They're the hedge funds for the masses, but now the masses want out.
Money pools that offer hedge fund strategies usually reserved for sophisticated investors to regular folks are seeing an unprecedented flight of capital after several supposedly liquid funds ran into trouble in Europe. Investors have fled these so-called liquid alternative funds, pulling more than $30 billion in the first half, the most since the 2008 financial crisis, according to data provider Eurekahedge.
Normally, that shouldn't be a problem because unlike traditional hedge funds, these more regulated products frequently offer investors the ability to get their money back daily. But after a stellar decade during which such funds increased assets fivefold, some of them have loaded up on investments that may be difficult to sell quickly — and put their promise of near-instant cash access to the test.
"It's just a movie that we have seen again and again, people taking risk that they shouldn't take," said Michele Gesualdi, who oversees $2.5 billion as the chief investment officer at Kairos Investment Management. "Liquidity mismatch will be one of the seeds of the next crisis."
The outflows from the hedge fund copycats amount to more than 10% of their total assets. They are facing scrutiny because of the recent concerns at H2O Asset Management, which runs more than a dozen such funds. Before that was the decision by star stock picker Neil Woodford to halt withdrawals at his flagship mutual fund. And even earlier, a fund freeze at GAM Holding last year rattled investors.
Although the two funds didn't employ hedge fund techniques, their travails have rippled across the market and made investors especially leery of managers that allow them daily access to their cash while investing in assets that cannot be sold quickly. That three firms faced crises in the span of a year highlighted just how far some are going to find returns, in a region that's been stuck with negative interest rates for half a decade.
"The temptation for a few extra basis points of return has perhaps led a small number of managers to overextend themselves," said Georg Reutter, a managing partner at Kepler, which tracks liquid alternatives.
The problem extends far beyond Europe and to a much broader range of funds. Over the past few weeks, Morgan Stanley and Deutsche Bank have pointed to hundreds of billions worth of bonds stashed in daily-dealing funds, while MSCI has identified seven stock funds that could fail to meet redemptions should they face requests.
As money managers displace traditional banks as providers of capital to companies, funds are swelling their holdings of debt. Mutual funds now hold 43 times more corporate bonds than dealers, compared with two times in 2007, according to the Deutsche Bank report. Morgan Stanley on Aug. 1 said about $1.1 trillion is held in daily dealing funds and exchange traded funds invested in high yield bonds, bank loans and emerging market debt, assets that can be more difficult to sell.
The growth of liquid alternative funds stems in part from the experience during the 2008 financial crisis, when such assets proved difficult to sell. Back then, many traditional hedge funds blocked investors from withdrawing money because they couldn't sell holdings fast enough without incurring huge losses. Regulators in Europe responded by slapping them with tighter rules, making it tougher and costlier to invest in hedge funds.
The copycat funds offered a workaround and carry the promise to investors of daily access to their money. Assets have increased by 406% since 2008 to $262 billion, compared with a 56% expansion in hedge funds, according to Eurekahedge. And more than a third of all that investment goes into fixed income.
Nearly all of the liquid alternatives are based in Europe, where the European Union's UCITS directive allows them to employ some hedge fund techniques, such as using leverage or shorting. And while hedge funds typically require a minimum investment of $1 million, investors can allocate $1,000 or less to their UCITS siblings, making them affordable to even retail investors.
"It is about time that the fund management industry, in unison with the regulator, fostered a more grown-up approach to the issue of illiquidity," said Andrew Clare, a professor at Cass Business School. "We should disabuse investors of the ridiculous notion that everything they invest in can be liquidated at the drop of a hat."
When Lehman Brothers Holdings Inc. went bust, hedge fund clients rushed to pull hundreds of billions of dollars. Holdings that managers thought were liquid turned out to be tough to sell. To avoid a fire sale, managers put the assets into so-called side-pockets, hoping to sell them at a better price at a later date. Billions of dollars worth of those assets still remains to be sold.
The recent events that have shaken funds in Europe have now drawn regulators' attention. U.K. watchdogs have blamed shortcomings in the EU regulations, which Brussels rejected and countered with criticism of London's fund oversight.
In June, Bank of England Gov. Mark Carney said that more than $30 trillion of global assets are held in funds that promise daily liquidity despite investing in potentially rarely traded underlying assets. His colleague Jon Cunliffe joined him, warning that the problem could pose a bigger threat to the financial system if it spreads.
"It's quite scary what is happening there," Kairos's Mr. Gesualdi said. "If investors want alternatives, they should not be liquid. It's an oxymoron."