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Regulated Alternative Funds:<br />
The New Conventional
Preface<br />
One of <strong>the</strong> most visible changes in <strong>the</strong> global investment management industry post-crisis<br />
has been <strong>the</strong> new, sustained demand for “alternative” strategies and asset classes in retailfriendly<br />
fund structures. <strong>SEI</strong> and Strategic Insight first examined <strong>the</strong> growth of alternative<br />
mutual funds in a 2010 <strong>report</strong>, Exotic to Mainstream: Growth of Alternative Mutual Funds<br />
in <strong>the</strong> U.S. and Europe. The fur<strong>the</strong>r growth that paper predicted has come to pass, and<br />
many o<strong>the</strong>r conclusions still hold true today:<br />
• The trend toward “mainstream alternatives” holds substantial appeal for investment<br />
managers. For alternative managers, offering <strong>the</strong>ir strategies in a mutual fund structure<br />
opens up a substantially broader market opportunity. Meanwhile, traditional managers<br />
see an opportunity for increased fund flows, and potentially higher margins.<br />
• A diverse group of strategies, including long/short and global tactical asset allocation,<br />
and a varied group of managers are already experiencing success with <strong>the</strong>se products.<br />
Sponsors continue to be geographically dispersed throughout Europe and <strong>the</strong> U.S.,<br />
and are beginning to emerge in Asia.<br />
• Managers entering this space must address expertise, regulatory, operational, and<br />
distribution considerations. Many of <strong>the</strong>se factors can be central to <strong>the</strong> retail alternative<br />
effort, whe<strong>the</strong>r it’s a traditional manager who will need to acquire shorting skills, a firm<br />
whose strategies will have to be adapted to UCITS requirements, or an alternatives<br />
manager requiring a new, retail sales presence. The challenges can be daunting, but<br />
<strong>the</strong> opportunities in this fast-growing segment of <strong>the</strong> market are substantial.
Executive Summary<br />
In what is beginning to seem like <strong>the</strong> distant past, a<br />
clear line had once separated traditional and alternative<br />
investment products. But as investors faced multiple<br />
market crises and rising volatility, fund managers<br />
responded with a range of innovative products<br />
designed to better manage volatility and offer<br />
alternatives to long-only investing in traditional markets.<br />
As investor segments and products converge,<br />
alternative strategies are increasingly being packaged<br />
within registered fund structures originally designed for<br />
retail buyers, but also used by institutions and o<strong>the</strong>r<br />
fund selectors. A growing number of alternative funds<br />
are being launched as UCITS (Undertaking for<br />
Collective Investment in Transferable Securities), a fund<br />
vehicle accepted for sale in countries throughout <strong>the</strong><br />
European Union and many o<strong>the</strong>r nations. Alternatives<br />
also are becoming more prominent within U.S. mutual<br />
funds (registered under <strong>the</strong> Investment Company Act of<br />
1940 or, in some cases, under <strong>the</strong> Securities Act of<br />
1933). The growing popularity of <strong>the</strong>se funds is clearly<br />
evident in strong asset flows, product proliferation, and<br />
a growing presence in Asian markets.<br />
One factor driving <strong>the</strong> popularity of alternative UCITS<br />
and mutual funds is <strong>the</strong> detailed requirements around<br />
risk measurement and management, liquidity,<br />
counterparty diversification, and limits on leverage.<br />
However, <strong>the</strong> increased use of derivatives and <strong>the</strong>ir<br />
associated counterparty and operational risks continue<br />
to concern investors and regulators alike. The regulatory<br />
environment remains in flux as new rules on hedge<br />
funds take shape in Europe, and as <strong>the</strong> framework<br />
around UCITS gets reviewed amidst <strong>the</strong> expansion of<br />
more complex products. Yet this too is encouraging<br />
fur<strong>the</strong>r innovation.<br />
Meanwhile, new frontiers are emerging. Europe and <strong>the</strong><br />
U.S. have led <strong>the</strong> way in <strong>the</strong> adoption of alternative<br />
strategies, but o<strong>the</strong>r markets are developing a taste for<br />
non-correlated funds. One of <strong>the</strong> biggest retail fund<br />
launches in Japan this year was an alternative<br />
managed futures strategy. Demand for alternatives is<br />
growing amongst sovereign wealth funds and national<br />
pension funds in Asia, Latin America and <strong>the</strong> Middle<br />
East. Wealthy individual investors around <strong>the</strong> world are<br />
also expected to consider alternatives more seriously<br />
after <strong>the</strong>ir recent experiences with traditional asset<br />
classes. Although U.S. institutions and high net worth<br />
individuals (HNWIs) can access hedge funds and<br />
alternatives directly, <strong>the</strong>y may see <strong>the</strong> benefits of<br />
sourcing such strategies through regulated structures,<br />
just as <strong>the</strong>ir European counterparts have done.<br />
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
“ Although U.S. institutions and high net worth<br />
individuals (HNWIs) can access hedge funds and<br />
alternatives directly, <strong>the</strong>y may see <strong>the</strong> benefits<br />
of sourcing such strategies through regulated<br />
structures, just as <strong>the</strong>ir European counterparts<br />
have done. ”<br />
1
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
Key Findings<br />
The evolution of investment philosophies and strategies is causing previously distinct investor segments and products<br />
to converge. The trend of packaging alternative investment strategies within mutual funds and UCITS continues<br />
unabated, with new products being introduced regularly and asset flows gaining momentum. Regulated Alternative<br />
Funds: The New Conventional offers an updated look at <strong>the</strong> dynamics of this rapidly evolving and maturing market,<br />
and shows how <strong>the</strong> popularity of <strong>the</strong>se funds continues to rise around <strong>the</strong> world. Key findings include:<br />
