Monday, October 30, 2006

Private banking savours a vintage era

Private banking has enjoyed a renaissance in the last few years. The rich have indeed been getting richer, thanks to resurgent economic growth worldwide, but also due to unprecedented demographic changes. The implications for wealth management businesses are far reaching and long term. Caroline Allen talked to businesses targeting different points on the wealth spectrum.
Private banking is buzzing. The industry is flourishing with quiet confidence, and a widening range of players want a part of it. Brokers, asset managers, tax and legal advisors, consultants and niche managers are all hoping to appeal to the rising number of wealthy worldwide.

"The industry is maturing, like a great wine," says Jeremy Marshall, CEO of Credit Suisse's private banking business in the UK. It is not a business that can deliver rapid results, but those players with a strong brand are about to enjoy a vintage generation. "The business is coming onshore, from its historical position offshore, and that means more transparency. It's also becoming more professional, and that is an excellent trend. No-one thinks anymore that it's about securing opera tickets for a client, or walking their dog. It is about delivering professional advice and solutions to your clients."

Surveys shows that high net worth individuals' assets have been growing at around 6% annually, against global economic growth of 3%. On top of that, the largest inter-generational transfer of wealth in history is underway. The post World War Two Baby Boomers are handing on to Generation Y, the healthiest, wealthiest and most demanding age set ever to inherit.

The attraction of private banking goes well beyond its exclusive cachet, although that remains. Notes Marshall, who has clocked up 20 years in the business: "Analysts are finally starting to realize just how valuable private banking franchises are, and how the revenue stream is considerably less volatile than investment banking, and therefore highly valued."

Pierre Mathé, global head of private banking at Société Générale, set about building a global franchise from 1998. The rapid growth of SG Private Banking is based on the implementation in every entity of a client centric business model supported by a strong financial planning expertise and a wide range of innovative products in a full open architecture environment. To appreciate the results of this strategy, Pierre Mathé identifies three critical factors: growth of net new assets under management, gross margins and a flawless client retention rate


So popular has the sector become the terms private banking, asset management, and wealth management are being used interchangeably as units re-brand to try to secure market share. For Eric Barnett, MD of SG Hambro, part of Société Générale's SG Private Banking unit, that is an indication of the intense interest in the industry.

Barriers to entry have been relatively low, although they are now rising, and while a 200-year old 'brand patina' is nice to have, it is not essential if you can truly deliver, and meet the expectations of your new clients. "We are definitely a private bank, that is we provide banking services, in the wider context of wealth management. We think of asset management as focusing on institutions, while wealth managers serve individuals or private interests. It is still a very fragmented business worldwide, but we like that, it represents an opportunity."

In such buoyant times, M&A activity should be rife. There have been surges (notably when UBS started re-organising its subsidiaries in 2003). Each announcement came with claims that a shake-down would follow. But it hasn't, at least not in the way expected. SG's Mathé says: "Acquisitions in private banking are an extremely hazardous venture. Firstly, what you are buying is essentially goodwill, so you have to be sure you can retain that, and price it correctly. Then there is the question of cultures, and private banking has a very special one that doesn't work like investment or retail banking."

Joint ventures are another option, but as the market becomes more competitive, that is seen as a diluted offering, unless it opens a specialist market. Where acquired firms are left to get on with their business, they are the envy of banks which are not. Hugh Titcomb, chief executive officer at Ansbacher, now a fully owned subsidiary of Qatar National Bank, has felt free to build a strong franchise in a focused way. He calls it "getting properly organised" and in the process he has disposed of a clutch of marginal businesses, with which, however, he retains friendly connections.

Ansbacher, a 110-year old institution with roots in commercial banking, is using its shareholders' connections to grow its global network of clients. As leading Qatari figures expand their investments worldwide, Ansbacher is alongside them. The bank's other strong card is its presence in the superyacht market. Ansbacher provides the finance on craft worth $10 million-plus and through its subsidiary Sarnia Yachts, arranges corporate ownership, and registration services for the luxury yacht sector. This affords access to the kinds of clients many other players hope their occasional sports sponsorship deals might secure them.

Among those staking a claim in what several executives admit is something of a gold rush, there are stockbrokers like Brewin Dolphin, asset managers like GAM, Newton and Mercury, investment banks like Morgan Stanley and JPMorgan, and a scattering of boutiques. And there are also those offering support services for product providers.

SEI is one of the consultancies that has moved into that space. It has just announced a deal with HSBC Private Bank to provide a dedicated wealth management platform to handle customer relationship queries and to satisfy regulatory and reporting demands. "The sector is growing at a pace where traditional resources just can't keep up," says Brandan Sharett, senior vice president and managing director at SEI Global Private Banking. "The complexity of even existing clients' needs has grown as well. They are looking for more value-added investment advice."

He feels future winners among private banks must follow other parts of the financial services industry and institutionalise their back office operations. "There is a lot they have to stop doing. The client-facing part of the process is obviously critical, but they have to be best of breed in all fields – products, advice and infrastructure." He points to how brokers, masters in the customer relationship management universe, are already eroding private banks' share of wallet with systems that clients can access and monitor for themselves.

On the service side, he believes it is independent financial ad¬visers (IFAs) who are making the running. "This is about deciding if you are a manufacturer or a distributor. The IFA declares and commits. They are distributors. The conflict of interest issue is not going to go away. Look at the class action lawsuits in the US on pushing products, and the impact of MiFID (the EU's Markets in Financial Instruments Directive) here. Independence resonates with clients, but especially the younger generation, who are invariably far more knowledgeable investors."

Todd Ruppert, president and CEO of T Rowe Price Global Investment Services, makes a wider point about perpetuating a successful business model: "Private banking is a lot more than just investment management. We are not a private bank, but it applies as much to us as it does to the investment management part of a private bank.

"Asset management is first a profession, with a business wrapped round it. If you do not diligently and consistently focus first on those factors that will enable the profession to perpetuate itself, you set in motion the eventual loss, decay and possible destruction of the business. An integrity-driven organisation, rather than a distribution-driven organisation, is better placed to serve the profession."

