The extension of hedge funds into the retail arena introduces a question not usually asked by hedge fund managers: How can a private fund maximize the number of investors and broaden the types of investors eligible to participate, while at the same time complying with the regulatory limits on the investor universe and the manner of marketing? In the US, a handful of funds have recently cleared the regulatory hurdles to market funds to less wealthy investors, although most offerings are made pursuant to private placements and are focusing their efforts on investors with at least $25,000 to invest. In the older, more developed European industry, the bar is usually much lower - averaging around $15,000. The products vary enormously - some hardly recognizable as hedge funds. But in every country, a distinct retail hedge fund industry is being rapidly shaped by the three forces of investor demand, regulatory concern and manager innovation.
Several US firms have begun to offer a funds of funds structure which gives hedge fund exposure with a conventional mutual-fund regulatory status. The distinction between the new retail hedge funds of funds and the traditional hedge funds into which they invest concerns the number and type of investors they can attract and how the fund may be marketed.
Traditional US hedge funds are offered under exemption from both the 1933 Securities Act and the 1940 Investment Company Act, as a consequence of which they can only take a limited number of investors and they are very restricted in their ability to market. This in turn means minimum investment limits are high - around the $1 million mark. By contrast, the new retail products, while investing in the traditionally structured funds, themselves register under the 1940 Act as closed-end investment companies, allowing them an unlimited number of investors. Most funds have not registered under the 1933 Act and offer interests through private placements. However, a couple have registered under the 1933 Act which could grant them access, in theory, to the same type of investor as conventional mutual funds and enables them to market their funds in a similar manner - advertising in periodicals and distributing sales literature.
The new funds of funds are typically set up as limited liability companies and manage to avoid consideration as "publicly traded partnerships" by leaving up to their board the ability to decide when the fund accepts to repurchase its own shares.
By European standards, the US funds are still expensive. Minimum investments are high: between $25,000 and $125,000. George Berridge, part of the Deutsche Bank team responsible for their US retail offering, identifies two reasons for this. Firstly, the distribution network of major banks in the US cannot yet manage a cheaper product. "The further you drop the bar, the bigger the distribution network must be. Such a network does not exist for us in the US". Secondly, awareness of this type of product is still at a low level. For Berridge, this justifies a high minimum: "Most investors considering allocating to hedge funds have a large portfolio and are prepared to make a sizeable allocation to the hedge fund".
So what are the prospects for the new products? Berridge believes that the key is educating brokers. "Because minimums are higher, most non-regulated funds only need a few experts trained to explain and market the funds to investors. To reach a mass retail market you have to educate a whole class of brokers". Berridge estimates five to ten thousand brokers are needed to make the products work, and believes this process will take time. Hedge funds are a complicated and difficult concept for brokers to grasp, "particularly given the baggage associated with hedge funds and leverage".
In the UK, retail exposure to hedge funds is through multi-manager products with lower minimums, typically around the equivalent of $10,000. Funds register as open-ended investment companies then list on the London Stock Exchange. After the initial issue, investors enjoy the liquidity of buying and selling shares in the funds, as with conventional long-only unit trust funds. The retail funds of funds invest into traditional hedge funds domiciled in tax efficient offshore locations. As listed companies, the retail funds of funds can be marketed to the general public. The products are frequently wrapped in the capital-gains-tax exempt ISA (Individual Savings Account) structure.
A raft of retail funds of funds was released onto the UK market in time for the end of the last tax year. The new funds came both from established long-only managers - HSBC, Deutsche and Henderson - and leading hedge funds managers - world leader Man Investment, International Asset Management and Morley. The long-only specialists in particular set out on agressive marketing campaigns targeting Independent Financial Advisors - the main brokers for financial products to the UK public. But commentators criticised the complex structures of the funds - complaining that the average retail investor would not be able to understand them - and the seemingly high and obscure fee structure. These and other concerns were voiced by the Financial Services Authority in a statement in March: "Hedge funds can be difficult to understand, and the costs and charges may not be clear. Investors should also check if the ISA is based outside Britain and, if so, what protection they have if anything goes wrong."
The market in UK retail funds of funds did not take off dramatically. Subscriptions have generally been lower than managers hoped - in Deutsche?s case the actual ?55m raised fell a gulf short of the targeted $500m. Four investor-focused reasons help to explain this. Firstly, investors and their advisors certainly find the structures hard to understand. Secondly the association of hedge funds with high-risk shorting and leverage is hard for many IFAs to stomach. Neither names like "Conservative Approach Strategy", nor road shows highlighting the low-volatility wonders of hedging, appeared to alter this unease. Thirdly, UK retail investors are unfamiliar with the guaranteed structures which may help to assuage these fears. A final reason is that IFAs are reluctant because the trail fees they rely on are harder to earn on the new products. Jacob Schmidt, Head of hedge fund research at Allenbridge Hedgeinfo, explains: "IFAs rely on the trails provided by introducing investors to funds. As the new funds of funds products are listed (on the LSE) these are not available after the initial issue".