• Global financial crises and continued market volatility using alternative strategies and managing a combined<br />
have transformed attitudes toward investing. As<br />
$254 billion of assets.<br />
managers respond to <strong>the</strong> evolving needs of investors<br />
• Alternative strategies through U.S. mutual funds and<br />
and <strong>the</strong>ir advisors, previously segregated products<br />
ETFs drew $39 billion in net inflows in <strong>the</strong> first eight<br />
and segments are converging.<br />
months of 2011, on pace to come near 2010’s $65<br />
• The convergence is seen in growing capital flows billion. By <strong>the</strong> end of August 2011, <strong>the</strong> U.S. had<br />
into regulated alternative investment products, most roughly 730 alternative mutual funds and ETFs,<br />
often in <strong>the</strong> form of UCITS funds and U.S.-registered 118 of which had been launched in <strong>the</strong> first eight<br />
mutual funds.<br />
months alone.<br />
• During <strong>the</strong> first eight months of 2011, more than $61<br />
billion poured into regulated funds using alternative<br />
strategies. With no slowdown of demand in sight,<br />
assets in alternative mutual funds and UCITS could<br />
hit <strong>the</strong> $1 trillion mark by 2014.<br />
• Growth is being driven by several factors. Investors<br />
are looking for ways to bolster portfolio performance,<br />
protect capital, and lower volatility. Traditional<br />
managers want to tap higher-fee areas. Alternative<br />
managers would like to expand and diversify <strong>the</strong>ir<br />
client base.<br />
• Alternative strategies still account for a small portion<br />
of <strong>the</strong> UCITS and U.S. mutual fund markets, but<br />
<strong>the</strong>y continue to capture increased market share.<br />
They are also <strong>the</strong> most popular category in product<br />
development pipelines.<br />
• Alternative strategies inside UCITS attracted $22<br />
billion of net new flows in 2011 through August,<br />
following $50 billion in <strong>full</strong>-year 2010. Up until this<br />
summer’s volatility and impact on sales, gains were<br />
running at an even higher pace than last year. And<br />
2011’s flows came despite a 90% drop in overall<br />
flows into long-term UCITS during <strong>the</strong> same period.<br />
There are now over 1,500 UCITS funds in Europe<br />
• Regulators remain concerned with <strong>the</strong> growth of<br />
derivatives use amongst regulated funds and have<br />
been reviewing derivatives policy for more than a<br />
year. The SEC has gone so far as to freeze most<br />
approvals of new funds and ETFs that rely heavily<br />
on derivatives, as it continues to conduct its review.<br />
• Investors and <strong>the</strong>ir advisors can be intimidated by<br />
<strong>the</strong>se often-complex products. Active outreach and<br />
marketing campaigns are common amongst <strong>the</strong><br />
retail-oriented firms that dominate <strong>the</strong> space.<br />
• Assets in <strong>the</strong> regulated alternatives space tend to<br />
migrate to <strong>the</strong> largest professionally managed funds<br />
with <strong>the</strong> strongest performance. Whilst performance<br />
matters for funds with track records, new unrated<br />
funds also get a large share of sales.<br />
• The future of alternative investments through<br />
regulated funds hinges to a large degree on robust<br />
risk management. Fund managers assume primary<br />
responsibility for implementing <strong>the</strong> necessary<br />
controls, but independent service providers also play<br />
important roles. Investors can also take some comfort<br />
in detailed regulatory requirements around risk<br />
measurement and management, liquidity,<br />
counterparty diversification, and limits on leverage.<br />
2
• Europe and <strong>the</strong> U.S. have been at <strong>the</strong> forefront of product innovation, but<br />
alternative strategies in regulated retail fund form are now appearing in<br />
o<strong>the</strong>r parts of <strong>the</strong> world. Opportunities for alternative managers are growing<br />
across Asia, Latin America, and <strong>the</strong> Middle East, driven by demand from both<br />
private investors and institutions.<br />
• Despite becoming increasingly competitive, <strong>the</strong> market for regulated alternative<br />
funds remains much more fragmented than traditional parts of <strong>the</strong> business, and<br />
no dominant players have yet emerged. As managers jockey for position and vie for<br />
<strong>the</strong> attention of investors, intermediaries, and gatekeepers, product innovation and<br />
distribution expertise will be key factors in determining <strong>the</strong> winners.<br />
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
• Partnerships that combine <strong>the</strong> investment expertise of existing alternative<br />
managers with <strong>the</strong> distribution prowess of traditional managers will become more<br />
common as managers of all stripes look for ways to gain a foothold in one of <strong>the</strong><br />
most dynamic and growing parts of <strong>the</strong> asset management business.<br />
“ With no slowdown of demand in sight,<br />
assets in alternative mutual funds and<br />
UCITS could hit <strong>the</strong> $1 trillion mark<br />
by 2014.”<br />
3
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
The Convergence Factor<br />
Three major global financial market crises in a ten-year<br />
span have dramatically transformed investor attitudes.<br />
As a result, asset managers and advisors are grappling<br />
with how to adapt to this new era. Their responses, along<br />
with those of regulators and distributors, are redefining<br />
investment product structures.<br />
A key facet of this evolution is <strong>the</strong> convergence of<br />
strategies previously segregated along retail versus<br />
institutional lines as well as traditional versus alternative<br />
investment approaches. Retail investors and <strong>the</strong>ir<br />
advisors now are gravitating towards <strong>the</strong> greater diversity<br />
(and complexity) of alternative strategies that before<br />
were pursued mainly by institutional and high net worth<br />
individuals. Institutions, meanwhile, continue to seek<br />
diversification through alternatives, but increasingly<br />