Although the biggest players are global, Credit Suisse's Marshall points out that national distinctions remain, due mainly to varying tax and regulatory systems. However, where regulators are collaborating, there are significant implications in the long run for a more homogenous industry.

In Europe, MiFID is due to come onstream in early 2007 and according to most consultants, many firms are still largely unprepared. The stringent requirements suggest that only those with substantial resources are going to be able to meet all compliance demands.
Open architecture, a mantra in the industry, is widely considered to be the future. SG's Mathe warns: "The clients are wise to that now. We have funds research centres worldwide looking at funds, structured products and hedge funds. For instance, they have looked at 15,000 products this year and selected 340. Twenty of them were SG products. That is what open architecture is about."

Globally, there are clearly different business models. The big US banks' private banking operations are more linked to an equity and brokerage culture familiar at home, but they realise the value of the European approach. "The US does not have the sophistication and the brand recognition we see in Europe, they are very interested in how it is done," comments SEI's Sharrett. "But Europe has issues over implementation where they could learn from the US."
In the US, it is the most focused firms that are doing best. They know what type of client they want to appeal to, and they don't try to serve everyone in all fields. "Look at Wilmington Trust and Philadelphia-based Glenmead — they are clear and disciplined about their core competencies and how those fit into their business models," explains Sharrett.

Where, on the scale between the mass affluent client, who has a portfolio of maybe less than one million, and the family office, a mini institution running several hundred million, do you pitch your stand? Basic fees are undoubtedly higher at the lower end of the scale, and there is greater volume. At the top, there is relentless pressure on fees, and the client is typically far more demanding, not only in terms of more complex product, but service overall. Most private banks value a few well connected names on their client list, but realise that this strata may not be the most profitable.

"This is a critical strategic question, because wherever you choose to be, you better be able to provide the necessary service," says Heinrich Adami, managing director of Pictet. His target is mandates of five million upwards. The "million" always refers to investible assets. "If a small firm is highly specialised, it can probably survive. At the top end, the bigger the fortune, the more confined the number of private banks likely to be considered. Inbetween it is becoming extremely competitive. Mid-tier generalists without world class expertise are going to find it tough."

Private bankers are far too discreet to be rude about each other, but they make the point that clients should be certain they are not dealing with "a Ford Mondeo in a Jaguar skin". Some clients may set great store by the brand name, but from the business point of view, the bank needs to understand exactly what resources it has, to be able to deploy them best. Global banks with strong databases and low marginal costs will have a different proposition from a niche advisor.

The mid tier is precisely where a clutch of venerable British private banks now sit. Some still offer a doorman in top hat and tails to welcome gentlemen (few women attend). But what one executive called "banking artisanale" – firms with a craft, or handmade style - could be in danger of going the way of the quill pen. The new generation of clients is more likely to interact online. It is not that they are not interested, but they have better things to do than attend the office of their banker.

Segmenting clients by background as well as asset level is a new refinement (see accompanying story). While some firms might comb celebrity lists for stars of field or screen to add sparkle to their client list, the numbers look decidedly dowdy next to the pickings available right on bankers' doorsteps: their own colleagues. "With 3,000 people getting bonuses of £1 million-plus in the City of London last year, why do I want to trawl the Premier League for a few footballers?" comments one banker. Entrepreneurs are also on the private banker's A-List, especially if there is time to build a relationship before they make their fortune. Then there is the referral potential.

However, the days are gone when a good relationship would guarantee loyalty. "Clients have complicated needs and want more information faster than ever before," states Adami. "The key to retaining them is performance. With decent performance and a good relationship, you can hold the client. But with a good relationship and only average performance you are in danger of losing them."

SG's Mathé agrees: "You have to ensure there is no gap between the promise and the reality. This is when many clients experience a reality check. The presentations are flawless, the figures impressive. But consider an entrepreneur who might sell his business after 30 or 40 years, and the next year his private banker says, 'Sorry, we lost 10% of it'. This is no hedge fund manager who may do better next year. It's his life's work."

"He may even have said he accepts risk. But when it happens, it is no use pointing to the tick in the box. You are going to lose this client for sure, and he is not going to keep quiet about his disappointment. It is fine to show net new assets under management, but I want a 100% client retention rate. No names, but some of the more aggressive banks fail to address this point. Long term, a bad name is harder to reverse than a market dip."

In the drive for increased market share, capacity or expertise, leadership is critical, and few firms are above naked poaching. Among many recent executive moves, Barclays Wealth Management enticed Ian Ewart away from HSBC bank, while US-based Asset Management Advisors snared Maria Elena Lagomasimo, Michael Zeuner and Michael Holden from JPMorgan Private Bank.

Skilled client advisors command a premium. Banks declare they would rather invest in home-grown talent, but the fact is, in this fast growing market, there is not time enough, nor candidates to hand. "War for talent" is a phrase used by several executives interviewed, and it is no exaggeration.


"Banks are looking at universities, other professions, they are getting creative," notes Pictet's Adami. He lists the required attributes: "Advisors have to be technically impeccable and socially talented with a wide network. It is not enough to be a nice guy at the cocktail party. On the other hand, if you have a great technician who is unsociable, the client says 'The guy knows a lot, but I can't stand him'."

Both UBS and Credit Suisse now run their own wealth management academies, both in Singapore, where they are building their foundations for the wealth management region of the future. UBS anticipates training some 5,000 existing and future UBS Wealth Management staff between 2006 and 2010. Liquid assets held by individuals in Asia (excluding Japan) are projected to grow by 9.7% annually between 2005 and 2010, versus a corresponding global growth rate of less than 6%.

Although most big names have global reach, there is a lot to be said for a provincial profile as well. Notes Marshall at Credit Suisse: "There is a lot of money in many countries which is not seated in the capital. In the UK and Europe, Italy and Germany, in particular. These clients want to talk to someone from their local area, so you see some private banks expanding regional office networks."

The list of the world's biggest wealth managers is topped by UBS, consistently. By common consent, UBS spotted the fantastic opportunity in private banking years before anyone else, and went after it with a determination and a war chest no-one has even yet quite managed to match.
Meanwhile, even the biggest names in the business are battling a discreet brain drain as key advisors eschew the big corporate environment for the boutique. Everyone has seen it work for hedge funds, and private banking advisors are doing the same thing.

