Warning from the Federal Minister of Finance: Investors must be willing and able to carry the risk of a loss in the value of their investment, which may mean a total loss.
--from a German hedge fund marketing brochure
Armed with high hopes and a hefty advertising budget, the resolute salesmen of DWS, the Frankfurt-based retail fund arm of Deutsche Asset Management and Europe’s biggest seller of mutual funds, marched into uncharted territory in March when they started selling hedge funds to individual investors in Germany. Available to pension funds and high-net-worth customers in Germany since 1999, hedge funds were verboten for small-fry investors until the start of this year, when Germany’s financial regulator permitted their sale to all investors.
DWS promptly jumped at the opportunity to cash in on the red-hot product, joined by Deutscher Investment Trust, the Frankfurt-based German retail arm of Allianz Dresdner Asset Management, which also began selling hedge funds in March. Union Investment, the fund group of Germany’s cooperative banks, plans to follow suit in the next few months. Other German financial services companies, from Cominvest, the fund arm of Commerzbank, to private bank Metzler Seel Sohn & Co., to independent money manager Arsago Alternative Asset Management, are gearing up to sell their own hedge funds.
Investor appetite seems strong and the possibilities promising. DWS has not yet disclosed any sale information, but Deutscher Investment Trust raised more than E360 million ($433 million) in a little more than four weeks. Assets of European hedge funds totaled nearly E168 billion at the end of last year, but virtually none of that money was in retail accounts, and none of it was onshore. Paul Manduca, chairman of Deutsche Asset Management in Europe, predicts that hedge funds and funds of hedge funds could account for 20 percent of Germany’s E1 trillion retail fund market within the next five years. “There is enormous potential for this market,” Manduca says. “Savers want to see their money generating absolute return. The sharp falls in their funds during the bear market caught many of them by surprise. These products deliver the steady, low-volatility returns that retail investors want.”
The potential is not limited to Germany. Across the Continent, regulators have begun to crack open the retail market to hedge fund managers. Within the past year France, Ireland, Italy, the Netherlands and Switzerland have all sanctioned the sale of funds of hedge funds to retail investors onshore for the first time. (Luxembourg and Ireland had been the main offshore European domiciles for hedge funds.)
Opening the sales of hedge funds to small investors across the Continent doesn’t guarantee, of course, that the market will take off immediately. Even some of the promoters of the change are circumspect. “If you walked down the street in Frankfurt asking people about hedge funds, most would shrug their shoulders,” says Rolf Drees, a spokesman at Frankfurt-based Union Investment, Germany’s second biggest money manager. “These are good products for retail investors, but education will take time.”
This new market will be a boon to established retail fund companies with strong distribution networks, which may prosper even more than well-known names that have dominated institutional and high-net-worth hedge fund sales -- specialist firms like London’s Financial Risk Management and Union Bancaire Privée in Geneva, Switzerland.
UBS, for example, aims to launch this summer an onshore fund-of-funds product in Germany structured for UBS Wealth Management clients and third-party distributors. Man Group, the world’s largest hedge fund manager, seems sure to be a major competitor in this new market; its 2002 acquisition of Switzerland’s RMF Investment Management, based in Pfaffikon near Zurich, strengthened Man’s presence in German-speaking Europe. The London-based company is building German distribution and is looking to structure a fund of hedge funds compliant with the new German law.
Their plans notwithstanding, enthusiasm for hedge fund sales to mom-and-pop investors is far from universal throughout Europe. Spain is resisting retail sales of hedge funds, as is the U.K., arguably the most sophisticated mutual fund market in Europe. Indeed, in April when Britain’s Financial Services Authority, the industry regulator, issued its updated rules covering collective investment schemes, it took the opportunity to reiterate its stance: “Hedge funds and funds of hedge funds are not appropriate for retail packaged products (including authorized funds) at the present time.”
To be sure, a loophole in U.K. investment law allows retail investors to participate indirectly in the asset class through closed-end investment trusts that invest in funds of hedge funds. But because the FSA has so strongly and publicly discouraged retail sales of hedge funds, money managers have been wary of promoting them. In addition, the key retail intermediaries, independent financial advisers, are reluctant to promote investment trusts, which are exchange-listed and thus include no sales load to pay IFA commissions.
“I would be wary of offering these products to clients,” says Mark Dampier, head of research at one of the U.K.'s largest IFAs, Bristol-based Hargreaves Lansdown. “When someone starts talking about fixed-income arbitrage, am I wrong to think about Long-Term Capital Management? How can a portfolio built from these strategies be anything other than absurdly complex?”
In its approach to hedge funds, as in other kinds of policy matters of late, the U.K. stands shoulder-to-shoulder with the U.S., where money managers are prohibited from selling the products to retail investors. Stateside, to meet the most commonly used regulatory safe harbor for conducting private offerings, hedge funds may sell their interests only to accredited investors, defined as individuals with a minimum annual income of $200,000 ($300,000 with spouse) or at least $1 million in assets. Indeed, so-called retailization of hedge funds has become a controversial issue in the wake of the widespread mutual fund scandals and the Securities and Exchange Commission’s desire to introduce more direct supervision and regulation of hedge funds.
Advocates of hedge funds for Everyman argue that individual investors, like their well-heeled neighbors, should be able to achieve absolute returns in good markets and bad. “Why should these products remain the domain solely of the wealthy?” asks Manduca.