appreciate <strong>the</strong> transparency, liquidity, and regulatory<br />
controls found within regulated pooled products,<br />
previously associated primarily with retail investors.<br />
Ano<strong>the</strong>r Year of Robust Inflows<br />
Convergence can be seen in <strong>the</strong> significant levels of<br />
capital that continue to migrate into alternative<br />
investment strategies found within regulated UCITS<br />
funds and U.S.-registered mutual funds. There is no<br />
universally agreed-upon definition of “alternative”, but<br />
it can be applied to virtually any strategy that ventures<br />
beyond long-only investing in equities and debt<br />
instruments. This definition includes funds using hedge<br />
fund-like strategies or tactical allocation, and ranges to<br />
funds investing in commodities and currencies. During<br />
<strong>the</strong> first eight months of 2011, investors around <strong>the</strong><br />
world put more than $61 billion into regulated funds<br />
using alternative strategies. This comes after $116<br />
billion of inflows into such funds during all of 2010.<br />
Figure 1: Net Flows into Alternative UCITS and Mutual Funds/ETFs<br />
20<br />
U.S. $Billions<br />
10<br />
0<br />
-10<br />
-20<br />
Alternative UCITS Funds<br />
U.S. Alternative Mutual Funds/ETFs<br />
-30<br />
Jan'07 Dec'07 Nov'08 Oct'09 Sept'10 Aug'11<br />
Source: <strong>SEI</strong> Knowledge Partnership; Strategic Insight Simfund GL, MF<br />
Source: Strategic Insight Simfund GL, MF<br />
The industry is thus on track for 2011 to be ano<strong>the</strong>r big<br />
year of flows into regulated funds with alternative<br />
strategies, with no slowdown of demand on <strong>the</strong> horizon.<br />
Indeed, assets in alternative mutual funds and UCITS<br />
could hit <strong>the</strong> $1 trillion mark in 2014—and double<br />
today’s $644 billion in 2016.<br />
As investors face an uncertain and more volatile<br />
economic future, <strong>the</strong>y are recognising <strong>the</strong> value that<br />
strategies around absolute and/or uncorrelated returns<br />
could provide as a way to help bolster portfolio<br />
performance, protect capital, and lower volatility.<br />
Meanwhile, traditional managers are launching long/<br />
short, absolute return, and o<strong>the</strong>r alternative funds<br />
to tap higher-fee growth areas, whilst alternative<br />
managers are launching regulated retail funds<br />
to expand and diversify <strong>the</strong>ir client base.<br />
Alternative strategies are <strong>the</strong> most popular category in<br />
asset managers’ product development pipelines with<br />
4
managers such as Altegris, BlackRock, PIMCO, Nuveen, Alternative investment strategies within both UCITS<br />
and First Eagle filing with <strong>the</strong> U.S. SEC to offer mutual funds and ‘40 Act mutual funds continue to grow even<br />
funds that rely on managed futures, long/short, credit, as <strong>the</strong> overall asset management industry faces more<br />
commodities, arbitrage, absolute return fixed income difficult business conditions. At <strong>the</strong> end of August 2011,<br />
and o<strong>the</strong>r alternative strategies. Even investment<br />
alternative strategies in UCITS and U.S. mutual funds/<br />
management firms without “alternative” fund offerings ETFs managed a combined $644 billion in assets, up<br />
are being affected, as <strong>the</strong>y must navigate a marketplace 134% from <strong>the</strong> $275 billion at <strong>the</strong> end of 2006.<br />
that is being redrawn by <strong>the</strong> growth of such products.<br />
Figure 2: Assets in Alternative UCITS and Mutual Funds/ETFs<br />
700<br />
U.S Alternative Mutual Funds/ETFs Alternative UCITS Funds<br />
600<br />
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
500<br />
U.S. $Billions<br />
400<br />
300<br />
200<br />
100<br />
0<br />
Jan'07 Dec'07 Nov'08 Oct'09 Sept'10 Aug'11<br />
Source: <strong>SEI</strong> Knowledge Partnership, Strategic Insight Simfund GL, MF<br />
Source: <strong>SEI</strong> Knowledge Partnership, Strategic Insight Simfund GL, MF<br />
What’s more, alternative strategies, although still a small<br />
portion of <strong>the</strong> UCITS and U.S. mutual fund markets,<br />
have continued to increase <strong>the</strong>ir market share. At <strong>the</strong><br />
end of August 2011, alternative strategy funds’ AUM<br />
were 4.4% of “traditional” UCITS and U.S. funds’ AUM,<br />
up from 2.2% at <strong>the</strong> start of 2007. This is due to <strong>the</strong> fact<br />
that assets in traditional UCITS and U.S. funds have<br />
been growing at 3.6% per year since 2006, whereas<br />
assets in alternative strategy UCITS and U.S. mutual<br />
funds have been growing at 17% per year during that<br />
time. As Figure 3 shows, annual growth for alternative<br />
UCITS and U.S. funds handily outpaced <strong>the</strong> total<br />
industry’s growth in five of <strong>the</strong> past six years, and<br />
is on pace to do again this year.<br />
Figure 3: Asset Growth Rates: Alternative vs. Total UCITS & Mutual Fund Industry<br />
100%<br />
80%<br />
Total UCITS & U.S. Fund Industry<br />
Alternative UCITS & U.S. Funds<br />
Annual Asset Growth Rate<br />
60%<br />
40%<br />
20%<br />
0%<br />
-20%<br />
-40%<br />
2005 2006 2007 2008 2009 2010 2011E*<br />
*Annualised<br />
Source: Strategic Insight Simfund MF, GL *Annualized<br />
Source: <strong>SEI</strong> Knowledge Partnership; Strategic Insight Simfund MF, GL<br />
5
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
One Third of UCITS Flows Go to Alternatives<br />
The remarkable progress of alternative strategies is Alternative UCITS funds have navigated this volatile<br />
evident in <strong>the</strong> substantial share of total industry gains environment without any meaningful operational<br />
<strong>the</strong>y now capture, accounting for 39% of year-to-date or liquidity crises so far, a fact that is encouraging<br />
flows to all long-term actively managed UCITS, a confidence. Growing familiarity with <strong>the</strong> strategies,<br />
far higher proportion than many had anticipated. and acknowledgement by Europe’s fund industry that<br />
Alternative strategies inside UCITS attracted $22 <strong>the</strong> use of sophisticated investment techniques or<br />
billion of net new flows in <strong>the</strong> first eight months of derivatives do not necessarily imply higher risks 1 ,<br />
