Hedge fund investment growth picking up from retail and into Shadow Banking

We’ve been thinking lately about hedge fund dynamics, the “other side of the fence,” if you will. Finadium’s next two research reports are surveys of hedge funds on prime brokers, leverage, repo and prime custody, the first of which will be out next week. Today we read an interesting piece from Citi about where new hedge fund growth will come from.

Citi Prime Finance released their report in May, “The Rise of Liquid Alternatives & the Changing Dynamics of Alternative Product Manufacturing and Distribution.” The report focused on investor behavior and had some conclusions we found useful for the securities finance and asset servicing industries.

“Investors are… moving out the liquidity curve in search of yield and perceptions were that inflows to shadow-banking products are back to levels not seen since [2007/2008].” The report notes that CLO issuance reached its third highest level on record in Q1 2013, and that investors are showing more interest in longer dated credit funds. These factors give greater credence to the argument that hedge funds are picking up where banks can’t in the Shadow Banking space, including taking on regulatory capital trades. Institutional investors see the value in this also and are willing to put their money in to back hedge funds in the Shadow space. (Note to the Fed: so much for moral righteousness solving the ills of Shadow Banking. Back to regulatory solutions.)

As further references on hedge funds picking up steam in Shadow Banking, we cite a May 7, 2013 Bloomberg Businessweek article on hedge funds taking on fixed income trades that banks won’t. For Finadium research subscribers, we summarized several specific examples of hedge funds taking over Shadow Banking trades in a Securities Finance Monitor article on April 16, 2013.

A surge in new hedge fund assets is coming not only from institutional investors but from a “middle tier” market of wealth managers. This is something we thought would happen some years ago, but it has taken a greater emergence of hedged mutual funds to make access more democratic. The report notes that 75% of retail investors do not quality to enter a private fund, but that public mutual fund structures that allow retail investors are well suited for this activity, particularly for hedge funds wearing US ’40 Act mutual fund clothing. Other big reasons for these new inflows include:

– Greater regulation has forced more transparency of hedge funds, which in turn encourages more retail investment.
– Wealth advisors need more alternatives to keep clients interested.
– US Registered Investment Advisors (RIAs) are seeing greater cash inflows and have more discretion on what investments to make for their clients as opposed to retail brokerages.

Citi sees US retail demand for alternative ’40 Act funds and ETFs rising from US$259 billion 2012 to US$779 billion by 2017. These figures seem realistic, but we are also reminded of 2007’s expectations that 130/30 funds would reach US$2 trillion in assets over by 2010. The market is much changed since then and the leverage costs for hedged mutual funds are lower, and operations are easier, but this is still a tough number to predict with certainty. For now though it appears that hedged mutual funds are gaining steam, a trend that should be good for securities finance and asset servicers.

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