The management of external advisors is an art, one that appears to sit easier in the Swiss banking culture than the US one, where the big players don't take kindly to employees walking out with a set of client accounts. In theory, Continental Europeans insist the relationship just "evolves" and that in a thriving market, there is room for everyone. In practice, even the biggest players are nervous about allowing access to clients, or even their contact details.

"We try very hard to ensure that the client knows and feels they are dealing with the bank, not an individual," says Mathé. "But in fact a client list is not a golden key as such. If it was, you could buy mailing lists. It's the relationship that counts."

Artickle by the excellent Global Investment Magazine

Friday, October 20, 2006

Investors Guide To Hedge Funds

Hedge funds have historically lodged in a dark corner of the investment universe, where investors and regulators were happy to leave them. There they have rested, mostly in the investment portfolios of the wealthy clients of private banks as tools to preserve wealth.

But institutional investors - the big pension funds, local authorities, charities and university endowment funds - have become more interested in alternative investments. Falling markets have highlighted the benefits of funds that can pay positive returns regardless of what stock markets are doing, apparently with less volatility.

Fund managers, too, are seeking more flexibility in the way they invest, and have migrated in their hundreds to set up and run their own hedge funds. The number of hedge funds now exceeds 7,500, according to some estimates. And the amount of money invested has more than doubled since 1998 to more than USD 1 trillion.

The most developed market is in the US, where most managers are based. But more funds are being set up across Europe as demand has risen.

Regulators have always worried about the risks attached to these alternatives investments to traditional, onshore equity and bond funds. Hedge fund managers can take huge, unmonitored bets and cause funds to collapse entirely for no other reason than that the manager got his strategy wrong. These funds are unlike the funds that most investors are used to, they say.
But as the demand for alternative investments continues to grow, regulators and tax authorities are being forced to temper their antipathy. The rules governing hedge funds have changed out of all recognition in the last few years, and look set to change even faster over the next few years.

What are Hedge Funds?

Like mutual funds, hedge funds pool investors' money in the hope of paying a positive return. But they do it in a huge variety of ways. No two funds are alike and there is no precise or legal definition of what a hedge fund is. There are a few well-known giants, such as George Soros's Quantum fund. These funds account for a large percentage of the industry's assets - as much as half, by some accounts.

But the majority of hedge funds are designed to be small and nimble, run by a few people who outsource almost everything but the investment management to other banks, brokers and advisers. These funds have limited numbers of investors, who have faith that the manager has the skill to find value in out-of-the way investments that the big, onshore institutions miss.
In an attempt to come up with a blanket definition, hedge funds are often described as funds that use high levels of debt and derivatives to leverage returns, and go short - that is, buy or borrow stock to sell in the expectation that the price will drop and they can buy it back at a lower price. This gives them a unique tool to bet against falling markets. But not all funds go short or are highly leveraged.

A wider definition is that hedge funds are absolute return funds - they aim to pay out returns regardless of how markets have performed. The attraction to investors is that they shouldn't lose money when markets fall. However, not all absolute return funds are hedge funds.
Some authorities say that the best way to describe a hedge fund is to focus on what they are not - that is, regulated in the UK or other European Union jurisdictions, or in the US - other than in the sense that access is restricted.

Unlike mutual funds sold to ordinary investors in these jurisdictions, hedge funds are subject to very few regulatory controls. Of the 6,500 funds thought to exist, few are registered onshore or monitored by the onshore regulatory authorities.

Regulated funds have to have:

An identifiable investment objective;

A policy that ensures that changes to policy or objectives must be subject to investor approval;* An outside board of directors, trustee, auditor or administrator to monitor the fund and its managers frequently

Timely audited accounts;

A regular and detailed statement about the portfolio and big sales or purchases.

Regulators subject onshore funds to all kinds of rules barring them from activities such as going short, switching between asset classes or using debt and derivatives to leverage returns or bet against falling markets. Regulators in the UK have also until recently banned onshore funds from charging performance fees.

In contrast, performance fees are one of the characteristics of hedge funds. Typically hedge funds charge high fees of 1 to 2 per cent of assets up front, another 1 to 2 per cent of assets in annual management fees and then performance fees of about 20 per cent or more if assets grow by pre-determined amounts.

Another characteristic of the hedge fund industry is its attitude to risk. Hedge fund managers use techniques to isolate and analyse risk in ways that traditional fund managers are only just beginning to employ. This means that they can minimise risk while targeting double-digit returns.

During the last few years, they have gained a reputation for succeeding, even if not all have paid the high returns investors hoped for.

What are the different Hedge Fund Strategies?

Alfred Winslow Jones is said to have set up the first hedge fund. In 1949 he set up a private partnership that invested in equities, but also used leverage and short selling to "hedge" the portfolio's exposure to the movements of equity markets.

Jones's premise was that it was impossible to forecast the direction of the stock market with any consistency. His idea was to eliminate market risk, shifting the onus of the fund. He used borrowing to enhance returns, but took pains to hedge out the effect of market movements. Instead, he picked undervalued stocks, which he would buy, and overvalued stocks, which he would sell short. Shorting was a form or insurance, or hedge, against a drop in the market. Hence the term hedge fund.

Since Jones came up with the idea many more strategies have developed. These can be broadly classified as:

Market trend strategies

These exploit broad trends in, for example, currencies, commodities equities, interest rates. They include macro funds, which can take huge bets on currency movements based on the manager's view of a country's economic position. If, for example, the manager believes a country will have to devalue its currency, the fund will short the currency. These funds are notorious for being highly leveraged and high risk. Some macro funds are also called global asset allocators, because they take positions in any security. The most famous was George Soros's fund, which bet against sterling and the UK government and is credited with having forced the UK out of the European Exchange Rate Mechanism in 1992.

Long/short funds, which try to exploit anomalies in the value of securities, are also market trend strategies. Equity market neutral funds fall into this category. These funds will, for example, buy shares in one company that they think is under-priced, while matching their exposure by selling shares in another company in the same sector that they think are over-priced. The largest group of funds follows this strategy. Sometimes equity market neutral funds are called relative value funds. Market trend strategies also include other sectors, such as emerging market funds.