2011. This was achieved despite overall flows into suggest more supportive views on <strong>the</strong> long-term role<br />
long-term UCITS declining by over 90% during <strong>the</strong> of such products in <strong>the</strong> regulated retail world than<br />
same period.<br />
before. The industry and regulators alike never<strong>the</strong>less<br />
remain attentive to <strong>the</strong> potential risks of alternative<br />
Such gains are being facilitated by <strong>the</strong> emergence<br />
strategies, and are constantly reviewing additional<br />
of a few well-established alternative UCITS funds with<br />
protective measures.<br />
appealing track records, competitive returns, relatively<br />
transparent investment and risk management<br />
Efforts are underway in Europe to better identify<br />
strategies, and strong brands. The biggest individual <strong>the</strong> distinct strategies and hedge fund styles being<br />
product, Standard Life Global Absolute Return<br />
implemented in UCITS. One example is <strong>the</strong> recent<br />
Strategies, now has $13.6 billion in assets and is <strong>the</strong> introduction of more precise classifications by<br />
15th-largest long-term fund in Europe. In addition, independent fund information providers, a significant<br />
<strong>the</strong> top selling alternative UCITS new introduction improvement from <strong>the</strong> generic “absolute return”<br />
thus far this year is a SICAV version of this fund groupings used previously, which fur<strong>the</strong>r promotes<br />
designed for cross-border distribution collecting over <strong>the</strong> professional selection, monitoring, and<br />
$1.5 billion. During <strong>the</strong> same period, PIMCO GIS benchmarking of regulated alternative funds and<br />
Unconstrained Bond, launched in December 2008, easier integration of <strong>the</strong>m into investment portfolios.<br />
success<strong>full</strong>y raised nearly $3 billion in flows making<br />
it <strong>the</strong> best-selling alternative UCITS product to date<br />
in 2011. The growth and visibility of such alternative<br />
fund leaders are buoying faith amongst a broadening<br />
base of investors.<br />
“The evolution of investment philosophies and<br />
strategies is causing previously distinct investor<br />
segments and products to converge.”<br />
6<br />
1<br />
See “The Evolving Investment Strategies of UCITS”, European Fund and Asset Management Association, May 2011.
New European Launches Broaden <strong>the</strong> Field<br />
There are now over 1,500 UCITS funds in Europe using The most successful offering in 2011 is <strong>the</strong> Standard<br />
alternative strategies and managing a combined $254 Life SICAV Global Absolute Return Strategies, which<br />
billion of assets 2 . Moreover, many of <strong>the</strong>m have<br />
raised $1.5 billion in <strong>the</strong> eight months following its<br />
achieved a meaningful size, with 41 funds managing in launch. O<strong>the</strong>rs include Deutsche Asset Management’s<br />
excess of $1 billion and ano<strong>the</strong>r 65 portfolios running DB Platinum IV dbX Systematic Alpha Index, which<br />
between $500 million and $1 billion apiece.<br />
captured $1.1 billion of net flows in <strong>the</strong> 12 months since<br />
its launch and <strong>the</strong> Solo Absolute Bond & Currency Fund<br />
The field is growing with new introductions and product<br />
from Natixis, which pulled in $750 million in <strong>the</strong> three<br />
range extensions. During <strong>the</strong> first eight months of 2011,<br />
months since its launch. Toge<strong>the</strong>r <strong>the</strong>se and o<strong>the</strong>r funds<br />
fund managers launched 170 new alternative UCITS,<br />
confirm a more robust evolution of demand for new<br />
collectively raising $10 billion from investors across<br />
alternative products than predicted after <strong>the</strong> relatively<br />
Europe and internationally.<br />
lacklustre UCITS experiments by hedge fund managers<br />
New launches are also ga<strong>the</strong>ring greater assets than a year or two ago. See Figure 4.<br />
before. The amount raised in <strong>the</strong> first half of 2011 is<br />
a notable leap from <strong>the</strong> second half <strong>the</strong> previous year<br />
when new funds raised just $4 billion.<br />
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
Figure 4: Biggest Alternative UCITS and Mutual Funds<br />
Morningstar Category<br />
Launch Date<br />
Net Flows<br />
$B YTD Aug ‘11<br />
Assets<br />
$B Aug ‘11<br />
Europe UCITS<br />
Standard Life Invsmts Glo Absolute Return Strat Alt—Multistrategy 2008 2.7 13.6<br />
Julius Baer BF Absolute Return-EUR B Alt—Long/Short Debt 2008 -0.6 7.8<br />
Newton Real Return A GBP Fund GBP Flexible Allocation 1993 2.5 7.0<br />
JP Morgan Income Opportunity A Acc EUR USD Flexible Bond 2007 2.1 7.0<br />
PIMCO GIS Unconstrained Bond Institl USD Acc USD Flexible Bond 2011 2.9 6.4<br />
U.S. Funds<br />
<br />
SPDR Gold Shares Gold 2004 -2.4 71.8<br />
PIMCO Commdty Real Return Strategy Commodities 2002 2.4 27.6<br />
Ivy Asset Strategy World Allocation 1995 1.8 27.1<br />
iShares Silver Trust Silver 2006 -1.2 13.0<br />
iShares Gold Trust Gold 2005 2.5 9.7<br />
Source: <strong>SEI</strong> Knowledge Partnership; Strategic Insight Simfund GL, MF<br />
Though acceptance is spreading, many investors and<br />
intermediaries remain in <strong>the</strong> early stages of incorporating<br />
alternatives into <strong>the</strong>ir investment programs. This<br />
suggests much room for growth if regulated alternative<br />
funds continue to manage <strong>the</strong>ir risks, offer investors<br />
<strong>the</strong> same level of fundamental protections as o<strong>the</strong>r<br />
regulated products, and deliver reasonable results and<br />
value over time. And managers of <strong>the</strong>se funds must<br />
help intermediaries and investors better understand<br />
<strong>the</strong> strategies and how <strong>the</strong>y fit in a portfolio.<br />
2<br />
Strategic Insight has been tracking alternative strategies in UCITS for over half a decade, and now combines its own research with classifications from Morningstar, Lipper, and o<strong>the</strong>r<br />
specialist fund trackers who focus on <strong>the</strong> hedge fund style UCITS universe to determine <strong>the</strong> most relevant peer group of alternative investment funds.<br />
7
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
