Finding the best apples in the barrel

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The use of hedge fund of funds (FoHF) has shown a dramatic increase over the last two years after a sustained period of lagging direct holdings in hedge funds. Globally, almost 40% of new investments into hedge funds are now via fund of funds whilst in Europe this is even more marked with in excess of 60% of new investments being made via fund of funds.
The advantages offered by FoHFs can provide the only acceptable method of investing by institutions who need to satisfy their clients that the ‘normal’ standards of risk control, liquidity and expertise are employed.
The claim of many FoHF operators is that they can bring access to managers who are closed, and not always by resorting to re-allocating existing holdings, and provide enhanced levels of liquidity and transparency. This is given credibility when the reputational, or ‘soft,’ side of the business is considered – managers are more likely to provide enhanced transparency and liquidity to those organisations who have consistently demonstrated a proper level of understanding of investing in their strategy, an independence that cannot mis-use the information provided and a track record of sensible treatment of managers. The role of the FoHF manager as the interface between managers and investors can provide the appropriate framework for full transparency leading to detailed risk analysis and control as required by the institutional investor without compromising the manager.
The risk/reward profiling made possible by those FoHFs that employ real asset allocation techniques has proved to be of value to both direct investors and to the banks that write structured products on such portfolios.
So, do the benefits of FoHFs justify the additional fee load? It is interesting to note that the difference between the performance of the HFR Fund-weighted Index, a measure of the performance of funds themselves, outperforms the HFR FoHF Index by just over 1.5% over the past two years. This equates roughly to the fees levied by the FoHFs. Importantly, however, there is a positive benefit in risk terms with the average FoHF displaying lower volatility than a basket of globally representative funds.
Do the advantages offered by FoHFs stand up to scrutiny? The answer depends largely on the structure they employ as it relates to the benefits being sought.
For a FoHF, understanding portfolio and manager risk, and having the ability to monitor and control this risk, is key. Therefore, it is necessary to provide an infrastructure that enables the managers to be monitored daily by independent entities. One such structure is the increasingly used managed account structure.
Managed accounts are becoming increasingly accepted by the manager community particularly when operated by well known/respected FoHFs. They facilitate portfolio construction and rebalancing by having a clear understanding of the opportunities and vulnerabilities of the strategies and managers in which we invest. The FoHF can then focus on analysable investment risk, that is, risk we can understand and for which we can develop reasonable expectations. The daily transparency of such an arrangement allows us to better monitor and manage portfolio and manager risk.
Similar to traditional asset classes, for any given hedge fund strategy and sub-strategy there is a return to the strategy and a return to manager skill which are analysable. In addition to manager skill, hedge fund returns are driven systematically by market factors such as change of market volatility and credit spreads. The understanding of the return drivers for these strategies, sub-strategies and managers is critical to constructing a fund of funds. Investing in a strategy or a manager without knowing the source of the return is to accept unknown risk. An objective is to keep unknown or non-quantifiable risk in a portfolio to a minimum.
The framework for fund selection and portfolio construction is based on three key components:
o understanding the attributes and return drivers of the various hedge fund strategies and sub-strategies in different market/economic environments;
o understanding the source or return, consistency and repeatability of return of individual hedge fund managers; and
o understanding the relationship among these strategies and managers.
For a portfolio, the overall goal is to achieve a mix of strategies and managers that will best achieve the portfolios risk/return objectives. Diversification by manager and strategy, and maintaining low/moderate correlation among strategies and managers, facilitates this goal because some strategies and some managers are usually doing well even if others are not doing particularly well. The element of diversification itself contributes to an improved risk/return profile of a portfolio. Alpha generated through superior manager selection improves this ratio.

The use of the information and data obtained by FoHFs can provide an important edge. For example, both in the daily data observed in separate accounts, and in talking to managers and following industry data, it was apparent last year and into this year that merger arbitrage activity was falling off. There were fewer deals for managers to invest in, cash as a percentage of assets was rising in manager portfolios, and managers were trying to shift investment into other investment areas. FoHFs with full transparency and high levels of liquidity were able to rebalance away from this less promising strategy and towards strategies that had better prospects in the near-to-intermediate term.
One of the strategies that looked more favourable than merger arbitrage in the first part of this year was distressed investment. The default ratio seemed to be peaking, distressed opportunities were plentiful, and the economic fundamentals in the US economy seemed to be improving – all positive signs going forward for distressed. However, in May and June, corporate earnings prospects were beginning to dim, and the market was severely affected by a series of disclosures on corporate fraud and malfeasance. The substantial increase in the supply of distressed securities coming onto the market as a result of these events, combined with lowered economic expectations, in effect extended out the time frame, and therefore the expected return, of distressed investments.
Given the flexibility of a segregated account approach, FoHFs were able to reallocate away from ‘deep value’ distressed managers to long/short and capital structure arbitrage distressed strategies, which would provide more stable and more attractive returns than the long-biased deep value strategies. Mispricings between distressed companies’ debt and equity would provide a more stable opportunity set in the near term. In addition, they were able to allocate away from distressed to areas thought were more promising in the near term, such as quantitatively-oriented market neutral trading strategies, which benefited from the volatility expansion and liquidity-driven selling from July through September.
In order to choose a manager that is more able to extract returns from a particular strategy vis-à-vis its peers, it is imperative to have a like group of managers with which to compare. Part of the problem facing FoF structurers in the past has been poor definition of strategies, sub-strategies and categorisation of individual hedge fund managers. To have a hope of finding the best apple in the barrel, one has to first know what an apple looks like, and then separate the apples from the other fruits to compare the apples. If we were to lump all equity hedge managers into one group, the end result of any analysis, whether for manager selection or portfolio construction, would be less useful than if manager analysis was by style (growth/value), geography (US equity, European equity, emerging markets equity) or exposure (long-biased, short-biased, leveraged, unleveraged).
Analysis of these ‘clean’ peer groups yields a target list of promising managers that are candidates for more intensive research. Having a useful sub-strategy peer group for comparison also allows better measurement of the value added of a particular manager. Also, it helps to focus not just on what have been the elements contributing to a manager’s attractive return history, but what could go wrong with a manager’s process or the investment area in which they operate. In addition, a sub-strategy peer group provides a point of reference for identifying style drift and other anomalies in a manager’s past performance.
It can be demonstrated that a quality FoHF company can add value in a number of different ways from risk control, to manager access, to asset allocation skills. Depending on the investors’ needs, the added performance or reduced risk, or even the ‘normalisation’ of the infrastructure, can provide strong value for the fees expended.
There are in excess of 950 FoHFs in the world. In five years the number is likely to be much smaller with the survivors offering excellent skill sets, strong track records and, importantly, sufficient critical mass to access all areas.
John Godden is managing director with HFR Europe in London

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