Event-driven funds

These try to exploit specific events, such as bankruptcies, mergers or takeovers. Into this class fall distressed securities funds. These take bets on companies going through reorganisation or bankruptcy. Risk/merger arbitrage funds are also event-driven, betting on pending takeover activity. They might buy stock in a company being bought, and short stock in the purchaser.

Arbitrage strategies

These exploit pricing inefficiencies and discrepancies between closely related securities that may be mis-priced, if only temporarily. These strategies are generally designed to be very low risk. Arbitrage is also an important feature, though, in event driven and long/short funds. Convertible arbitrage funds invest in convertible bonds, warrants and preference stock while shorting the ordinary shares. Fixed income arbitrage exploit small price inefficiencies in bonds. Similarly statistical arbitrage funds try to exploit pricing inefficiencies revealed through mathematical models.

Funds of Funds

Although the first fund of hedge funds is thought to have emerged in the late 1960s, this product has taken off recently. Recent estimates suggest that the 6,500 hedge funds now include 1,700 funds of hedge funds. Around 250 were launched in 2003 alone.

Funds of funds work on the basis that they spread risk. Rather than investing in individual securities a fund of hedge funds invests in several hedge funds. These funds are taking off in Europe. France, Ireland, Italy, Luxembourg and Sweden all now have domestically domiciled fund of hedge funds products with low (or no) investment threshold. The attraction for private investors is that the manager of the fund bears a significant responsibility for due diligence, while the broader spread of investments and strategies reduces the potential impact of the failure of a single fund.

For this reason, these are seen as more appropriate vehicles than single manager funds. Many jurisdictions, including the US and UK, allow funds of hedge funds to be sold to private investors more freely than single manager funds and many funds have much lower investment minimums than individual funds.

The investment case for investing in a fund of funds is that the managers are supposed to specialise in assessing hedge funds and have access to better information and to funds that are closed to private investors. The downside is that they charge a fee for this service, in addition to the fees charged by the underlying funds. This structure has given rise to criticisms that these funds add risk in order to raise returns to cover fees. Alternatively, they are criticised for diversifying returns so much that they become "cash minus fees" funds.

How can I buy a Hedge Fund?

Wealthy private investors have historically been the biggest holders of hedge funds, gaining access through their private banks. Many regulators are wary of giving ordinary private investors access to hedge funds and prohibit the way hedge funds are sold and distributed. In the US, for example, the Securities and Exchange Commission allows only "accredited" investors can invest in hedge funds. Eligible investors are often defined by the amount of money they can put in. Many regulators stipulate minimum investment thresholds. Italy, for example, has imposed an EUR 500,000 minimum investment.

Increasingly, providers have avoided the rules by developing derivative products that invest in hedge funds. In Europe, particularly in Germany, banks have issued certificates where the interest rate or amount repayable depended on the value of a portfolio of hedge funds.
In other jurisdictions, such as Ireland, firms offer funds of hedge funds packaged up as investment trust companies with listings on stock exchanges. The US also allows investors to buy shares in some SEC-registered funds of hedge funds as long as the funds subject themselves to the full regulatory scrutiny of the SEC.

In the UK, only funds authorised by the Financial Services Authority can be marketed publicly to investors, which bars single-manager funds from public offers. There is nothing to stop a UK investor choosing to invest in an offshore fund, but he or she will lose some of the protection offered by the financial services regulations, and may find it hard to get information because of the marketing prohibition.

UK investors can also buy funds through authorised intermediaries. Alternatively, a number of funds of hedge funds (which do not go short) are eligible to list on the London Stock Exchange as investment trusts. Investors can buy as little as one share in these trusts.

Changing Regulations

Each regime in Europe has developed its own regulation and tax laws reflecting its own culture. Most try to bar all but the wealthiest and most sophisticated private investors from buying shares or units in hedge funds, or limit investments to funds of hedge funds.

This is because regulators are concerned about the risks that hedge funds present to investors who are ignorant of their methods, and also because hedge funds are usually opaque. Regulators find it hard to tolerate the lack of disclosure prevalent among hedge funds.

Some jurisdictions, such as Finland, have established a more disclosure-based regime, setting a higher priority on managers telling investors exactly what they are doing rather than trying to regulate sales and protect investors.

The UK's Financial Services Authority, which has a statutory duty to protect consumers while also aiding the UK's financial services industry to innovate and to compete globally, has developed a different approach.

The FSA has put in place strong rules to protect private investors from buying unsuitable high-risk products. At the same time, the UK has applied a lighter-touch regulatory regime to hedge fund managers themselves, allowing them to operate from the UK as long as they don't try to sell their products to the public.

Partly because of this lighter regulation and partly as a reflection of London's dominance of the asset management industry generally, almost 70 per cent of European single-manager hedge funds are managed from London, even though neither single-manager funds nor funds of hedge funds can be domiciled in the UK.

A recent rush of regulatory changes around the world has prompted the FSA to consider more changes to its rules in order to maintain the UK's competitive position. It has proposed to introduce regulations allowing the establishment of a new class of onshore fund that would be allowed to use hedge fund techniques, such as gearing and derivatives. These funds would be, in effect, authorised hedge funds, but would be only available to institutional investors and sophisticated private investors.

Parallel tax changes are required before any such funds are likely to be established, and such changes have not yet been approved by the Treasury or the Inland Revenue (at Feb 9). Even before that happens, however, pressure is mounting on the FSA to consider whether the UK should introduce a form of onshore hedge fund that could be sold to ordinary investors.
This is a reflection of how quickly the industry is changing. In 2003, the FSA sounded out the fund management industry and concluded that there was no pressure and little need to change the rules on investors' access to hedge funds. It continues to worry about consumer protection.
But the Investment Management Association, which represents the UK's fund management institutions, recently admitted that it has reversed its thinking on retail access to hedge funds. Its members were concerned that they would lose out to other regimes if they could not offer hedge funds to UK investors.