Gains in <strong>the</strong> U.S. Despite Challenges<br />
Alternative strategies through U.S. mutual funds and “microsites” devoted to particular alternative-strategy<br />
ETFs drew $39 billion in net inflows in <strong>the</strong> first eight products complete with whitepapers and videos in<br />
months of 2011, on pace to come near 2010’s $65 addition to fact sheets and regulatory filings. For<br />
billion. The “alternative” category, which comprises example, in early 2011, seven asset managers,<br />
multiple investment strategies and asset classes, is including Forward, JP Morgan and Eaton Vance,<br />
heterogeneous enough that when precious metals funds teamed up for a three-city road show aimed at<br />
in 2011 failed to continue <strong>the</strong> torrid sales of 2010, <strong>the</strong> explaining alternative-strategy mutual funds to<br />
slack in alternative fund flows was picked up by o<strong>the</strong>r independent registered investment advisors (RIAs).<br />
commodity funds and by alternative-style global tactical Still, <strong>the</strong>se products can be hard to place in <strong>the</strong> huge<br />
asset allocation (GTAA) funds, a fast-growing category and highly regulated arena of defined-contribution<br />
whose funds may invest anywhere around <strong>the</strong> world in retirement plans, where plan sponsors tend to be<br />
any asset class, akin to global macro hedge funds. By conservative; but alternative-strategy funds are slowly<br />
<strong>the</strong> end of August, <strong>the</strong> U.S. had roughly 730 alternative gaining a toehold as sleeves within funds-of-funds in<br />
mutual funds and ETFs, 118 of which had been<br />
such plans.<br />
launched in <strong>the</strong> first eight months alone.<br />
In <strong>the</strong> retail-oriented U.S. market for alternative strategy<br />
Despite <strong>the</strong>ir momentum, alternative mutual funds face mutual funds, managers’ marketing and sales efforts<br />
several challenges. Like <strong>the</strong>ir colleagues across <strong>the</strong> often prioritise <strong>the</strong> independent RIAs, who tend to be<br />
Atlantic, <strong>the</strong> SEC has been concerned about <strong>the</strong><br />
early adopters of alternative strategies and structures.<br />
regulatory and disclosure implications of <strong>the</strong> growth of Broker-dealers, <strong>the</strong> most important distribution outlet for<br />
derivatives use amongst mutual funds and has been mutual funds, also have a growing population of RIA-like<br />
reviewing derivatives policy for more than a year. The advisors: those who use a rep-as-portfolio manager<br />
agency has gone so far as to freeze most approvals platform. These advisors have <strong>full</strong> discretion over client<br />
of new funds and ETFs that rely heavily on derivatives, assets and construct client portfolios ra<strong>the</strong>r than using<br />
as it continues to conduct its review.<br />
model portfolios provided by due diligence teams at <strong>the</strong>ir<br />
firm’s headquarters. Advisors utilising this fast-growing<br />
Investors and <strong>the</strong>ir advisors can also be intimidated<br />
model are decidedly heavier users of alternative mutual<br />
by <strong>the</strong>se often-complex products. Active outreach and<br />
funds (especially GTAA) and ETFs. They also tend to<br />
marketing campaigns are common amongst <strong>the</strong> retailoriented<br />
firms that dominate <strong>the</strong> space. Money<br />
hold funds and ETFs for shorter periods than o<strong>the</strong>r<br />
advisors, so managers should recognise that <strong>the</strong>re<br />
managers such as Putnam Investments have web<br />
is a trade-off for <strong>the</strong>ir early acceptance.<br />
8
Performance with O<strong>the</strong>r Factors Driving Sales<br />
Similar to hedge funds and traditional long-only<br />
less. As a group, <strong>the</strong>se low-rated funds suffered net<br />
managed funds, assets in <strong>the</strong> regulated alternatives redemptions, as Figure 5 illustrates 3 . We observed<br />
space migrate to <strong>the</strong> largest professionally managed similar relationships between performance and flows<br />
funds with <strong>the</strong> strongest performance. Sales results in practically all asset classes, markets, and time<br />
closely correspond with an individual fund’s absolute periods over <strong>the</strong> past 20 years.<br />
and relative results, and various measures of riskadjusted<br />
returns.<br />
Whilst performance matters for funds with a track<br />
record, new unrated funds also get a large share of<br />
For example, amongst alternative UCITS with a track sales. This is especially true in <strong>the</strong> alternatives segment<br />
record, 69% of YTD 2011 flows went to funds with where many funds do not yet have long track records,<br />
Morningstar’s top 5-star risk-adjusted return rating, but where <strong>the</strong> manager might have a reputation running<br />
and ano<strong>the</strong>r 28% of flows to products with a high similar strategies in ano<strong>the</strong>r format. Views that newer,<br />
4-star rating—even though only a third of rated funds smaller funds could exercise greater flexibility and<br />
earned <strong>the</strong>se star ratings. Most have three stars or potentially outperform larger funds may also play a role.<br />
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
Figure 5: Alternative UCITS Flows YTD Aug ’11 By Morningstar Rating*<br />
6.0<br />
5.0<br />
4.0<br />
U.S. $Billions<br />
3.0<br />
2.0<br />
1.0<br />
0<br />
-1.0<br />
5 4 3 2 1<br />
Morningstar Rating<br />
* Data reflects only funds with Morningstar ratings. Data does not include<br />
all alternative UCITS funds, in particular new funds without a rating.<br />
Source: <strong>SEI</strong> Knowledge Partnership; Strategic Insight Simfund GL<br />
3<br />
Based on Strategic Insight’s analysis through August 2011 of its own calculated flows within SI’s Simfund Global database, for <strong>the</strong> entire SI universe of alternatives, using Morningstar Ratings.<br />
9
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
Figure 6: Alternative and Traditional UCITS Fund Asset-Weighted Performance<br />
110<br />
105<br />
100<br />
95<br />
90<br />
85<br />
80<br />
Alternative Strategies<br />
Traditional Long-Term Assets<br />
75<br />
Dec ’06 Jun ’07 Dec ’07 Jun ’08 Dec ’08 Jun ’09 Dec ’09 Jun ’10 Dec ’10 Jun ’11<br />
