NICK EVANS, EDITOR, EUROHEDGE
After a disappointing year in 2011, European hedge funds have generally delivered a more robust result for investors over the past year or so – in a European and global investing environment that has continued to present very tricky and testing conditions for active asset managers.
Overall, hedge funds in Europe turned in a respectable performance in another highly unsettled year in 2012, against a backdrop marked by sporadic crisis in the Eurozone and by major economic, political, financial and regulatory challenges around the world.
There were a number of strikingly good performances from some of the biggest and most respected names in the European hedge fund space – such as CQS, Cheyne, Odey, BTG Pactual, The Children’s Investment Fund, AKO and many others besides.
In aggregate, the improvement was still relatively muted – with hedge fund indices lagging equity markets by a margin in a year when sentiment in risk asset markets turned increasingly positive, although the absolute and relative performance of hedge funds against other benchmarks, such as cash or Libor, was much better than against equities.
While strategies such as credit produced some eye-catching returns in a strongly bullish market environment, there were poor performances in other areas – notably in managed futures, where systematic traders struggled to cope with the market fluctuations all year.
And, despite a welcome advance on 2011, which has continued into a strong first quarter in 2013, many managers remain under pressure to up their game after a five-year period in which returns to investors have been less than compelling.
In many respects, 2012 was a year of two halves for European-based managers – with the investment climate in Europe changing dramatically after ECB chief Mario Draghi’s critical interventions in the summer and autumn appeared to convince investors that the systemic tail risk of a collapse of the euro and break-up of the Eurozone had been substantially reduced.
For much of the first half of the year, the risk-on/risk-off environment that had bedevilled asset managers and investors in 2010 and 2011 persisted – leading to high volatility and high correlations between all risk asset markets, and making for a very binary and hazardous environment in which to run money.
But the second half was a very different story. Although markets remained prone to occasional outbursts of choppiness, the overall levels of volatility and market correlation both reduced dramatically in the final months of 2012 as participants started to focus more on fundamentals and less on political risk.
The first few weeks of 2013 saw a pronounced strengthening of the increasingly bullish sentiment in world equity and other risk asset markets – enabling many managers to start the year on a very strong note, just as most had ended 2012.
But it did not take long for tail risk to rear its head again – both in Europe and the US. In Europe, the shock Italian election result in February delivered a stark reminder of the deep-seated problems, perils and political risks that remain across the continent, which were further highlighted by the Cyprus bail-out furore in March.
Across the Atlantic, meanwhile, fears that the US might start to slow its quantitative easing programme sooner than expected sent tremors through markets in February – underlining the extent to which markets have become addicted to central bank stimulus ever since the crisis.
And opinion is still split about the way in which 2013 might ultimately go – with many managers and investors concerned by a potential for a ‘Groundhog Day’ repeat of last year, when early euphoria in the first quarter of the year quickly turned to despair.
Such an unsettled macro and market backdrop would be difficult enough for European hedge fund managers to cope with on its own. But the industry’s operating environment is being further complicated by widespread uncertainty and unease about a whole raft of regulatory changes affecting hedge funds and the wider financial industry.
Chief among these is the European Union’s Alternative Investment Fund Managers Directive (AIFMD) – which comes into effect this summer, and which is widely seen as an excessive and disproportionate reaction to a global financial crisis in which hedge funds were generally more victims than villains.
But the AIFMD – which many people see as a key front in a fast-escalating war that is being waged by other EU member states against the City of London – is only one of a swathe of new and proposed regulations affecting remuneration, compliance, taxation, short-selling, sovereign CDS, derivatives trading and many other areas. And all of these are adding to the cost burden of hedge fund management companies, and creating layers of operational uncertainty, at a time when the industry needs it least.
Not surprisingly, the combination of Europe’s financial and governance crisis, global macro-economic and political uncertainty and the wide-ranging regulatory upheavals has taken its toll on the European hedge fund industry – in terms of new funds, in terms of asset growth, in terms of the industry’s overall vibrancy and in terms of investors’ appetite for risk.
This has been felt most keenly in the new fund area – where new European hedge fund launches are now at their lowest levels since 2000, when EuroHedge first began covering the industry.