Germany, which has historically been antipathetic to hedge fund structures, this year dismantled laws prohibiting foreign hedge funds distributing in Germany to retail and institutional clients.

It is allowing single manager funds to set up onshore. These funds cannot be sold publicly but there will be no minimum investment threshold. Germany is also permitting funds of hedge funds to be sold to ordinary private investors.

France, meanwhile, has begun to open the doors to hedge funds, making them eligible for investment for the first time.

European jurisdictions are competing to draw the lucrative and fast-growing hedge fund industry into the EU.

John Purvis, a member of the European parliament and vice president of its Economic and Monetary Affairs Committee, has pointed out that in 2001 the number of hedge funds managed in Europe was just 446, representing only 15 per cent of the global total of hedge fund assets. Purvis is pushing the European Commission to introduce a single EU-wide regulatory regime to accommodate sophisticated alternative vehicles, which will include hedge funds as well as property, currencies and commodities to be sold to sophisticated investors. His aim is to coax investors back onshore and into a more supervised environment.

Part and parcel of all these changes are changes to the rules on tax. Some EU states, including Germany, have begun to relax the prescriptive tax laws around which the industry is structured. But the quid pro quo for loosening the prohibitions is more information from these funds. Those funds that don't want to or can't improve disclosure, and don't want to market themselves to a wider investor base, are likely to remain offshore.

Hedge Fund Performance and Investment Risk

How do you judge whether a hedge fund is successful?

Unit trust managers and onshore fund managers, who largely invest in one asset class, such as shares, can be relatively easily measured against a weighted index of shares, such as the FTSE All Share.

In contrast, many hedge funds and "absolute return funds", which aim to make a positive return regardless of indices, claim they diversify portfolio risk away from the returns of a particular index by trading between asset classes, such as commodities, cash, bonds and equities - and use sophisticated instruments, such as derivatives and debt, to do it. The hard line approach to judging success or failure of an absolute fund is that if it makes money it is succeeding, if it isn't it has failed.

But as the hedge fund industry develops, it is clear that there is a market component in most, if not all, hedge fund strategies.

As a general rule, the greater the expected returns, the greater the fund's exposure to share and bond markets. Some strategies have a greater correlation to these markets than others. Returns on funds investing in distressed debt can be compared with fixed interest markets; long/short equity funds, which tend to show a bias to being long of shares over time, can be compared with the fortunes of stock markets.

In general hedge funds do seem to have performed better than stock markets and shown less volatility - the CSFB Tremont index, for example, shows that over the five years to the end of 2003 hedge funds returned nearly 10 per cent to investors against 4.6 per cent from the Dow Jones and -0.6 per cent from the S&P 500. At the same time the volatility - the extent to which returns deviate from the average - was half that of the S&P and Dow Jones.

But there are wide disparities in the returns and many strategies have moved more in line with markets than investors would have expected. What is more, observers fear that as more money flows into hedge funds, it will become more difficult for managers to gain an edge over their competitors and generate extraordinary returns. Some pension and fund performance consultants believe this may already be happening.

Figures from CSFB Tremont show that the average return from hedge funds was 3 per cent in 2002, when stock markets plummeted. This was still a positive return, but it will well below the 12 per cent or more absolute annual payout that most hedge funds aim for. Average returns including income in 2003 were markedly better - up 15 per cent. But stock markets also recovered. Total returns from the Dow Jones and S&P 500 both rose by more than 28 per cent. Returns from the FTSE 100 rose by just under 14 per cent.

Some studies have concluded that far from diversifying investors' exposures to stock markets, the correlation between hedge funds and stocks can increase during market declines.
Others argue that hedge fund returns have different risk-return characteristics from share-based funds and are more akin to derivatives. They do reduce the volatility of portfolio returns, and there is a body of evidence that suggests that if investors add a limited proportion of hedge funds - around 10 to 20 per cent - to their overall portfolios, they lower risk while enhancing returns.

However, investors should be prepared for more periods of negative or low returns than they may expect.

Hedge Fund Indices

A number of benchmarks have been developed over the past decade by organizations such as Hedge Fund Research (available on""). These are useful as ways for investors and fund of hedge fund managers to assess current and historical market trends and relative performance.

Only by comparing management styles and returns against some kind of broad market or sector benchmark can investors begin to understand whether returns are due to a manager's particular skill - as most hedge fund manager will claim - or to the market. Indices help investors to pinpoint what some of the key drivers behind performance might be. However, these indices do not provide investors with a foolproof method of gauging funds.

There are problems with the way some indices are set up - most only cover a sliver of the 6,500 hedge fund universe. Many funds don't give data and the information from those that do is often incomplete. In some cases, funds decide themselves which sector they should fit into.

Indices also show a bias to better performing funds that survive. This bias, which tends to raise the apparent rate of return, is true of any index. However, the rate of attrition in the hedge fund industry is high and rising. Just 60 per cent of the funds that were in business in 1996 were still trading in 2001. In 2002, 800 funds are thought to have closed.

During 2003, anecdotal evidence suggests that more funds fell out of the index. Some fall out voluntarily. In recent years some of the biggest and most successful funds have closed down and returned money to investors because the manager has retired or given up.

But most funds stop reporting because they have failed, and they have failed because they are too small and have performed badly.

The danger, according to some academics, is that by concentrating on surviving funds, indices are in danger of overstating returns by as much as 6 per cent a year, leading investors to overestimate the benefits of hedge funds.

Some hedge fund managers argue that it is pointless to categorise funds and compare them against an index. The essence of hedge funds is that they tap into the unusual flair of a few individuals in picking money-making opportunities.

Every fund does it differently, even funds in the same sector. Not only will the managers' styles vary, but there are also big differences in reported returns and fees.

Some say it is unrealistic to expect funds of funds to track indices, because indices suggest a flexibility that investors don't have in real life. Investors are unlikely to be able to access half the funds that make up an index because many are closed to new investors. Nor can they divest themselves of funds as quickly as private investors problems arise and funds fall out of an index.
Even so, indices remain the best tool that investors have to monitor and assess fund performance.


Much is made of the risks in hedge funds. Investor awareness was heightened by the spectacular failure of Long-term Capital Management, the $7bn fund set up in the US, which had to be rescued when a bet on bond markets backfired in 1998.