Source: Strategic Insight asset-weighted calculations in Euro terms based on returns from Morningstar Inc and Lipper Inc Returns represent<br />
asset-weighted composites of Euro-base primary share classes only; traditional long-term assets excludes money markets and alternatives<br />
Source: <strong>SEI</strong> Knowledge Partnership; Strategic Insight asset-weighted calculations in Euro terms based on returns from Morningstar Inc and Lipper Inc<br />
Returns represent asset-weighted composites of Euro-based primary share classes only; traditional long-term assets exclude money markets and alternatives.<br />
More importantly, in Figure 6, <strong>the</strong> success of alternative<br />
UCITS coincides with returns that have matched<br />
traditional assets—with lower volatility—over <strong>the</strong> past half<br />
decade. From <strong>the</strong> viewpoint of a Europe-based investor,<br />
regulated alternative strategies lost only 7% during <strong>the</strong><br />
year of <strong>the</strong> 2008 financial crisis, whilst traditional funds<br />
(equity, bond, balanced, and o<strong>the</strong>r long-term asset<br />
classes) suffered a 21% average loss on an assetweighted<br />
basis 4 . Though traditional assets delivered<br />
higher returns during <strong>the</strong> 2009 and 2010 calendar years,<br />
alternative UCITS achieved similar cumulative returns<br />
since <strong>the</strong> start of 2007, with lower volatility.<br />
Results appear even better for UK-based investors.<br />
Alternative UCITS in <strong>the</strong> UK returned 13% on an<br />
average asset-weighted basis in 2009 and 8% in 2010 in<br />
GBP terms which, along with <strong>the</strong>se funds’ o<strong>the</strong>r<br />
attributes, proved appealing to local institutional<br />
investors and retail investors through IFAs.<br />
Comparing <strong>the</strong> performance of alternative UCITS versus<br />
unregulated offshore hedge funds is difficult, since most<br />
hedge funds and indices are managed and <strong>report</strong>ed<br />
on a U.S. Dollar basis, whilst alternative UCITS are<br />
better understood in Euro terms from <strong>the</strong> vantage point<br />
of European investors. In any case, most sophisticated<br />
investors do not necessarily expect results from<br />
regulated alternative vehicles to match or exceed<br />
unregulated leveraged hedge funds. Most instead weigh<br />
<strong>the</strong> potential performance trade-off against <strong>the</strong> benefits<br />
of a regulated, transparent, and liquid vehicle, using<br />
recent years’ track records as a guide.<br />
Similarly, performance comparisons between U.S.<br />
alternative mutual funds and U.S. hedge funds are<br />
difficult, in part because <strong>the</strong> vast majority of <strong>the</strong><br />
alternative mutual funds are—unlike in Europe—<br />
managed by traditional fund managers and are <strong>the</strong>refore<br />
not versions of existing hedge funds. The promise of<br />
alternative mutual funds in <strong>the</strong> U.S. has flipped in recent<br />
years. Prior to <strong>the</strong> financial crisis, <strong>the</strong> sale of alternative<br />
strategies relied heavily on <strong>the</strong> possibility of boosting<br />
alpha (potentially a risk enhancer). Since <strong>the</strong> crisis,<br />
alternative mutual funds have been positioned more<br />
as a means to reduce volatility and provide downside<br />
protection (potentially a risk reducer). This has been a<br />
particularly important feature given <strong>the</strong> tumultuous rise<br />
and fall of <strong>the</strong> equity markets—toge<strong>the</strong>r with <strong>the</strong> low<br />
or no return fixed income market—throughout 2011.<br />
10<br />
4<br />
Asset-weighted average returns provide a better proxy of <strong>the</strong> experience of most investors, and <strong>the</strong>reby helps explain investor choices.
The Role of Risk Management<br />
The future of alternative investments through regulated This summer ESMA issued a consultation on <strong>the</strong> risks of<br />
funds, whe<strong>the</strong>r UCITS, ’40 Act mutual funds, or similar syn<strong>the</strong>tic ETFs and structured UCITS, with implications<br />
structures around <strong>the</strong> world, will depend to a large for alternative strategies relying on derivatives. Amongst<br />
degree on robust management of <strong>the</strong> many complex <strong>the</strong> issues emerging from <strong>the</strong> process are proposals for<br />
risks of such strategies. The responsibility rests primarily separating UCITS into non-complex versus complex<br />
on <strong>the</strong> fund managers to implement <strong>the</strong> necessary products. In October, <strong>the</strong> European Commission’s review<br />
internal controls, but with <strong>the</strong> help of independent of <strong>the</strong> Markets in Financial Instruments Directive (MiFID<br />
service providers and with effective oversight by<br />
II) supported <strong>the</strong> distinction of structured UCITS as<br />
regulators and industry peer review.<br />
complex instruments, which would place certain<br />
restrictions on <strong>the</strong>ir availability to retail investors.<br />
The regulatory frameworks of both UCITS and U.S.<br />
mutual funds provided a strong foundation for risk The regulation and distribution of hedge fund-style<br />
management and investor protection. Investors seeking alternative UCITS will remain closely intertwined with<br />
alternative investment strategies following <strong>the</strong> 2008 evolving policy orientations on syn<strong>the</strong>tic ETFs. The use<br />
financial crisis have found comfort in <strong>the</strong> detailed of derivatives and swaps in ETFs, a segment where<br />
requirements around risk measurement and<br />
syn<strong>the</strong>tic products account for 65% of <strong>the</strong> European<br />
management, liquidity, counterparty diversification, and industry, is an increasingly visible issue that has led<br />
limits on leverage, whilst leaving sufficient flexibility to regulators o<strong>the</strong>r than ESMA to examine <strong>the</strong>ir<br />
implement a diverse range of strategies.<br />
counterparty, liquidity, and systemic risks 5 . The<br />
spotlight on <strong>the</strong>se risks has contributed to a shift in<br />
Yet <strong>the</strong> expanding use of derivatives and <strong>the</strong>ir associated<br />
