A mainstream alternative?
The market-defying performance of many funds of hedge funds (FOHFs) so far this year has attracted the attention of pension funds and others. Many FOHFs have lived up to their promise to carry on producing absolute returns despite falling markets. That is more than can be said for most other asset classes, as many pension funds know to their cost.
What is evident is that there is now a strong argument for considering and including FOHFs in an institution’s portfolio of investments. However, questions do need to be answered by the FOHF’s providers. As an institution deciding whether to make an allocation to this asset class, what questions should you be focusing on asking the potential providers before making a commitment?
A fund of hedge funds, or multi-manager fund, is more than just a fund that invests client assets in a range of hedge funds. You should satisfy yourself, first, that a FOHF’s management team has both the expertise and the experience to track the overall universe of potentially investable hedge funds, to identify opportunities within that universe, and to monitor its portfolio and any other opportunities that might arise over time. There are many strategies and styles of hedge fund management, and an institution should satisfy itself that a FOHF manager has the expertise to blend these to construct a portfolio that provides both diversification and non-correlation.
A successful FOHF will be able to show a long track record, based on durable relationships with hedge-fund managers and a wide array of talent and experience within its own management team. Ask how many new hedge fund managers the FOHF manager meets in a typical month. Also ask about portfolio turnover. A manager who is not prepared to remove underlying managers risks under-performance when market conditions change.
A FOHF should also be able to demonstrate that it has a stand-alone and independent operational-risk and due-diligence function. This should take a quantitative and qualitative look at all of a hedge fund’s processes, from risk management through disaster recovery to its back office in general and its reputation in the market. Did the FOHF examine the underlying hedge funds’ founding documents, for example? Also included should be an assessment of any factors that might take a hitherto successful hedge-fund manager’s ‘eye off the ball’, and you should be able readily to obtain written evidence of the due-diligence findings in respect of any hedge fund within the FOHF’s portfolio.
By virtue of its size and the quality of its relationships, a FOHF should have the clout to gain access to opportunities that might be closed to other investors and to negotiate favourable terms for its own investors.
There is, unsurprisingly, a much greater interest today from institutions in capital preservation than in the past. The challenges of previous and current extreme market conditions have fuelled an enthusiasm for low-correlation, low volatility, absolute-return products. Today, the long-only manager, who is not able to short the market, who can only raise his cash level by selling stock, has suffered, while the hedge-fund manager, who has the strategies to generate returns in falling markets, has become a player to take very seriously.
The most compelling case for FOHFs today, therefore, rests on the appeal and necessity of absolute-return products in difficult market conditions. Such conditions are not rare; it is worth remembering that they occurred in 1987, 1990, 1994, 1998, 2000, 2001 and 2002.
While this might explain FOHFs’ current popularity, it is only the starting point for a long-term argument in their favour. We are very aware that institutions have a number of very specific concerns when considering FOHFs.
Our discussions with institutions suggest that their primary concerns about potential investment in hedge funds and FOHFs relate to a number of key issues. Unfamiliarity, in that hedge funds are new to them, so that they face a learning process before they can invest. Potential lack of transparency, in that some hedge funds are more opaque than is comfortable. Concerns about reporting and client servicing, in that details of hedge funds’ activities are not easily obtainable. Expense, in that some FOHFs charge a management fee as well as a performance fee. Terms and conditions and the possible lack of liquidity, in that some FOHFs offer only quarterly rather than monthly liquidity.
On each of these concerns, it is possible for institutional investors to satisfy themselves that the FOHFs being considered meet their requirements.
Unfamiliarity. This is an issue that a good FOHF management team should readily address. A FOHF team should facilitate the learning process by discussing and demonstrating its own hedge-fund selection and monitoring methods.
Transparency. Many hedge funds and FOHFs are not as transparent as traditional asset classes. Some do not disclose any holdings at all. A good FOHF provider should at least disclose its top 10 holdings. There is a discernible trend towards greater transparency across the hedge-fund industry. Institutions should be aware that there could be data relating to a FOHF’s investment process that might not be accessible to them. For example, not disclosing short positions which could have the potential to create market swings and sacrifice competitive edge.
Reporting and client servicing. Institutions should satisfy themselves that a FOHF provides timely information on its own and its underlying funds’ performance, including an array of information and technical data on investment policy and style, consistency of performance and risk. Look at the way the FOHF manager assesses and monitors the market; how able are they to tell you at short notice everything you need to know about an underlying manager? Related to this, an institution should satisfy itself that a FOHF provider is geared to providing an appropriate level of client servicing. Does the FOHF provider understand the needs of institutions and their consultants?
Expense. Fees generally range from 1–2% and there may be incentive fees on top of this (not all FOHFs charge performance fees). Hedge funds are clearly more expensive than traditional asset classes. We would argue that this reflects both their scarcity value, in that they can be difficult to access, and their performance. Hedge fund fees should be judged relative to their performance over several cycles.
Terms and conditions. Often a key concern is that some hedge funds impose lock-ups on invested funds – the knock-on effect being that some FOHFs limit their liquidity. A FOHF should have the ability to negotiate preferential terms that are acceptable to its investors. There is, clearly, a presumption in favour of size here, but institutions should also assess the quality of a FOHF’s relationships.
Liquidity. Many FOHFs offer only quarterly liquidity. While this may be acceptable, it is possible to achieve monthly liquidity within this market.
A traditional long-only fund is defined by its professional management and its function of identifying and buying shares or bonds likely to rise in price, then selling them when they are no longer expected to rise. Thus, it can only sell what it owns. A hedge fund can do everything that a traditional fund does, and it can also sell stocks that it does not own. It can borrow (although it doesn’t have to) and some hedge funds invest in a wider range of assets than traditional funds. On top of this, a good FOHF will provide the expertise and track record necessary to identify, invest in and monitor hedge funds.
As a good FOHF team will demonstrate, a hedge fund can spot both undervalued and overvalued assets and profit by doing so. Whereas traditional funds must spot undervalued shares and then spot when to sell them. Flexibility is a key characteristic of hedge funds giving them a greater range of opportunities to generate return, and complementing the already strong performance case for FOHFs.
The combination of performance and flexibility not only suggests that FOHFs have the potential to generate return in all market conditions it is ensuring they take their place alongside mainstream investments. Barra Strategic Consulting Group (BSCG) estimated in its report, Fund of hedge funds – rethinking resource requirements, in September 2001 that some $100bn was being managed within FOHFs and that US institutional investors already have over $15bn in FOHFs.
Related to this, FOHFs are becoming more resource-intensive, in terms of the required risk-management and due-diligence capabilities, and the FOHF market is becoming more competitive. We are beginning to see a significant increase in the number of FOHFs sufficiently resourced to meet institutional investors’ professional and process standards.
FOHFs were pioneered in the late 1980s to solve the problem that many of the best hedge-fund managers value their independence to the extent that no incentive package is sufficient to attract them into an asset management house. Today, the track record of the best-performing FOHFs suggests that the question has become: can you afford not to consider investment in this asset class?
Jonathan Moseley is managing director, clients, Europe for GAM in London