UNDER THE NEW GERMAN REGULATIONS, hedge funds will be far from restricted to the rich. German law is considerably more liberal than its European counterparts. In Germany the minimum investment level can run as low as E5; it takes E10,000 to open a retail hedge fund account in France, E12,500 in Ireland and E25,000 in Italy. Germany’s BaFin allows unregulated funds to be included in fund-of-hedge-funds rosters; France’s regulator, the Autorité des Marchés Financiers, on the other hand, expressly forbids it.
Across the Continent, fees average approximately 2 percent of assets and between 10 percent and 20 percent of outperformance against a selected benchmark. The Deutscher Investment Trust fund collects a 2 percent management fee and 25 percent of performance above three-month Euribor.
To be sure, Germany’s regulator, BaFin, has imposed several restrictions on the business. A fund of funds cannot be leveraged or invest in a hedge fund that uses leverage. No more than 20 percent of the total fund-of-hedge-funds portfolio can be invested in a single fund. And marketing brochures for funds of hedge funds must warn investors against the risks.
In addition, German law requires that the hedge fund distributor be a German institution. As a result, U.K. and U.S. fund-of-hedge-fund managers are joining forces with German distributors that lack expertise in running hedge funds. London-based International Asset Management, for example, joined forces with Frankfurt-based private bank Hauck & Aufhauser Privatbankiers in January; LJH Global Investments, a Naples, Floridabased firm, started an alliance with Cologne-based private bank Sal. Oppenheim jr. & Cie. in January; Union Investment hooked up last year with Swiss hedge fund manager Partners Group. All plan to set up German onshore fund products to sell to local investors.
But even if the law did not mandate that German distributors sell hedge funds, the country would be a tough market for foreign fund managers to crack. Foreign investment firms managed only 14 percent of mutual funds sold in Germany in 2003, according to Feri Fund Market Information, a London consulting company. That was partly because, until a recent reform leveled the playing field, foreign managed funds were taxed on all of their profit, while German funds were only taxed on half.
France imposes its own set of barriers to foreign fund managers. According to rules promulgated by French regulator AMF in November, funds of hedge funds sold to retail investors must be listed on a European stock exchange. That excludes the vast majority of U.S. hedge funds and funds of hedge funds. Since the AMF issued its directive, at least 50 asset managers have applied to enter the market, including Société Générale subsidiary Lyxor Asset Management, Crédit Agricole Asset Management and HDF Finance. Industry sources expect that the AMF will publish its list of authorized hedge fund and fund of hedge-funds managers within the next few months.
In both France and Germany, the biggest mutual fund distributors -- BNP Paribas, Deutsche and Société Générale -- enjoy considerable clout with retail investors. All three have had some success selling notes linked to the performance of funds of hedge funds in private placements to wealthy and simply well-heeled investors. (Minimum investment levels typically run between E5,000 and E15,000). Société Générale’s Lyxor unit raised more than E3 billion last year for a range of hedge-fund-linked structured products.
At the same time, the U.K. retail fund market, which boasts assets of E296 billion, remains elusive for hedge fund managers. Despite FSA disapproval, individual investors can buy London Stock Exchangelisted closed-end investment trusts that invest in hedge funds -- ten trusts collectively manage assets of about £500 million ($894 million).
Edward Morse, head of sales at Thames River Capital, whose closed-end trust Hedge + debuted in March, says his London-based firm is looking to sell to retail investors -- but only indirectly. “We are not a retail house, and there is regulatory risk,” Morse says. “We sell through intermediaries, IFAs and brokers. It’s up to these advisers to decide whether this product is suitable for their clients or not.”
The FSA has eased some restrictions against hedge funds. In April it authorized a new class of fund called qualified investor schemes. These new quasihedge funds can short investments and employ leverage, borrowing up to 100 percent of their net asset value. In addition, they can invest in almost any asset class, including commodities.
Hedge fund industry officials see this loosening, while not directly related to retail investors, as nonetheless encouraging. Says Christopher Hilditch, a partner in the London office of New York based law firm Schulte, Roth & Zabel: “It shows that the FSA’s thinking is shifting. It allows some hedge-fund-style investing.”
In the meantime, new EU-wide regulations that took effect late last year allow fund managers the chance to sell investment products that some have described as hedge fund lite. The new regulations liberalize the use of derivatives and allow funds to go short synthetically. But they do not allow the leverage typical of hedge funds.
Baring Asset Management of London made the first move in this market, launching Baring Directional Global Bond Trust, a U.K.-authorized unit trust, in March. The trust, which aims to produce absolute returns 4 percent above three-month sterling LIBOR after fees, will short currencies and bonds using forwards and futures. “I think the new regulations are very good news for retail investors,” says Ian Pascal, Baring’s marketing chief. “We can protect capital and deliver returns even if the market is against us.”
Man Group recently announced plans to launch its first hedge fund product targeting U.K. retail investors. Its new Channel Islandsdomiciled investment trust will carry a minimum investment limit of £10,000.
Julius Baer Investment Management in London, which manages a $1.2 billion bond hedge fund, is also planning to introduce its own hedge-fund-lite product, a bond fund aiming for absolute returns of between 3 and 5 percent above cash. “It is pretty clear we have been in a 25-year bull market for bonds and we are at the bottom of the rates cycle,” says chief investment officer Edward Dove. “It seems pretty obvious to me that bond managers should be running their funds with an absolute-return mind-set.”
Still, U.K. asset managers hope that the FSA will eventually loosen up and permit the retail sales of hedge funds. Asks Alan Djanogly, a partner and founder of International Asset Management, “If the Germans can do it, why can’t the British?”