European ETF flows in 2011, with more capital flowing<br />
counterparty and operational risks continues to concern<br />
to “physical” ETFs in recent months than to swapsbased<br />
“syn<strong>the</strong>tic” ETFs. Clearly, industry players have<br />
investors and regulators alike. Regulators and industry<br />
associations are exploring additional measures to improve<br />
strong incentives to buttress confidence in derivatives<br />
internal controls and streng<strong>the</strong>n oversight. Last year, <strong>the</strong><br />
use, and we believe <strong>the</strong> focus on this issue will help <strong>the</strong><br />
Committee of European Securities Regulators (CESR)<br />
industry in <strong>the</strong> long run.<br />
provided guidance on risk management including<br />
counterparty risks. CESR has since been replaced by <strong>the</strong><br />
European Securities and Markets Authority (ESMA), an<br />
independent EU authority that continues to actively<br />
assess <strong>the</strong>se issues.<br />
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
“ The future will depend on robust management of <strong>the</strong><br />
many complex risks of alternative strategies.”<br />
5<br />
See “Market Structures and Systemic Risks of Exchange-Traded Funds” from <strong>the</strong> BIS, April 2011.<br />
11
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
AIFMD Opens New Doors<br />
Earlier uncertainties around changing hedge fund<br />
regulations, particularly fears that <strong>the</strong> Alternative<br />
Investment Fund Managers Directive (AIFMD or<br />
Directive) might create hardships for certain non-EU<br />
funds to conduct business in Europe, had prompted<br />
hedge fund managers to consider or launch alternative<br />
strategies within UCITS which sit outside <strong>the</strong> scope<br />
of <strong>the</strong> Directive.<br />
Questions still remain, but <strong>the</strong> final draft of <strong>the</strong><br />
regulations as published in July 2011 is causing less<br />
worry for hedge fund managers than first feared.<br />
This is helping to dissipate <strong>the</strong> attention of hedge fund<br />
managers on UCITS as a way to get around <strong>the</strong><br />
limitations of AIFMD. The positive development allows<br />
both alternative and traditional managers to consider<br />
various different vehicles—both offshore and onshore<br />
hedge structures as well as UCITS where appropriate—<br />
and choose <strong>the</strong> most suitable for <strong>the</strong>ir investment<br />
strategy and target clientele.<br />
Luxembourg and Ireland are adapting <strong>the</strong>ir respective<br />
laws on Specialised Investment Funds (SIFs) and<br />
Qualifying Investor Funds (QIFs)—both regulated<br />
product structures—to align with AIFMD, and to<br />
establish <strong>the</strong>se vehicles as a suitable structure for<br />
hedge fund providers. These and o<strong>the</strong>r EU-domiciled<br />
alternative investment funds (AIFs) offer transparency,<br />
liquidity and access to Europe’s investors whilst also<br />
providing greater flexibility than UCITS, possibly making<br />
<strong>the</strong>m preferable structures for certain hedge fund<br />
strategies and investor types. SIFs and QIFs are thus<br />
expected to grow in <strong>the</strong> coming years as AIFMD settles<br />
into place. Assets in Irish QIFs expanded 35% in 2010<br />
to end <strong>the</strong> year at $209 billion, whilst Luxembourg SIFs<br />
grew 39% to reach $292 billion. This suggests that<br />
investors put in about $102 billion combined of net<br />
new money into QIFs and SIFs.<br />
Despite <strong>the</strong> expected growth of AIFs as AIFMD takes<br />
effect, many hedge fund and mainstream asset<br />
managers will undoubtedly continue to recognise<br />
UCITS as an appropriate structure for many highly<br />
liquid and unleveraged alternative strategies. Wellmanaged<br />
alternative UCITS with <strong>the</strong> right distribution<br />
approach have proven that <strong>the</strong>y can consistently attract<br />
a very high level of assets. Moreover, <strong>the</strong>ir popularity<br />
continues to grow amongst institutional and individual<br />
investors as well as fund selectors and advisors, as <strong>the</strong>y<br />
seek less correlated investments, additional sources<br />
of capital appreciation and income potential.<br />
12
New Frontiers<br />
Europe and <strong>the</strong> U.S. have been at <strong>the</strong> forefront of<br />
product innovation, but alternative strategies in<br />
regulated retail fund form are now appearing in o<strong>the</strong>r<br />
parts of <strong>the</strong> world. Notably, <strong>the</strong> $2 billion launch in <strong>the</strong><br />
2nd quarter 2011 of Nomura Global Trend in Japan,<br />
a fund based on Man AHL’s managed futures strategy,<br />
signals an important milestone in <strong>the</strong> spread of<br />
alternative strategies to <strong>the</strong> Asia region. The fund’s<br />
size would have been impressive under normal<br />
circumstances, but is all <strong>the</strong> more noteworthy given<br />
that fundraising occurred just after <strong>the</strong> country’s tragic<br />
earthquake and tsunami.<br />
The success of this fund will encourage additional<br />
launches of regulated alternative investment funds<br />
in Japan beyond <strong>the</strong> historic route of structured<br />
products and private placements. The mutual<br />
fund market in Japan is <strong>the</strong> single greatest<br />
source of new assets, with multi-billiondollar<br />
mutual funds introduced on<br />
a monthly basis. Thus, hedge fund<br />
and o<strong>the</strong>r alternative managers may<br />
increasingly consider building<br />
relationships in that market.<br />
Alternative strategies may benefit through adaptation<br />
to <strong>the</strong> needs of investors in new markets, to incorporate<br />
<strong>the</strong>mes and features <strong>the</strong>y find important. For instance,<br />
Nomura Global Trend was offered in three currency<br />
classes: (1) yen, (2) a basket of currencies driven by<br />
natural resources—Brazilian real, Australian dollar,<br />
and South African rand, and (3) a basket of Asian<br />
currencies. The natural resource currency class<br />
captured more than half of assets.<br />
Opportunities for alternative managers are growing<br />
across Asia, Latin America, and <strong>the</strong> Middle East, driven<br />