Just 86 new European offshore hedge funds launched in 2012, raising assets of $8.9 billion. The assets figure is only fractionally ahead of the $8.8 billion level in 2002, while the number of new funds is lower even than the 104 recorded in 2000, when the European hedge fund industry was just starting to develop.
The scale of the decline from the industry’s pre-crisis peak is extreme. In 2006, for instance, more than 420 new European hedge funds were launched in the year – raising assets of $37.4 billion. It is the first time that the number of new funds in any year has fallen below 100. And the number of new launches was also lower than the number of fund shutdowns during the year – with nearly 115 European hedge funds liquidating in 2012, as a growing number of managers concluded that they were simply unable to make money in the current market environment.
The fall in the launching of new offshore funds in Europe has been offset to some extent by the increased popularity of onshore UCITS-compliant hedge fund strategies – particularly as a way of accessing certain types of institutional investors on the European continent. But here, too, the ‘curse of Europe’ has been felt – with only 47 UCITS-compliant new onshore hedge fund strategies being launched in 2012, raising assets of $1.46 billion – compared with 91 new UCITS funds in 2011, which raised assets of over $5 billion.
Taken together, the combined total for new offshore and onshore fund launches in Europe in 2012 rises to 133 funds with assets of $10.4 billion. But this is still the lowest number of funds since 2000 and the lowest new fund assets total since 2002.
These statistics underline the extent to which market volatility, the depressed business and economic conditions in Europe, regulatory uncertainty, investor caution and escalating business start-up costs have all affected the new fund side of the industry.
As the industry’s institutionalisation accelerates, the barriers to entry are rising inexorably – at a time when asset-raising remains tough, particularly for managers focused on European investing strategies.
While the new fund market is still bumping along the bottom of its post-2008 trough, the overall assets in European hedge funds have also been slower to recover than in other areas of the global hedge fund industry – further underlining the extent to which Europe’s existential crisis has served as a powerful deterrent to global investors and allocators.
Having peaked at $575 billion at the start of 2008, assets in traditional offshore European hedge funds stood at $436 billion as at the start of 2013 – up by only a meagre 2.5% from the level at the start of 2012, despite an average return of around 5% for the EuroHedge Composite index during the year.
As with the new funds, however, the comparison is less stark if one adds in the additional $120 billion or so that are managed in UCITS-compliant hedge fund strategies – which would take the overall European industry assets figure to $556 billion, just 3% below its pre-crisis peak.
So the industry in Europe has clearly been treading water for some time now. Over the past five years, European hedge funds have had to battle against powerful and unprecedented headwinds.
But there are signs of a thawing in investors’ previous coolness towards anything to do with Europe. Many recent investor surveys identify distressed European credit and the deleveraging of European banks as one of the biggest global investment opportunities for this year – while several firms report signs of a shift in sentiment towards long/short European equity strategies at a time when investors are pouring money back into equities globally.
Seeders and other emerging-manager platforms are also on the look-out for new opportunities in Europe – particularly among some of the new bank traders that are spinning out to start hedge funds in areas like credit, commodities, macro and quantitative trading (notwithstanding the high-profile shutdown of Goldman spin-out Edoma in 2012), and among the increasing number of ‘second generation’ managers from established global and European hedge fund groups.
There is no doubt that the quality of the new funds that are being launched in such a harsh climate is higher than ever – or that investors are gradually turning their focus more towards newer and emerging managers, after a multi-year period when a safety-first attitude has driven the majority of flows into the largest and most established ‘brand name’ firms.
So there are reasons for optimism. Performance is improving. Investors are more prepared to look at investing in Europe than they were. And investors of all shapes and sizes are clearly allocating (or planning to allocate) more and more money to hedge funds.
Having weathered a previously unimaginable series of storms in recent years, the European hedge fund industry could certainly do with a period of stability – or at least a period when investing fundamentals take precedence over macro-driven sentiment swings.
But, as recent shocks from Italy and Cyprus have shown, politics will remain a key driver in Europe this year. And, for all the current buoyancy of equity markets, the potential is still high for hedge funds – and for all investors – to remain at the mercy of events.