Since LTCM, the industry says gearing levels have been cut, that the risks in funds have declined, and that hedge funds have brought to the investment world a new awareness of risk. Indeed, the goal of many funds is to minimise risk by using sophisticated new techniques of mathematical modeling.

Investment Risk

Much effort is spent on defining where the risks to portfolio performance are, and how it affects returns. For example, how do stock market moves affect returns? Has the manager taken on too much debt? And has the manager factored in a global drop in interest rates or a worldwide event that triggers a flight to safer assets, such as US bonds?

Most investors concentrate on this kind of investment risk. But there are other forms of risk inherent in the way that funds are set up and run.

Manager Risk

The US regulator's big concern is that investors are trusting their money to unknown managers. Hedge funds have become a byword for making big returns, which has proved irresistible to both honourable and dishonourable managers.

The SEC has brought a number of fraud cases against hedge fund managers in recent years where the hedge funds lied to investors about the experience of managers and the fund's track record. Many gave the appearance of probity by paying good returns to early investors to make schemes look legitimate.

These cases have prompted the SEC to look hard at ways of making sure all hedge funds managers are registered with it. In the meantime it urges would-be investors to check schemes with it. If the managers have previous records for conning investors it may show up in its records. Investors can also check managers in the UK through the FSA.

Structural Risk

Other risks associated with fund structures are less likely to make the headlines than manager fraud, but can be more widespread.

Many hedge funds are small, focused operations that outsource many functions. Typically, in the case of a European hedge fund, investors' money is fed through an offshore vehicle - to minimise the tax liabilities for both the fund and the investor - to an investment adviser who sponsors or organises the fund. These advisers are often based in low-tax jurisdictions, such as the Cayman Islands. Many will then sub-contract management of the assets to a UK-based investment manager.

The fund will also employ a prime broker - a big investment house that may trade on the fund's behalf, lend stock enabling funds to go short, help to value the fund's trades and provide clearance and settlement services. The fund will also employ administrators who provide support services such as valuing assets and may be based in another EU jurisdiction, such as Dublin or Luxembourg.

In addition, hedge funds employ outside professional consultants, lawyers, accountants and systems managers.

These structures are complex, can add layers of costs, are hard to control and put investors at a considerable distance from the manager of their assets.

Valuation Risk

A growing concern is that outsourcing introduces uncertainties about the way that hedge funds value their assets. One of the biggest risks that any investor in a hedge fund faces is how to value what the manager is doing. Hedge funds are notoriously reluctant - and are under little regulatory obligation - to publish their holdings. LTCM, for example, did not disclose the details of its trades to outsiders because it had developed a highly-specialised proprietory strategy. Investors were also unaware of the level of gearing in the fund - as much as 100 times assets by the time it failed.

Yet valuation methods are integral to the success of any hedge fund. Strategies often revolve around backing small discrepancies in asset valuations with large amounts of money. If managers get the value wrong, the strategy fails.

Difficulties arise because valuing funds is by no means as straightforward as valuing assets in long-only onshore funds that buy shares in regulated stock exchanges at prices listed on an index.

Hedge fund managers deal frequently in thin and illiquid markets, where there is no public price for the assets and it is hard to buy or sell stock. They may add to the complexity by borrowing against these assets and shorting them. Others create synthetic instruments that are made up of a combination of inter-related trades.

Managers often give themselves significant discretion in valuing assets. Some value securities in non-publicly traded companies at cost, some at a suggested market value. Others will rely on administrators or their prime brokers to value trades on the fund's behalf. This can, in itself, create potential conflicts of interests among the brokers, say regulators.

For investors who are unprotected if something goes wrong, and who are unlikely to be able to sell their holdings in a fund quickly or easily, poor disclosure and uncertain valuations pose big risks.

It is important, says the SEC, to find out and understand how a fund's assets are valued, and to ensure that there is some kind of independent check.

Taxation of Hedge Funds

The success or failure of hedge funds rests on the way they are taxed. Many of the big jurisdictions in the EU tax the funds in ways that make it uneconomic to set up in Europe, which is why hedge funds go "offshore" to low-tax states where the tax rules are less onerous.
But this has implications for investors in these funds, depending on where they buy the funds and where they are taxed. Every state has a different set of rules governing the taxation of hedge funds and the investors who put their money in them.

The UK authorities currently categorise offshore funds as distributor and non-distributor funds or roll-up funds. Distributor funds must pay out 85 per cent of their annual income to investors to qualify, rather than allowing it to roll up. Roll-up funds, in contrast, don't pay an income but allow all gains to accumulate in the fund.

Distributor funds are taxed in the same way as UK unit trusts, with income tax due each year on income payments and capital gains tax on profits above the annual CGT allowance (£7,900 in 2003/4). With roll-up funds, there is no tax to pay until you cash in all or part of your holding, but any money you make is then liable to income tax.

Investor Protection

As one regulator describes it: "Investors aren't likely to make a fortune in a unit trust, but they are also unlikely to lose all their money. In contrast, the risks of investing in one hedge fund can veer from zero to infinity".

And, because these funds are not subject to onshore regulation, if it all goes wrong there is little chance that the authorities in your home schemes or compensation schemes set up to look after investors will be able to help.

It is vital, says the SEC, that investors do their homework - and they need to do more than they might for onshore investments. Investors should read the prospectus and any documents to do with a hedge fund carefully to ensure that the goals, time horizons and risks in the fund match their needs and risk-tolerance.

Investing in hedge funds requires a lot more effort from sensible investors than buying into an onshore regulated fund. Make sure you understand the way that the manager works and what strategies are being used.

Note that you may not be able to sell your investments when you want. Most funds set fixed times - say every three or even six months - when investors can buy or sell units in the fund. Some lock investors in for much longer.

Ask questions about fees, too. Fees make an impact on your returns and performance fees can motivate managers to take greater risks to achieve greater returns.

Above all, check out the manager, and don't put all your money in one fund.