by demand from both private investors and institutions.<br />
In particular, sovereign wealth funds and national<br />
pension funds, many of <strong>the</strong>m collecting new assets on<br />
a sustained basis, are considering greater alternative<br />
investments to put those assets to work and to diversify<br />
<strong>the</strong>ir traditional strategic mix. Alternative<br />
managers are also expecting wealthy<br />
investors across Asia to consider<br />
alternatives more seriously now,<br />
following negative experiences over<br />
many years with o<strong>the</strong>r asset classes.<br />
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
13
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
Looking to <strong>the</strong> Future<br />
Growth in <strong>the</strong> global retail market by alternative UCITS<br />
and mutual funds will be spurred mostly by smaller<br />
institutional investors. In <strong>the</strong> U.S., a greater number of<br />
financial advisors are adding alternative funds to retail<br />
portfolios as risk and volatility management become<br />
higher priorities in advisor-client discussions. In Europe,<br />
retail and institutional investors alike are gradually<br />
migrating toward UCITS, attracted by <strong>the</strong> fact that <strong>the</strong>y<br />
are relatively liquid, transparent, and regulated.<br />
However, it would be a mistake to view UCITS and ’40<br />
Act funds as some sort of panacea. They work well as<br />
vehicles for some investment strategies, but illiquidity<br />
factors prevent <strong>the</strong>m from working for o<strong>the</strong>r strategies.<br />
They are ultimately just one more way for managers<br />
to expand <strong>the</strong>ir investor base.<br />
Despite this caveat, assets in alternative-strategy UCITS<br />
and U.S. mutual funds should top $1 trillion in 2014,<br />
assuming only modest performance gains over <strong>the</strong> next<br />
few years, and barring a dramatic bear market. By 2016,<br />
assets in such funds should more than double <strong>the</strong><br />
current $644 billion. Absolute return, hedge fund-like<br />
strategies, and global tactical allocation funds are likely<br />
to be major drivers of this growth. Commodity funds may<br />
also grow as portfolio diversifiers, but demand is less<br />
certain as <strong>the</strong>y often mirror erratic commodity price<br />
movements. Geographically, any slowdown in growth in<br />
<strong>the</strong> U.S. and Europe will likely be partly offset by growth<br />
in Asia and o<strong>the</strong>r newer regions.<br />
Figure 7: Projected Growth of Alternative UCITS and Alternative U.S. Mutual Funds<br />
1,500<br />
1,250<br />
U.S. $Billions<br />
750<br />
600<br />
500<br />
250<br />
0<br />
2007 2008 2009 2010 2011E 2012E 2013E 2014E 2015E 2016E<br />
Source: Strategic Insight<br />
Source: <strong>SEI</strong> Knowledge Partnership; Strategic Insight<br />
14
Conclusion<br />
A market of $1 trillion or more, and growing at such<br />
a robust pace, means opportunities lie ahead for both<br />
retail and institutional managers interested in alternative<br />
strategies. With <strong>the</strong> development of regulated non-UCITS<br />
funds such as QIFs and SIFs as vehicles for alternatives,<br />
<strong>the</strong> market is even more substantial.<br />
As managers jockey for position and vie for <strong>the</strong> attention<br />
of investors, intermediaries, and gatekeepers, product<br />
innovation and distribution expertise will be key factors<br />
in determining <strong>the</strong> winners. And as <strong>the</strong> market matures,<br />
assets will ultimately coalesce around managers that are<br />
able to effectively combine both of <strong>the</strong>se attributes with<br />
a sterling reputation, an institutional quality process,<br />
and proven performance.<br />
Traditional fund managers should be able to leverage<br />
<strong>the</strong>ir existing relationships with distributors as <strong>the</strong>y roll<br />
out alternative funds. Those with experience in educating<br />
investors and advisors are likely to have an additional<br />
advantage that will enable <strong>the</strong>m to secure additional<br />
market and mind share. Hedge fund managers wishing<br />
to enter <strong>the</strong> market for regulated alternative funds may<br />
prefer to find a retail-oriented manager with whom to<br />
partner or enter into a subadvisory relationship. Such<br />
partnerships, combining <strong>the</strong> investment expertise of one<br />
firm with <strong>the</strong> distribution prowess of ano<strong>the</strong>r, will almost<br />
certainly become more common as managers of all<br />
stripes look for ways to gain a foothold in one of <strong>the</strong><br />
most dynamic and growing parts of <strong>the</strong> asset<br />
management business.<br />
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
“As managers jockey for position and vie for<br />
<strong>the</strong> attention of investors, intermediaries, and<br />
gatekeepers, product innovation and distribution<br />
expertise will be key factors in determining<br />
<strong>the</strong> winners.”<br />
15
REGULATED ALTERNATIVE FUNDS: THE NEW CONVENTIONAL<br />
About <strong>SEI</strong><br />
<strong>SEI</strong> (NASDAQ:<strong>SEI</strong>C) is a leading global provider of investment processing, fund processing, and investment<br />
management business outsourcing solutions that help corporations, financial institutions, financial advisors, and<br />
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partnerships in which <strong>the</strong> company has a significant interest, <strong>SEI</strong> manages or administers $395 billion in mutual<br />
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strategies and jurisdictions. With expertise covering traditional and alternative investment vehicles, <strong>the</strong> division<br />
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The <strong>SEI</strong> Knowledge Partnership is an ongoing source of action-oriented business intelligence and guidance for <strong>SEI</strong>’s<br />
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About Strategic Insight<br />
Begun in 1986, Strategic Insight is a competitive intelligence source for <strong>the</strong> investment management industry,<br />
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16
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