolio in 2007 with exposures to CTA and macro managers, gradually building a more diversified portfolio, with long/short equity, long/short credit, event-driven and emerging markets strategies.”

AP3 had exposure to some 20 managers at its peak but reduced this significantly over the last few years as performance has been disappointing, Stanghellini explains.

Looking for liquidity
The demand for greater liquidity has been especially prevalent in Europe – a hangover from the financial crisis – and the move to further regulating the industry has led to an influx of onshore products in the form of Ucits.

Alternative Ucits funds managed less than €20bn in 2003, when Ucits III was enacted. Assets crossed the €100bn mark in 2012, grew to some €350bn by 2016 and as of 30 November 2018, stood at €426bn ($487bn), according to data from Morningstar and Deutsche Bank.

Many blue-chip managers have been leading this trend, including Marshall Wace, Aspect and IPM, although not everyone views it as positive.

“Many investors, from a compliance and regulatory standpoint, are compelled to buy Ucits. I think the tax framework has made it more difficult to potentially own offshore funds,” Aurum Research’s Gundle says.
He adds: “The essence of what hedge funds are all about is an unconstrained approach to investing and as soon as you put constraints [on that], you diminish outcomes and opportunities.”

Another trend that has characterised the industry over the last few years is alternative risk premia.

Seeking to provide systematic exposure to various risk premia that have an academic, economic or behavioural rationale underpinning expected returns, these strategies have been a blessing and a curse for managers, who need to weigh up the investor diversification and asset-raising benefits against the threat of cannibalisation and overall lowering of fees.

An additional consequence is that simpler, cheaper, more liquid products increase the pressure on managers to demonstrate that their high-octane, higher-fee products can deliver the alpha they promise.

“There was kind of a feeling that hedge funds had some sort of magic in the past, whereas now the growth of alternative risk premia has shone a torch on some of the things that hedge funds were doing that were inherently capturing a risk premium out there,” says Robert Howie, a principal in Mercer’s hedge fund team.

The convergence between mainstream and alternative has seen long-only firms launch hedge fund-like products and hedge fund giants such as Man Group and Lansdowne become equally well-known for their long-only offerings.

Roy Kuo, head of alternatives at the Church Commissioners, which managers the Church of England’s £8.3bn endowment, argues that many investors are better off investing in risk premia products than traditional hedge funds due to the limited alpha generated by the latter compared to their costs, but he cautions that implementation needs to improve significantly to be effective.

“If you do [alternative beta] as a dedicated allocation you will underperform everything, you need to do it as an overlay on your existing holdings.

He suggests this is one area where allocators in Europe can learn from their US counterparts.

The European hedge fund industry has undergone a remarkable transformation over the last 20 years.

The next two decades will no doubt bring about more change, which managers and allocators will have to adapt to and embrace.

A version of this piece was first published in a special 20th anniversary edition of EuroHedge. The full report can be found here.

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