Focus and flexibility
One can tell from the name ‘Alternative Investment Group’ that this is a more venerable fund of hedge funds, pre-dating the post-dot-com stampede: it’s not exactly ‘Google-search optimised’.
More pertinently, this was a time when funds of funds were set up to manage assets for family, friends and the partners themselves – not anonymous clients investing through a forest of intermediaries – and the firm’s website proudly refers to its ‘partners’ rather than ‘clients’ or ‘customers’. It would be easy to be cynical about this were Alternative Investment Group not also walking the walk.
Take its AUM, which also looks like something from a more innocent age: after almost 20 years, it sits at just $1.6bn (€1.3bn) – $100m of which is partners’ money. Co-founder David Storrs claims that it could have been $4 or $5bn had the firm not soft-closed through 2002-04 to focus on building the partnership.
“There are lots of ways to make money in this industry,” he observes. “You can invest your own capital with talented managers. Or you can grow so much that the fees are larger but returns are lower.”
Hedge funds are pretty good on this score, Storrs argues, because they prioritise performance fees and are less subject to the distorting incentive of the ‘annuity for life’ that bloated long-only managers enjoy. That is debatable but, in any case, Alternative Investment Group again goes the extra mile to back up the fine words.
Most funds have a hurdle that they have to clear before charging a performance fee but, as Storrs points out, most will charge the full rate whether they clear that hurdle by 20 basis points or 20 percentage points. Alternative Investment Group has a tiered performance fee, instead: nothing if the investors earn less than 5%; 5% if investors earn 5-10%; rising to 10% if investors make 15% in a year, and on through 12.5% to 15% on truly exceptional returns.
Some argue that performance fees either encourage managers to swing for the fence, or to sell volatility and expose clients to left-tail risk. Won’t a tiered fee encourage a manager to swing even harder, or leverage his short-vol positions even more aggressively?
“Our investors are very happy with the idea,” Storrs counters. He recognises that these are legitimate concerns with single funds, but emphasises that his firm’s strategy is entirely geared towards treating risk reduction equally importantly as return. “We know that going to your boss and asking for a contribution to the pension fund because you went down 30%, even if the market went down 50%, is a terrible meeting to have to go to, and we emphasise downside protection much more than most funds.”
That sounds very ‘institutional’ and, sure enough, Storrs traces this mindset back to his experience as Yale University’s first director of investments. In the late 1960s the university trustees had concluded that growth stocks were the most successful investment sector – and made a big allocation. They promptly tanked by 50% in the 1973-74 bear market following the collapse of Bretton Woods. The trustees brought Storrs in from 1978 to come up with a safer strategy.
“That was a searing lesson about the importance of not putting all of your eggs in one basket,” Storrs reflects. “Yale’s success today is largely about broad diversification across many inefficient market areas and avoiding big losses. That is the basis of what we do at Alternative Investment Group.”
But the firm isn’t the standard ‘institutional’ fund of funds. For a start, its original investors were high-net-worth individuals: co-founder Stuart Greenfield’s background with Oak Investment Partners meant that many were venture capitalists or entrepreneurs with concentrated technology portfolios, looking for an off-setting risk-reduction solution.
“We still have every one of our founding investors from 1996,” says Storrs. “Eventually some asked us to help with their college endowment, family foundation or company pension plan.”
Institutions account for 60% of assets today, but it is the ‘word-of-mouth’ origins of this institutionalisation that exemplify the true soul of the firm. Even today, many due diligence leads begin as informal conversations with ‘partners’ about talented managers they might have come across.
“We try never to leave a meeting without asking, ‘Is there a manager you think we should meet?’” says Storrs. “Now and then, someone will say, ‘you know, it’s funny no-one else asks me that, because as it happens….’. You won’t see that at the mega-funds – and yet it means we’ve been with what are now household names since they were just a couple of hundred million dollars.”
The firm’s portfolio also looks different from those of many younger institutional funds of funds. While early funds of funds packed a lot of directional long/short equity and macro, that was never feasible for Alternative Investment Group’s risk-averse seed investors. But neither did it load up on the arbitrageurs that launched, post-2000, to attract volatility-averse institutions. Illiquidity and excessive leverage is frowned upon, as are computer-driven strategies or anything too top-down or concentrated. Of its 20 or so managers, 85% will typically be long/short equity, tilted towards low net market exposure and fundamental bottom-up stockpickers.
How does that square with those lessons about eggs and baskets? Storrs argues that greater diversification can be achieved with fewer of the right funds than more of the wrong ones.
“Combining long/short equity with credit arbitrage, macro, mortgages or whatever might look like a safer strategy,” he says. “But break all those down and you find many overlapping risks.”
By contrast, long/short equity is all about pure stock selection as long as net exposures are kept low – and Alternative Investment Group’s managers average about 30%. When stock-selection alpha outweighs beta the probability of manager correlation decreases.
Those skills are rare – but that’s why the portfolio isn’t weighed down by 100 funds. How has this worked out in terms of downside risk protection? The portfolio ended 2008 down 21.9%, pretty much in line with the HFRI Fund of Funds Composite index, but significantly better than the HFRI Equity Hedge (Total) index and, of course, long-only equities.
Investors are buying into Alternative Investment Group’s offering – since the middle of 2012, a major corporation has allocated $100m and another $30m has come in from three smaller US pension plans and two university endowments – and Storrs hears that “the common theme is concern that this money supply-generated bubble may burst”.
But is the market rewarding stockpickers’ skills at the moment? Implied US stock correlation has come down from almost 0.85 at the end of 2011 to less than 0.50 today but, nonetheless, the major market-moving threats are resolutely top-down: the US fiscal cliff, the slowdown in China, tensions in the euro-zone.
“Today’s environment takes you away from traditional Graham-and-Dodd company fundamentals,” Storrs concedes. But that merely informs against what he calls “company-spreadsheet” managers and in favour of bottom-up stockpickers who think about the context of bailouts and money supply as they pick winners and losers within and across industry sectors.
Speaking more broadly, he argues that with Europe on the brink of recession, US growth disappointing, four times as many companies saying they expect to miss analysts’ earnings expectations than beat them and bonds looking very expensive, the importance of long/short equity as a source of return with good downside protection is increasing.
“Anything that makes investors more comfortable and their investments more productive in the capital markets is good for all of us,” he says. “If our industry isn’t careful, the owners of capital will go sour on the idea of putting that capital at risk. We don’t want that; we want capital to be available to build factories and businesses.”
It’s an old-school sentiment from a refreshingly old-school hedge fund manager. That Google optimisation has been improved: as you type the ‘G’ in ‘Alternative Investment Group’ it suddenly pops up to the top of the list. But let’s hope that that’s the only concession the firm makes to the post-dotcom age.