The process of selecting a fund of hedge funds manager starts with the initial rationale and process for including hedge funds in a scheme’s asset allocation.
By looking to include hedge funds in the asset allocation, the pension scheme investors will have been driven by some of the following thoughts or emotions:
q A long-term view that hedge funds are an attractive ‘diversification’ asset – by which I mean that their returns are driven by different economic forces from those that drive equity and bond markets.
q A long-term view that equities will have lower prospective returns and higher volatility (the latter arising not least from the activity of hedge funds) than in the past.
q A shorter-term view that a reduction in equity weightings is desirable, but bonds appear to be very fully priced.
q A longer term view that, if we are in a stable inflation environment, then bond yields can be considered to be broadly stable long term. This leads – when taken with the bond-yield-related liability valuation methods being adopted by scheme actuaries – to a general desire for asset classes that are targeting an absolute level of positive return, regardless of general market conditions.
It is not too difficult to persuade pension schemes of the asset allocation investment case for hedge funds, as illustrated by the theoretical example of an equity market-neutral hedge fund.
This analysis shows a market neutral fund to be non-directional (by definition) with alpha arising from some positive stock selection of the long stocks and large amounts of positive stock selection of the shorts. The greater contribution of shorts is because there is greater market inefficiency on the short side – especially for stocks with low market weightings.
However, a number of questions of practicality arise at this stage:
q Because there is no investible benchmark (the exposure is neutral to the market so the benchmark is cash and therefore has no investment) active stock selection is the key to success in market-neutral investing. Since the success of schemes’ historic investments in equities has been driven by market returns rather than the particular active managers they have appointed, we need to be concerned that we have a process for appointing managers that is likely to generate the stock selection needed to drive the market-neutral process.
If we are that concerned about the selection of active managers then we need to diversify these selections, and select more market-neutral managers than we would have selected long only managers.
q If we are highly dependent on short-side stock selection, we need to be very wary of potential hedge fund managers whose ‘star status’ has been achieved by their skills at running long-only funds.
q The lack of an investible benchmark and the emphasis on inefficient areas of the market to generate the short-side return suggests that risk control (especially market liquidity) and cost control are especially important in the market-neutral arena.
What about hedge fund strategies other than market-neutral? Can the market-neutral case be extrapolated to justify investment in these?
Pension schemes that get through the first stage of accepting the asset allocation argument know that they are looking for hedge funds with the following characteristics:
q Broadly non-directional to meet absolute return criteria;
q Proven stock selection abilities (particularly on the short side);
q Sound risk control and cost control disciplines; and
q A diversified portfolio of the above to reduce fund specific risk.
The hedge fund market is principally US-based, with many hedge fund managers being very small. Furthermore, demand for hedge fund investments in recent years has exceeded supply, so most of these firms have little need to waste resources on expensive marketing personnel. This strong demand, coupled with the high fees (relative to traditional long-only management) that are typical in the hedge fund sector, leads to a high turnover of firms, which in turn leads to past performance numbers that are susceptible to survivorship bias.
The initial four fund characteristics, when considered in the context of the make-up of the hedge fund market, are a strong steer for trustees to seek a market specialist and proceed down the fund of funds route.
Hedge fund investment presents greater hurdles for most pension scheme investors to clear than the asset allocation case. For most lay trustees, their image of hedge funds is either George Soros holding central banks to ransom or the precipitate failure of a collection of Nobel laureates at Long Term Capital Management that nearly collapsed the global banking system. Naturally, a well-disciplined equity market-neutral fund is a far cry from either a highly leveraged fund such as LTCM or a thematic fund such as Soros – but for many trustees the scepticism remains.
To allay such fears, and for good prudential governance grounds, there are further hedge fund selection criteria that we might want to add to our initial list:
q Limit on use of leverage by the manager;
q No lock-in periods. Funds that are highly leveraged or taking unusual positions in illiquid assets are themselves illiquid. This leads to investors being unable to realise their assets which for many trustees is seen as undesirable;
q Controls on permitted investments;
q Transparency of investments;
q Sound corporate governance;
q Regulatory or supervisory protection; and
q Reasonable fee basis.
Whilst these issues in themselves do not suggest a preference for a fund of hedge funds solution, policing them is a detailed and time-consuming process and, for a diversified portfolio of hedge funds would be a very significant management time overhead that is best delegated to a specialist.
There are a number of accounting and good practice issues that also arise for pension schemes that add further selection criteria, such as:
q Preference for sterling-denominated funds;
q Daily pricing;
q Frequent dealing dates; and
q Fund of funds managers.
The most important criterion for selection of our fund of fund manager is to have the skill to select hedge funds that meet the criteria that we have already set out above. This should be a proven and demonstrable skill – both in terms of process and outcome.
The particular factors to consider are:
q Is the research process for appointing managers consistent with the size and structure of the underlying hedge fund universe?
q Is the process for monitoring existing managers likely to identify problems before they hit the bottom line?
q Is the process for removing managers expeditious?
q What is the expertise of the individuals operating the fund selection process and how does the process evolve over time?
Since demand has tended to outstrip supply for some hedge funds, and because many hedge fund managers employ techniques that are not scaleable to large volumes of assets under management, some funds are completely closed or only allow limited investment by existing investors or preferred investors. It is clearly no use for a fund of fund managers to identify a set of ‘winners’ if he has no access to capacity in those funds. This leads to a further set of factors to consider:
q Does the manager have special access to capacity?
q To what extent are historic performance numbers based on funds which are now closed?
Having identified underlying hedge funds that are suitable for investment, the fund of funds manager then needs to build a portfolio which aims to deliver the ultimate investment objective. For this part of the process, the types of factors we need to consider are:
q How is the portfolio of funds constructed?
q Does the manager understand the investment objectives of pension schemes?
q What is the typical number of funds and strategies employed?
q What is the maximum exposure to any one fund (as a proportion of that fund and as a proportion of the portfolio)?
q Can the aggregate exposure of the portfolio be monitored at all times? Is it monitored at all times?
q Does the fund of fund manager apply his own economic views in the short term to adjust the portfolio’s exposure to certain strategies and markets? What is the performance attribution of this part of the process?
Naturally, governance and administrative issues follow through from the individual hedge fund selection into the fund of hedge funds selection, so our fund of funds manager needs to meet suitable standards as regards:
q Corporate structure and regulation;
q Frequency of pricing and dealing; and
q Currency classes of shares.
Finally, I have avoided comment on fees, but it is undoubtedly the case that most pension schemes0…….. baulk at the combined level of fees payable to the individual hedge fund managers and then to the fund of funds manager. At present, there is limited scope for downward pressure on these fees. There is excess demand for hedge fund investment – and not from institutional investors – so most managers feel no pressure to accommodate pension scheme investors who want lower fees!
Peter Whitehead is principal of PD Whitehead & Co, an advisory firm based in Princes Risborough, UK