But for many London-based hedge fund managers, the regulator has to answer for not allowing sufficient choice to stimulate demand. David Harding, MD of London-based manager Winton Capital Management explains: "We wonder why British investors are being protected from sophisticated, scientific, statistical investment techniques, while being peddled endless highly speculative stocks on which they lose all their money". Recent developments in UK indicate that this complaint could be reaching the regulator. In August, the UK regulator published a "discussion paper". Inviting comment from industry players, it admits that "ordinary investors ... have been prevented from becoming involved by ... the current controls on the selling and marketing of hedge funds in the UK". Existing and prospective players in the new sector wait expectantly.
In Germany, conventional unregulated hedge funds attract punitive tax treatment - for example 90% of the capital gain where the investors sells his stake within a year. The German retail products are therefore structured notes, linked to a basket of underlying hedge funds. This changes their status considerably, as Carl Graf Hardenberg, of Hamburg lawyers Heimann Rechtsanwalte und Steuerberater, explains: "the notes are free of tax on their eventual sale if they are held for more than one year".
The note structure also allows the certificates to be marketed to prospective retail clients. While German investment law prevents public marketing and distribution of hedge funds, the certificates are treated as debt instruments rather than as funds, and so may be marketed to public investors.
The notes appear to have been a success in Germany. The largest product - Deutsche?s Xavex HedgeSelect - raised ?1.8 billion for its launch in October 2000. To explain this success, Sophie Van Straelen of Asterias, a London-based hedge fund consultancy, looks to the highly developed nature of retail distribution in Germany. "The relative success of Deutsche as against Dresdner or Commerzbank?s certificates can be explained in terms of their more highly developed distribution network". It follows that the recent spurt of mergers in German banking - Allianz IM with Dresdner RCM, Commerz Invest joining with ADIG - will cement the distribution machines of Deutsche?s competitors. There is good reason for this on the supply side. The retail investor is more crucial to the German hedge fund market than elsewhere in Europe. London-based Fulcrum Research surveyed 100 European institutions representing 60% of European institutions' assets under management in late 2000. The survey found 33% of French and 30% of Swiss institutions were invested in hedge funds, whereas demand in Germany was lagging far behind at 7%.
To the Swiss retail investor, as to the German, structured notes are a popular route to hedge fund exposure. In Switzerland they are treated as a bond rather than falling directly under Swiss fund regulation. However, the note structure is by no means dominant, and both domestic and foreign banks offer a variety of products, as Phillip Cottier, of Harcourt Investment in Zurich, explains: "Since 1994, retail funds of hedge funds can be domiciled and/or registered in Switzerland, and minimum investments of Swiss funds of funds can be as low as $100". All Swiss hedge funds are set up as investment companies or as "multiple investor contracts". The latter are similar to open-ended unit trusts in the UK.
Public solicitation is contingent on registration with Switzerland's Federal Banking Commission (FBC) - which imposes high custodial and advisory standards on applicants. Publicly circulated prospectuses must include a "warning clause" placed alongside the fund?s name explaining that alternative investment instruments and strategies are used and that this type of fund holds special risks entailing the chance of considerable losses to the investor.
Exposure to hedge funds for French retail investors has so far been via mutual funds of funds. Like the UK ISA structure, the funds are wrapped in a tax-efficient SICOVAM structure. These are freely marketable to the public, with the proviso that those investing the maximum 30% into alternatives must label their products "cash enhancement" funds (they may not refer to them as hedge funds). While allocation to alternatives in most cases is small, they are very popular. A recent Standard and Poor?s estimate valued this market at ?5billion.
Recently, the French regulator COB (Commission des Operation de Bourse) has appeared to soften, allowing several funds of funds to exceed the published 30% allocation, through a regulation-light "procedure alleg?e". The move has triggered many to ask for greater clarity in the regulator?s approach, a position shared by Van Straelen of Asterias. "Retail investor interest is clearly there. The time has come for the COB to create a proper legal status for hedge funds". A move by French supermarket giant Carrefour may force the regulator?s hand. In April 2002, it introduced the first hedge fund-linked guaranteed product to the French public. This 5-year structured note is linked to the performance of a basket of hedge funds with a modest ?1,000 minimum. The rapid pick-up of the new product further demonstrates demand for hedge fund linked products: the new note has raised ?100 million in its first six months, despite a thick documentation package designed to ensure that brokers make investors fully aware of the risks.
The COB will reveal its response to the obvious interest in hedge funds from the French retail investor early next year. While optimistic, Van Straelen of Asterias is keen to stress the importance of a good start for Carrefour?s new note: "The Carrefour product will be instrumental in the development of the industry in France".
At a glance, the European retail hedge fund market looks good. Asterias estimates that 18% of the ?75bn European retail fund market is tied up in products that have some exposure to hedge funds. In addition to those mentioned here, Asterias values the "Nordic" market at ?5 billion and points to the new retail products available in the two year old Italian market. Many regulators are responding to evident demand, and new products are constantly appearing. How quickly the US market follows remains to be seen.