Article by Hedge Week

Tuesday, October 17, 2006

The mystery of the vanishing tax payer

IT WAS not a pretty sight. In 1839, the roads of Wales were crowded with men wearing women’s clothes, in an obscure reference to a story from the Bible. By the time they were back in their usual attire, several turnpikes (tax collection points) had been demolished. During the following five years, these “Rebecca rioters”, as they became known, donned their frocks and smashed turnpikes many times, doing what most taxpayers before and since could only dream about. But now some governments are starting to worry that globalisation, spurred by the Internet, will do to their tax systems what those transvestite Taffies did to the turnpikes.

Like the boy who cried “wolf”, governments have raised the alarm about globalisation so often that their credibility is in doubt. For all the talk of footloose capital heading for low-tax countries, starting a “race to the bottom” in which governments slash taxes and services to lure global business, the taxman’s cut of world income is larger today than it has ever been. Yet in the story the wolf eventually did attack the sheep, and the boy’s shouts for help went unheeded. Is the same thing about to happen to the world’s governments?

It does not help that globalisation can mean many things to many people, but a minimum definition would probably include a diminishing role for national borders and the gradual fusing of separate national markets into a single global marketplace. The term “globalisation” was probably first coined in the 1980s, but the idea has been around for a long time. Indeed, by some measures the world was more globalised a century ago than it is now: certainly people were far likelier to emigrate to find work. After an anti-trade backlash in the 1920s and 30s, globalisation has been accelerating during the past three decades. And thanks to innovations in communications and transport that let people and capital travel at great speed, it is now moving into a different gear altogether.

As globalisation ebbed and flowed, the taxman’s share of economic output went relentlessly up, despite warnings from politicians that globalisation would make it harder for governments to collect taxes and thus to provide public services. But now a new factor has entered the equation: the Internet. It epitomises borderlessness, and the irrelevance of being in a particular physical location. By being everywhere and nowhere at once, it seems certain to speed up globalisation. And in doing so, according to the Organisation for Economic Co-operation and Development, it might damage tax systems so badly that it could “lead to governments being unable to meet the legitimate demands of their citizens for public services”.

Shopping around

The Internet age has dawned just as tax collectors are getting worried about another aspect of globalisation: tax competition. Both the European Union and the OECD have declared war on “harmful” low-tax policies used by some countries to attract international businesses and capital. The OECD says that tax competition is often a “beggar-thy-neighbour policy” which is already reducing government tax revenues, and will start to be reflected in the data during the next couple of years. The Internet has the potential to increase tax competition, not least by making it much easier for multinationals to shift their activities to low-tax regimes, such as Caribbean tax havens, that are physically a long way from their customers, but virtually are only a mouse-click away. Many more companies may be able to emulate Rupert Murdoch’s News Corporation, which has earned profits of £1.4 billion ($2.3 billion) in Britain since 1987 but paid no corporation tax there.

Taxpayers, too, may dematerialise. In a famous New Yorker magazine cartoon showing two dogs sitting in front of a computer screen, one tells the other: “On the Internet, nobody knows that you are a dog.” The ability to collect tax is contingent on knowing who is liable to pay it, but taxpayers may become increasingly hard to identify as anonymous electronic money and uncrackable encryption technology are developed.

As almost everybody knows, there are two ways of cutting your tax bill. Tax avoidance is doing what you can within the law. As a great American judge, Learned Hand, put it, “There is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich and poor; and all do right, for nobody owes any public duty to pay more than the law demands.” Tax evasion is what happens outside the law. There may be a thin line between the two, but in one sense it is a solid one: as Denis Healey, a former British chancellor, once put it, “The difference between tax avoidance and tax evasion is the thickness of a prison wall.” The Internet is likely to make it easier to break the law.

The second challenge the Internet raises for the taxman is its potential for intensifying tax competition between governments. Tax collection around the world is built on the belief that every nation-state has the right to decide for itself how much tax to collect from the people and businesses within its borders. Governments may be willing to pool their sovereignty by joining international bodies such as the UN, the IMF or the EU, but they cling to their right to set their own taxes. Even in what some see as the nascent EU superstate, member countries refuse to give up their control of direct taxation.

Competing visions

Many countries have bilateral tax treaties with other countries, mainly to avoid double taxation. But again the rules of such treaties assume that the nation-state is what counts: they merely determine which nation-state has priority where more than one country has a claim. Multinational companies complain that nationally based taxation inhibits them from operating as truly global businesses. But for governments, it makes sense to design tax systems that attract footloose wealth.
Tax competition raises three big questions which this survey will try to answer. First, is there really such a thing? Some pundits doubt that tax-cutting governments are indeed motivated by hopes of poaching economic activity from other countries. Yet, as we shall see, there is enough evidence to suggest that tax competition should be taken seriously, and that without intervention it will only get fiercer.
Second, can it be stopped? It will not be easy. Not many people will defend tax havens. But although they make fine whipping boys, tax havens simply do in a more extreme form what many “respectable” governments themselves increasingly indulge in.

Ireland opposes harmonising corporate tax rates in the EU because its low rates give it a competitive edge. Britain blocks an EU savings-tax directive because it might hurt the City of London. Luxembourg and Switzerland will not agree to share information with foreign tax authorities because people who want to cut their tax bills come to them looking for discretion. And America may well ask for a worldwide ban on new Internet taxes because as a net exporter of e-commerce it would be the biggest beneficiary.

Some policymakers think that a World Tax Organisation should take its place alongside institutions such as the UN, NATO, IMF, World Bank and World Trade Organisation (WTO). But tax nationalism is likely to ensure that this will not happen. The OECD lacks sufficient clout, especially over non-members. The EU has a better chance of curbing tax competition among its own members, both through its directives and through the European Court of Justice, which is steadily, if slowly, enforcing tax harmony in the name of the single European market. But any success the EU achieves internally may simply make it more vulnerable to tax competition from non-EU countries.

Third, is tax competition really so bad? The OECD thinks it could undermine democracy by stopping countries from pursuing the tax policies their voters want. Footloose capital is free-riding on less mobile taxpayers, getting the benefit of services provided by governments in higher-taxing countries while paying taxes in low-tax jurisdictions, if at all. The EU objects mainly to special tax treatment offered to some taxpayers but not others, on the ground that it interferes with the single market. Some EU governments also argue that tax competition makes it ever harder to tax mobile factors of production such as capital. Instead, they complain, they have to increase taxes on less mobile factors, notably labour, which may drive jobs away.

