FOHFs: how good a first step?
With predictions abounding of a new wave of interest in hedge fund investment in the UK and continental Europe, the issue of how pension funds and other institutional investors can best translate a theoretical interest in the asset class into reality is as much to the fore as it has ever been.
Once the decision has been taken to expose oneself to hedge funds, in essence the choice boils down to whether to do it directly (choosing a single hedge fund manager or series of single hedge fund managers) or indirectly (appointing a fund of hedge funds, for example, or investing in hedge fund indices).
Each approach has its advantages and disadvantages, depending upon the individual investor’s desire for concentration or diversification of risk, and the level of risk compared with likely reward. An institution’s stomach for charges also becomes an issue, as a fund of hedge funds involves a double layer of fees; the fund of hedge funds levies its own annual fixed and performance-related fees on top of the fees charged by the underlying managers. This expense must be balanced against the cost to an institution of trying to enter the hedge funds arena unaided. Building a team large enough to handle the task proficiently and professionally, to research and identify suitable single hedge funds, will be time consuming, and cash consuming.
An annual fixed fee of 1 to 2% plus a performance fee of 10-20% of capital gain (with a high watermark) added to fixed and performance fees of 1 to 1-1/2% and 20% charged by the underlying managers, means the funds of hedge funds need to deliver gross returns in the region of 15-20% to keep all parties to the transaction content. Do the returns justify the fees? It depends on individual circumstances, but not everyone is convinced. “One of our clients was looking for a hedge fund investment last year,” says Philip Menco, principal, of Fortunis Investment Consultancy in Amsterdam.“We looked at both options, and found the fund of hedge funds quoting a 6-8% annual return; we thought that a cumulative 3% fixed fee plus a 35% performance fee to generate a 6% return was stiff. We didn’t like it. On balance, the reward for the risks – often hidden – combined with the very high fees, rendered it unsustainable. My preference is for a basket of single hedge funds.”
Jim Vos, managing director, hedge funds, at Credit Suisse Asset Management, calls it differently. “Surprisingly, dilution is limited because most multi-strategy hedge funds charge much higher fees than single strategy funds (eg, 2/30 instead of 1/20). This is because the multi-strategy funds try to avoid netting risk – where one trader’s problems can result in an inability to pay all traders. They can only mitigate this by charging very high fees; I think this point is overlooked when examining this issue.”
A word of warning, though, for anyone hoping for fees to fall. Even in a low interest, low inflation environment, it would appear that fees, at least at the underlying level, might not have found their natural ceiling. “At the moment demand outstrips supply,” says Rossen Djounov, who runs the fund of hedge funds business for Forsyth Partners in the UK. “There is no price competition; on the contrary, the good managers are pushing up their fees.”
There is no single right answer to the puzzle of how to proceed. Seldom can the phrase ‘individual solutions for individual problems’ have been more appropriate. Having said this, soundings indicate there exists a broad consensus within the industry that the preferred route for a novice investor is to use a fund of hedge funds for initial exposure, before graduating to a single fund manager approach when comfortable with the concept and the practice. While there is no hard and fast timetable, and some investors inevitably move quicker than others, Vos says that in his experience this takes about two years on average.
“The attractions of a fund of hedge funds lie in four key areas: selection, strategy, diversification and access,” says Philippe Mimran, managing director of Axa Alternative Advisors in Paris. “A fund of hedge funds spends around 90% of its time on due diligence, each hedge fund has its own investment strategy, the fund of hedge funds manager knows how to allocate globally to meet an investor’s needs, and has access to funds that are denied to others.”
Rorsyth’s Djounov likewise suggests four main advantages of turning to a fund of hedge funds. “One, position-specific risk is lessened by not putting all your assets in one basket. Two, it gives you dynamically managed exposure to a variety of strategies. Three, the entry minimum is lower than with a single manager, multiple strategy approach. Four, investment capacity; you will find that a single manager simply cannot invest beyond a certain point.” Operational risk is identified by many as playing a key role in any institution’s decision. “At least one study has shown that half of all blow-ups can be traced to infrastructural issues,” says Jamie Murray, head of marketing at HSBC Republic Investments.
At consultants Hewitt bacon & Woodrow, Kerrin Rosenberg identifies a hierarchy of decision-making that should be observed before an investor takes the plunge. “It’s less a question of direct or indirect, more a question of what you want the hedge fund portfolio to achieve. You can spread risks by hiring 10 funds yourself, but having the appropriate type of strategy is more important than how many fund managers you hire. Step one, you need to decide whether to be in hedge funds. Step two, decide whether you want to enhance return or reduce volatility. Step three, decide to what extent you want to diversify manager risk. How do you choose? You need clarity on why you’re investing in the first place; that automatically guides you. Devise your strategy first. Ask what a fund of hedge funds will bring to the party in return for the extra fees. And consider whether you need that level of diversification.”
