One of the most interesting trends in the London-listed investment company universe over the last few years has been the growth in the number of funds making full use of the benefits offered by the closed end structure. In doing so, investors have been provided with access to a diverse range of non-traditional asset classes including property, hedge funds and private equity investments.
The advantages of closed-end vehicles over their open-ended counterparts when it comes to investing in illiquid assets are clear: unit trusts/OEICs’ requirement to provide daily redemptions makes them less suitable for investing in property, for example. If homeowners were finding it difficult during the fallout from the banking crisis just over a year ago to sell their houses at what they considered a fair price, imagine trying to sell a whole office block, both in a timeframe short enough to satisfy those unit-holders wanting an exit and at a valuation high enough to avoid being damaging to other investors. Contrast that with a closed-end fund that’s able to avoid a fire sale and concentrate on managing the assets without the distraction of redemption requests.
In fairness, the comparison isn’t quite as straightforward as this, and many property unit trusts called a halt to redemptions when the market crashed to protect the interests of those unit-holders not rushing for the exit. But as such measures effectively made the funds closed-end for a period (yet without the benefit of liquidity offered by shares trading on an exchange), this is clearly one area in which closed-end vehicles were shown to have an advantage over open-ended funds. This is only part of the story (leverage being another) but, in Part I of this article, we take a closer look at the investment companies set up to invest in hedge funds. Part II will focus on other alternative asset classes, including property and private equity.
Hedge Funds
An Expanding Universe
The turn of the century was accompanied by the growing popularity of hedge funds, as investors scarred by losses started to seek out investments with less equity market correlation. Unfortunately, the opaque nature and high minimum investment sizes of most hedge funds meant that investing in them directly was often impractical for many.
The solution came from the London-listed investment company world. While the first London-listed fund of hedge funds was launched as far back as 1996, the sector only really started to take off in 2004. The attractions were evident: a closed-end fund could invest in a diversified portfolio of hedge funds and, having the resources and expertise to conduct rigorous due diligence, would hopefully minimise fund-specific or “blow-up” risk. Being listed on an exchange, shareholders of the fund could sell their shares at any time without having to pay the early redemption charges that would often be incurred if investing directly in hedge funds. Such charges and associated minimum investment periods (or “lock-up" periods) are what makes it so impractical for an open-ended fund to invest in hedge funds; the universe of potential funds would either have to be confined to those with no restrictions on investment periods or the fund would have to keep an unacceptably high level of cash to fund redemptions.
The sector’s market cap grew from just over £1 billion at the end of 2004 to over £9 billion at its peak in mid-2008, with the number of hedge fund share classes rising from 14 to 73 (many funds issued three share classes to broaden their appeal, typically in sterling, euros, and US dollars, with the returns hedged back into those currencies to avoid unwanted exchange rate risk).
Mixed Performance
So, how successful has the sector been? With such a diverse range of hedge funds strategies, it’s unsurprising that performance has been very much a mixed bag. Over the two years to the end of 2009, the best performing sterling share class was BHMacro on an NAV basis (+45.4%) and BlueCrest AllBlue on a Share Price basis (+51.7%). This same period, a highly volatile one in which you would expect hedge funds to step up to the plate, saw the FTSE 100 and the MSCI World Index fall -8.8% and -3.8% on a total return basis, respectively. What makes these two funds’ performances so impressive is that even on a risk-adjusted basis, they are comfortably superior to their peers with Sharpe Ratios (on NAV) of 1.3 for BH Macro and 2.3 for BlueCrest AllBlue.
At the other end of the scale, Saltus European Debt Strategies saw its share price knocked down by -51.7% and its NAV by -32%. If we widen our focus to single manager funds (i.e., listed hedge funds rather than listed funds of hedge funds), the worst performer becomes RAB Special Situations, which has had a torrid time over the two-year period in which its exposure to junior mining companies saw its share price fall by -77% and NAV by -72.2%. Losses in high profile shares such as Northern Rock can hardly have helped its cause.
Widening Discounts
The disparity between funds’ share price and NAV performance seen above is worth highlighting. From 2005 to mid-September 2008, the Morningstar London-listed Hedge Fund Index shows the sector traded at a pretty tight average discount of -0.7%, while the average for the broader London-listed fund index was -6.6%--the popularity of the sector was such that many funds were able to increase their asset base by secondary issuance of shares.
But then came the credit crunch. The fallout from the banking crisis and several issues specific to listed funds of hedge funds made for a very challenging time for the sector. As noted earlier, most of these funds had currency hedging in place to eliminate the volatility from exchange rates. However, large movements in currencies left many funds with cash liabilities on their hedges that they could only settle by taking on borrowings, resulting in funds becoming leveraged just when volatility was at its peak. Some funds were forced to suspend hedging entirely, making them far less attractive propositions for investors concerned about currency exposure. It’s often said that all assets become more correlated in a crisis and the hedge fund sector wasn’t immune to this: the average (unweighted) correlation of the sterling share classes to the MSCI World Index as measured by the R-Squared statistic increased from 0.16 for the six month period to end-2007 to 0.28 for the following six month period, and to 0.43 for the second half of 2008. The sector became so unloved that the weighted average discount drifted out to -27.2% in late December 2008.
Looking Ahead
2009 was a year marked by corporate activity for the listed fund of hedge fund universe, as a handful of funds delisted and many more returned capital to shareholders through tender offers and share buybacks. With many funds having discount control mechanisms under which continuation votes or returns of capital are triggered by discounts exceeding specific levels, we can expect to see the sector shrink further over the next year. However, the sector’s average discount has narrowed to -10.5%--a significant re-rating from the darkest days of late 2008--and there is clearly still an appetite for the very best performers as evidenced by BlueCrest AllBlue recently raising just over £100 million in new assets. Exposure to hedge funds via closed-end vehicles could add diversification to investors’ portfolios and though the closed-end hedge fund sector may be slimming down, many investors may still see it as an appealing way to gain this exposure.
