Hedge Funds: The view from the Hilltop
Martin Steward talks to Rory Hills about what went wrong with the fund of hedge funds industry - and about how to put it right
"I believe in fund of funds as a concept," says Rory Hills, founding partner of Hilltop Fund Management. Hold that thought, because for the next page he will be telling you about everything that's wrong with funds of hedge funds as an industry. "The mainstream approach is flawed in a number of ways - but it wasn't ever thus."
Hills has observed the changes up-close. Before starting Hilltop, which launched its first fund of hedge funds in April, he worked with Dexion Capital - now best known for its exchange-listed funds of funds - running a third-party marketing division that researched hedge fund managers and introduced them to institutional investors and funds of funds. Of the nine funds Hills had selected at Dexion from the start of 2006, seven delivered double digits for July 2007 through February 2009 and four returned more than 30%. As important, he met about 400 managers and more than a thousand fund selectors across as many as 250 firms.
"That gave me a really good insight into what they did well, what they did badly and how things changed," he reflects. Today, he picks out four big problems that Hilltop has been designed to address: the top-down strategy-selection approach to building portfolios; junior analysts and their box-ticking processes; concentration in the biggest funds; and over-diversification. And the worst thing? Institutional investors must share some of the blame for them all. All men kill the thing they love, according to Oscar Wilde, some with a bitter word and some with a flattering look - and some, evidently, by pouring in too much capital and attempting to re-fashion it into their own image.
"Funds of funds wanted big mandates from institutions, so they were all trying to look institutional," says Hills. "In 2005, if you had more office space filled with more people, that was great. Frankly, it was probably one of the major metrics you were going to be judged on."
But this has consequences. When Hills joined Dexion in 2002, at a fund of funds he would generally meet someone with 10 or more years' experience in asset management, trading, broking or research, usually with an ownership interest (Hills was a broker for 13 years before Dexion).
By 2005, the first meeting would be with a junior analyst whose experience, in too many cases, would all have been in funds of funds. This cannot be helped if you want to grow your business without diluting equity between lots of senior partners. But while
the top fund selectors in a firm might stop any nasties slipping through, what they definitely cannot do is put things that have already been ruled out back into the mix. The juniors have to be guided with a set of ex-ante constraints (not too small, not too volatile, even located not too far away). Even if these are passed, Hills argues that the chances
of a junior approving something like 36 South Capital Management's Kohinoor Fund - a strategy in Hilltop's portfolio that buys out-of-the-money options and delivered 77% during the crisis - are almost non-existent.
"Frankly, no-one completely understands that strategy at the first meeting, and the business is based in New Zealand," he says. "No-one is going to grill you on why you said no. In a research meeting culture where everyone else is there to shoot you down and earn brownie points from the boss, if you're three years out of university you're going to play it safe. Investment committees can only select from the shortlist and if this is predominately populated by plain vanilla strategies from brand name shops there is never enough alpha to produce an alpha portfolio."
All of this, together with rising levels of assets to put to work, led to the concentration of 75% of hedge fund assets in the top 3% of managers. These strategies are already highly correlated; to disguise this, many funds of funds loaded up with as many as they could, alongside a tail of unsubstantial allocations to smaller managers, diversifying away what alpha there was and leaving a rump of over-priced systematic beta.
Furthermore, if you are locked into buying from the same predictable range of managers as everyone else, how can you claim to be offering real manager selection and meaningful due diligence? There are two ways around this: claim instead to be providing ‘access', or top-down strategy rotation skills.
"A lot of funds of funds put the macro call at the heart of things," says Hills. "There are problems with that, not least that they don't have the liquidity to implement those decisions."
More importantly, high alpha managers are often the least simple to classify according to traditional categories, which means committees either take ages to agree where to put them, shoehorn them in somewhat reluctantly - or even pass them over completely. Hills argues that even in the best-case scenario - where your macro view is correct and you find good managers that fit your strategy requirements nicely - a top-down approach will necessarily rule-out talented managers working in the strategies that you are under-weighting. Against those who argue that systematic risk dominates a hedge fund's exposure and we should therefore manage strategy allocations actively, Hills points out that as much as one-fifth of the hedge fund industry was up by double digits during 2008, and that this performance was far from concentrated in strategies like managed futures: "It was pretty broadly spread: 25% of long/short equity funds were up, for example."
So how will Hilltop differ from this portrait of the mainstream? We could start with the fees: a standard 1% management charge is augmented with a somewhat non-standard performance fee with a three, rather than one-year high watermark (five or even seven years for a large segregated account). Then there is a hurdle that gets higher the longer an investor stays onboard. In addition, the firm has no ambition to run more than $600m or take on more than 50 clients. That should enable it to maintain its portfolio at 15-25 managers and remain size-agnostic (right now it invests with two $1bn funds and two that handle less than $50m). Fund shortlisting will always be done by portfolio managers rather than juniors.
That, in turn, should preserve its bottom-up focus, intended to maximise the portfolio's share of alpha and create the efficiency to target an explicit R-squared of 0.16 or less against the HFR Fund of Funds Composite index over any three-year period. Hills describes the result as an ‘absolute return' strategy and contrasts this with the mainstream which, although it might describe itself that way, is actually more about ‘hedged' returns - participating in beta rallies while protecting the downside. That's a fine concept when it works. Hills says that real absolute return funds of funds tend to favour managers who operate in unusual markets, or in mainstream markets in unusual ways.
He does classify strategies to maintain balance in the portfolio, but those classifications - ‘pure alpha', ‘macro alpha' and ‘opportunistic alpha' - tend to cut across many of the traditional hedge fund categories. Pure alpha strategies tend to be process-driven and non-directional - "when we allocate to pure alpha funds we are not making a macro call and neither are they" - and might include volatility arbitrage index arbitrage or equity market neutral.
Macro alpha includes any strategy running a variable long/short bias, where Hills believes the most important call that manager makes is the macro call, and "where we are convinced the manager is capable of generating positive returns in down as well as up markets". And opportunistic alpha, rarely more than two allocations or 10% of the portfolio, is the one place where Hilltop can make a macro call on outstanding medium-term opportunities: "That could be stressed credit, or emerging markets, for example, and this is the only part of the book where we would ever consider a permanently long-biased manager".
Does Hilltop represent the only valid fund of hedge funds model? No. And nor are its founders' insights totally unique. But at the very least, its design can inform investors who need to take the fund of funds route of the kinds of questions they need to ask to avoid the industry pitfalls.