Reasons Why Investors Use Alternative Mutual Funds by Preqin
Alternative Mutual Funds – Introduction
The rise of liquid alternative products, such as UCITS and alternative mutual funds, have opened up the possibility of hedge fund investment for more than just the largest investors. These regulated products, with lower investment minimums and fees, have proved attractive to retail clients, and institutional investors and funds of hedge funds have shown an increasing interest in these products. In this section, we examine the current universe of hedge funds structured under the UCITS and ’40 act regimes, taking a closer look at the barriers to entry and the investors in these funds.
Overview of Liquid Alternative Funds
In recent years, there has been a proliferation of alternative routes into hedge funds, with new structures rising to prominence that offer investors greater liquidity and transparency with lower barriers to entry. In Europe, the UCITS structure has been a way for hedge funds to offer their hedge fund strategies to those investors looking to allocate to hedge funds through a more regulated and liquid product. Similarly, in the US, there has been significant growth in the number of hedge funds offered through a ’40 act mutual fund structure. In this section, we take a look at the demand for liquid alternatives and why they are attractive to investors.
Why Do Investors Allocate to Alternative Mutual Funds?
Preqin surveyed institutional investors with a current allocation to an alternative mutual fund or UCITS product in order to gain insight into their attitudes towards investing in liquid alternatives (Fig. 1). The majority of those interviewed (53%) cited increased liquidity as the leading reason for investing in hedge funds through a liquid alternative structure.
Looking at Fig. 2, we can see that both alternative mutual funds and UCITS funds grant their investors more frequent access to capital compared to traditional, commingled hedge funds, which makes them an attractive solution for investors that want frequent access to capital. Increased transparency (31%) and access to a regulated strategy (28%) are other leading reasons for investing in liquid alternatives.
Liquid alternative funds also have lower barriers to entry which make them accessible to a wide range of investors (Fig. 2). The minimum investment for alternative mutual funds is $190,000; the average hedge fund, on the other hand, requires a minimum investment that is fi ve times higher. UCITS funds have an average minimum investment size of $414,000. Nineteen percent of investors stated that they allocate to liquid alternatives as a lower-cost route into hedge fund investment (Fig. 1). Both UCITS and alternative mutual funds charge, on average, lower management fees than commingled hedge funds (Fig. 2). These traits have opened up the opportunity to invest in hedge funds to a wider audience of investors; in turn, those hedge fund managers that offer their strategies as liquid alternatives can grow assets across a broad spectrum of allocators.
Investors in Alternative Mutual Funds
Fig. 3 shows that fund of hedge funds managers make up the largest proportion of investors with an allocation to alternative mutual funds (62%) and UCITS hedge funds (48%). Fund of hedge funds managers were among the earliest adopters of these products, and many have begun to use liquid alternatives as part of their wider hedge fund investments. Asset managers and wealth managers account for 12% and 11% respectively of investors allocating to UCITS funds; the liquid, transparent and familiar structure meets the needs of the clients these asset managers and wealth managers serve, and these groups play a significant role in channelling capital into liquid alternatives. In the US, foundations have a signifi cant interest in alternative mutual funds: 13% of all alternative mutual fund investors tracked by Preqin are in this group.
Liquid Alternative Mutual Funds Launches
Alternative mutual funds have seen a rise in prominence over the past few years, as shown in Fig. 5. 2014 saw the highest number of alternative mutual fund launches on record; it is likely the final number of alternative mutual funds launched in 2014 will be even higher than this, as more data becomes available in the first half of 2015. This illustrates that fund managers are increasingly looking to diversify their product line-up to meet the demands of a growing audience of investors looking to gain access to hedge fund strategies. Undeniably, 2014 has witnessed the growth in significance of alternative mutual funds within the hedge fund industry, with the proportion of alternative mutual fund launches reaching the highest on record, at 7% of all hedge fund launches.
In contrast, there has been a decline in the number of UCITS-compliant hedge fund launches over the past few years (Fig. 4). Post-financial crisis, there was a surge in UCITS launches as fund managers responded to investor demands for liquid, regulated and transparent structures with new products that could meet these needs. This increase in the number of UCITS launches reached a peak in 2010, a year in which 152 new UCITS products came into market. In 2014, 64 hedge funds strategies offering a UCITS structure were launched; however, this number is expected to increase to around the same level as seen in 2013 and 2012, 90 and 92 respectively, as more data becomes available.
It is unsurprising, given the liquidity restrictions imposed on the structures, that liquid strategies, such as equity strategies and macro strategies, are dominating both the alternative mutual fund and UCITS landscape (Fig. 7 and Fig. 6, respectively). However, despite offering daily liquidity, a greater proportion of alternative mutual funds offer credit strategies than is seen among UCITS funds; in 2014, nearly a quarter of all alternative ’40 act fund launches had a credit focus, compared to just 9% of UCITS.
Performance of Alternative Mutual Funds
As regulated products, liquid alternatives are subject to restrictions on the instruments and leverage that fund managers can employ, which limits the implementation of the full hedge fund strategy. As a result, these products tend to produce lower returns, with lower volatility than their commingled hedge fund counterparts (Fig. 10) In 2014, UCITS hedge funds were unable to avoid the difficulties affecting the broader hedge fund industry, posting 1.45% for the year. This was more than five percentage points down on the gains posted in 2013 (+6.82%). Q4 proved to be the worst quarter for UCITS funds, with a slight gain in November failing to offset the marginal declines seen in October and December (Fig. 8).
In the alternative mutual fund space, Q3 proved the most testing, with a loss in July followed by a decline in September, representing the worst month for alternative mutual funds in over a year. Despite the performance in 2014 failing to match the double-digit return generated in the same period last year, the Alternative Mutual Fund benchmark beat the Preqin All-Strategies Hedge Fund benchmark in 2014 (Fig. 9).
Despite the disappointing performance in 2014, UCITS-compliant hedge funds and alternative mutual funds continue to demonstrate their ability to consistently deliver absolute returns over the longer term. Annualized gains of 3-5% were posted by UCITS hedge funds over the two-, three- and fi ve-year periods to the end of 2014. Although more volatile (Fig. 8), alternative mutual funds have delivered higher returns in the region of 6-8% over the same periods (Fig. 9).
Alternative Mutual Funds Outlook
As more investors look to diversify their portfolios by investing in hedge fund strategies, there has been a proliferation of alternative structures to the offshore commingled product to allow these investors access to the asset class. The US mutual fund structure and European UCITS structure have allowed fund managers to replicate their strategies in a transparent, liquid, regulated and familiar structure, which can appeal to both retail clients and, increasingly, institutional investors. Although the limitations on the strategy may impact the ability of liquid alternatives to deliver the same level of performance as hedge funds, the lower volatility and barriers to entry will continue to appeal to investors seeking alternative investments which can deliver consistent, risk-adjusted returns. For fund managers looking to strengthen their product offerings and appeal to a broader group of investors, the growing interest in these products from a large range of investors may lead to inflows in 2015.