Charles Tiebout, an American economist, argued back in the 1950s that competition between governments can be as good for everybody concerned as competition in any other marketplace. Like companies, governments can compete by offering different combinations of public services and taxes; if people want bigger government and are happy to pay for it, they are free to choose it, just as some people choose a snazzier car, or fly business class. Tax competition will put pressure on governments to provide their services efficiently, but that need not mean they have to be minimal. There are limitations to this theory, notably Tiebout’s assumption that every taxpayer is mobile, and can vote with his feet. In reality, richer taxpayers tend to be more mobile than poorer ones. If tax competition becomes stronger, using the tax system to redistribute money from rich, mobile taxpayers to poor, less mobile ones may become worryingly hard. The Internet will make more people mobile, rendering the rest even more wretched.

- It may interest you to know that the article above was written in 2000, six years ago. Since then we are seeing a growing number of mobile entrepreneurs moving to jurisdictions in where tax is low. Business jets are becoming more affordable for the ‘low level rich’ and as a consequence we are seeing more and more rich tax payers using this freedom of movement to live overseas and work in the UK. Don’t believe me? Read the story of the ‘Monaco Boys’ that has been all over the British press recently.

They are exploiting the fact that the day you fly and the day you leave the UK do not count towards the 90 days you can spend in the UK without becoming resident for tax, so if you fly on your jet (owned or hired) on Monday morning from Nice to City airport and fly back to your residence in the principality on Friday you have only spent three days in the UK. This would give you thirty weeks of the year to work in London and not have to pay a penny in tax (Monaco is tax free).

Some may say that this is an affront to the decent tax payers in the UK, others would say it is shrewd tax planning. All I know, is that governments, especially somewhere like the UK which is hugely taxed, most indirectly through duty and VAT, should be very careful because as the technicalities of working overseas are made easier by technology, specifically the Internet and as the cost of travel decrease, it won’t just be the super rich who look to escape the clutches of the tax man.

Monday, October 09, 2006

What is 'quant' or 'algorithmic' trading

The word 'quant' or 'mathematics' as an approach to investing rarely causes any excitement, rather, it causes some investors to walk away and others to either fall asleep or at best raise their eyebrows. We do not think this is justified, as quant is not just bean counting. We believe that a quant approach to investment is superior to a traditional discretionary approach and to show this, we list some of the main advantages of quant.

- In a quant investment process, focus is on the scientific approach as strategies are researched and tested before they are implemented. Indeed, only empirically proven strategies should be given a chance in the real world. The longer the testing period, the better, as the empirical evidence becomes more reliable. Quantitative investment processes are often perceived as lacking human judgment. This, in fact, is not true as human judgment indeed plays a critical part during the model building stage. The main difference between a quant and a traditional manager therefore is in the timing and not the presence of the judgmental input. Intuition, experience and understanding are important in research but not a feature in implementation.

- This leads to another advantage of quant. The implementation is model driven and therefore emotionless. And we know well that emotions and trading don't mix well. In fact, emotions often cause behavioural price anomalies (such as overreaction) that can be exploited readily by quant models. At the same time quant models can trade more cheaply and more efficiently. In this area program trading and algorithms are already being recognised as adding value compared to a traditional discretionary approach and their penetration is now widespread amongst quants and non-quants alike.

- Better timeliness is achieved by being able computer processing power. In contrast, discretionary managers can hold a rather more limited number of 'ideas' to analyse new information more quickly and simultaneously for thousands of stocks due to ever improving at any one time.

- More accurate volatility targeting is provided by quants who would typically exploit a linear relationship between leverage and volatility. Discretionary managers would typically seek higher volatility through concentration but as this relationship with volatility is more complex (i.e. quadratic), volatility targeting is much more difficult. This yields better Sharpe ratios for quants and it also implies better and easier structuring of leverage and portable alpha products for institutional clients.

- A further advantage concerns growth of the business. Better assessment of capacity is achievable through simulations in an environment that is already designed and built on simulations.

- In addition, the same simulation friendly environment yields easier and better risk testing. Again this is no longer thought of as a quant only feature. Few discretionary managers will admit to not using quant at all for risk measurement. However risk measurement is one thing and risk management another -merely measuring the risks might not lead to any action even in the case of excessive and/or unfamiliar risk taking. As in the case of some investors who 'do not care about Sharpe Ratios' many discretionary managers may not care either: 'If I look after the return, then the risk looks after itself.'

For all these reasons we don't think that you have to be a quant to understand the advantages of quant. Hardly surprising then that many of the biggest and the best performing fund managers are quant.

Why should Quants improve with time?

Recently, there has been a tendency amongst hedge fund investors to pursue hot new managers. This is justified on the basis that managers are more exciting early on as they are hungrier for returns and that their competitive edge declines with time. This is presumably because managers expand too much and lose alpha as they get too big at the same time during which they lose their competitive edge. But the obvious problem is that in absence of hard evidence, selection needs to be made on 'gut feel' and other soft criteria such as reputation (often in a different field!!!) or following the herd.

Not surprisingly, such an approach is not likely to bear fruit for many. Often start ups have failed to perform to expectations and we are aware that in the recent days at least one multi billion dollar quant start up is closing down after not much longer than a year.

We are not surprised with the difficulty in picking early stage quants, as good quant managers are unlikely to do better earlier rather than later on for the simple reason that good models do not decline but improve with time. As more and more data becomes available, better calibration can be made of the existing models and new strategies can be added to the process. This includes models that rely on data that can only be obtained in real time, as no historical databases exist for it. Such models are often called 'the Insider Models' as they do not rely on publicly available information but the manager's own databases. And the more such data exists, the better. Furthermore, the stronger the investment process, the more it makes sense to increase return and volatility targets. This is what comes with time.

The message is clear - 'Past performance is not indicative of the future performance. In the case of a good quant, it should get better!' Ignore established and successful quants at your peril.