Hedge Funds: Not such black boxes
Experts have come up with more reasons for the 2008 credit crisis than for the extinction of the dinosaurs – even though the latter happened 66 million years earlier.
“To my mind, one of the things that turned the crisis into a disaster was the opacity of the hedge fund industry,” he says. “Investors need to make meaningful decisions about their investments at times of extreme stress. The paucity of information led them to make the only decision they could, which was to get the hell out.”
This opacity reflected the origin of hedge funds as investment vehicles for high net worth clients – who, unlike institutions, did not demand reams of paperwork on strategy and risk exposures. Hedge funds’ sometimes stellar returns also dulled curiosity, as clients did not fret over where the money was going as long as more of it was coming back.
“Back then, it was a lot more a case of ‘trust me’, I’m a hedge fund manager’,” says Robert Howie, a hedge fund specialist at Mercer, recalling the pre-crisis days.
The hedge fund industry has, however, “learnt a big lesson” from investors’ 2008 stampede through the exit. “Since then transparency is much, much less of an issue,” says Barker.
Chris Jones, head of alternatives at the consultancy Bfinance echoes this sentiment. “It used to be the case that diehard old-school hedge funds would tell you nothing, and couldn’t see why you’d want to know anything,” he explains. “There weren’t such things as investor relations – there was the sales team, there were the managers, and that was it.”
Investor relations departments are now standard for mid-sized and larger funds. “Hedge funds have grown up a lot”, he concludes.
In addition to greater transparency, pension funds and their consultants say that hedge funds have improved in a related area: access to the relevant personnel, who can explain its strategy and operations.
When it comes to transparency, Stephen Oxley, senior partner for Europe at Paamco (and an ex-pension consultant), pleads mitigating circumstances – up to a point. “There are good reasons why hedge funds don’t want to reveal some positions, such as shorting, and niche strategies,” he says. In both cases, market knowledge of the strategy could endanger or destroy it.
Hedge funds begin, therefore, from an inherently more secretive starting point. What can be done to find a happy medium that gives pension trustees sufficient information, while allowing hedge fund managers to trade without having their hands tied behind their back?
The ultimate solution, in Oxley’s view, is a managed account set up for the pension fund client by a fund of funds – with the hedge funds providing information about every trade as they happen. Pension providers also sometimes have managed accounts with individual hedge funds.
Pension funds have, however, tended to move away from funds of hedge funds altogether since 2008, notes Howie of Mercer. “Investors want to invest directly to cut off the layer of fees,” he says. Those fees were commonly 1.0-1.5% of assets under management before the financial crisis, although market pressure has now pushed many as low as 0.5%.
Moreover, Barker at Hermes sees a downside, for pension funds, to managed accounts.
“If there’s a fat-fingered trade, that’s your problem, you own the liabilities,” he says. “[Moreover], what you get out of a managed account is a data dump, and a data dump is not what investors are looking for.” A pension fund with a global macro strategy in its portfolio, would “get an awful lot of line-by-line data on a daily basis”, he warns.
One way of managing all that information may have emerged from the hedge fund consultancy, Albourne, which publishes a spreadsheet-based risk management system, free for all to use, which is gaining popularity: Open Protocol Enabling Risk Aggregation (Opera). The theory is that hedge funds input their different kinds of exposure on Opera at the behest of clients, filling in tabs such as ‘equity exposure’ and ‘sovereign and interest rate exposure’.
When Albourne surveyed 1,500 hedge funds, 85% said they would consider producing an Opera report or having a third party produce it for them, says Gaurav Amin, global head of risk at the consultancy. He claims that the greater understanding of total risk exposure that Opera facilitates has “definitely” made some clients increase total hedge fund investment.
“When clients become more comfortable with their investments, they feel inclined to have higher allocations,” he reasons.
Amin’s 85% hit rate still leaves a hardcore of 15% of hedge funds that prefer to remain more mysterious. This rump of reluctance tallies with the experience of Howie at Mercer.
“Some hedge funds don’t provide enough information for us to get comfortable with them, so we screen them out,” he says. These days, however, he finds this in only a small number of cases – “only two or three in the last few years, among those which make the grade in other areas”.
Howie emphasises, however, that Mercer thinks of transparency not just as lots of data, but access to the key people – including, he says, the research team, traders and CEO. One way of testing a fund’s mettle is to use a meeting to ask the fund to work through a particular trade, from the inception of the idea, to how the position was created, he says.
However much hedge funds might be improving their customer service, it remains very difficult for a pension fund to navigate the complex currents of the hedge fund ocean without some assistance from an expert – whether a fund of funds manager, another specialist manager of hedge funds, or a consultant.
Following a review, Nick Greenwood, manager of the Berkshire Pension Fund, is sticking to hedge funds – currently 18% of its portfolio. However, the fund has appointed a specialist asset manager charged with finding new managers, recommending changes to the portfolio and monitoring its investments. Greenwood simply found that keeping tabs on the “the sheer volume” of the 6,000-plus hedge fund managers that exist was too much. Greenwood also expects that, by using a specialist, he can negotiate better fees with funds.
This is more expensive than managing hedge funds in-house in the purest sense, he concedes. But he remains philosophical about that. “My dream car is an S-type Jaguar,” he says, searching for the right analogy. “And if I bought one, I wouldn’t go to the cheap little garage down the street. I’d go to a Jaguar garage.”
And of course, if pension trustees get the same sort of turbo-charged outperformance from their hedge funds, everyone is a winner.