“There are practical issues that need to be borne in mind, including the issue of size and what it can mean,” says Amsterdam-based Jurcell Virginia, who founded the Alternative Investment Company in 2003 to advise pension funds on hedge fund strategy, allocation and selection. “Most investors will opt to use a fund of hedge funds because they need a level of diversification of investment risk and business risk that a single manager hedge fund cannot deliver. However, a larger single manager multiple strategy hedge fund can provide diversification more effectively than a small fund of funds.”
“Most pension funds will go with a fund of funds, because they wouldn’t feel comfortable selecting direct funds themselves, but I’m not convinced it’s the most sensible thing to do,” says Rosenberg. Hewitt Bacon & Woodrow estimates that less than 1% of total UK pension fund assets are currently invested in hedge funds, but suggests that that figure could rise to 5-10% within 10 years.
“One of the key points at which we advise on hedge funds is when we are conducting a full investment strategy review,” says Robert Howie, head of hedge funds research Europe at Mercer Investment Consulting. “We look at the liabilities and objectives and decide what the asset allocation should be between the different asset classes, including hedge funds. At that stage investors often say they are too small, or they are not interested and will perhaps consider them at the next review. The next stage is to provide further information for those pension fund trustees who express an interest; we can help them understand the nature and purpose of hedge funds and then decide if they should be investing in them. We have quantitative tools that we can deploy to analyse past performance and past risk, but the question of whether they will add value in future is a qualitative decision.”
This could be more difficult than it sounds, as one of the numerous caveats in hedge fund investment is that question marks surround past performance data and undermine the notion of whether the data are even less reliable as a guide to future performance than in other areas of investment. Coming from a small universe, and provided voluntarily, almost by definition during periods of positive performance, the data can sometimes even be unreliable as a summary of past performance. “Individually the numbers are correct, but you’re more inclined to supply them if you’re doing well than if you’re doing badly,” observes Howie.
“Most data vendors only supply data on funds that are still in operation,” adds Harry Kat, professor of risk management and director of the Alternative Investment Research Centre at Cass Business School, City University, London, and an arch critic of the hype that surrounds hedge funds. “However, disappointing performance is a major reason for hedge funds to close down; this means that the data available to investors will overestimate the returns that investors can realistically expect from investing in hedge funds by 2-4% per annum. In addition, concentrating on survivors only will lead investors to underestimate the risk of hedge funds by 10-20%.”
The point at which investors move to direct hedge fund investment is less a question of time than a function of the cost of resources and the investor’s willingness to pay that cost, added to the acquisition of expertise. “You need people, and people need IT resources and experience,” observes Dr Dirk Soehnholz, managing director, alternative assets at Germany’s Feri Trust. “It’s a question of know-how, and very few people have it. We know of investors who started with a fund of hedge funds, progressed to single manager investments, then reverted to a fund of hedge funds.” Says Nadja Pinnavaia, head of Goldman Sachs Asset Management hedge fund strategies for Europe: “Investors allocating to hedge funds for the first time or without an extensive in-house due diligence and risk monitoring infrastructure are typically best served by investing through fund of funds. Direct investing makes sense when you have the expertise to discern quality managers; even then it may only make sense to do this in certain strategies where the investor feels they have sufficient expertise.”
“How much will it cost to appoint your own individual hedge funds?” asks Howie. “The economics need to work. For most of our clients the fund of funds route is what works best, but the bespoke route is worth considering for those who are big enough.”
Dutch pension fund ABP, which bills itself as the world’s biggest investor, began using hedge funds in 2002, initially taking the fund of funds route. A year later, it began appointing direct hedge fund managers. “We went direct for three reasons,” explains Jelle Mensonides, ABP’s chief investment officer, alternative investments. “Firstly, to have access to certain managers. Secondly, to avoid a second layer of fees. Thirdly, to allocate the funds in our care more directly to styles more attractive to us. We see many funds of funds using long equity managers in emerging markets; we try to avoid that in our hedge funds. Our hedge fund exposure must have a low correlation with our existing traditional portfolio.
“We started with funds of funds to achieve exposure quickly, while the team in New York who look after our hedge fund activity was small and the processes had to be built. Our goal is to increase the allocation to 3.5% of assets, a figure equivalent to €5bn. We expect it be around $4.5bn by the end of 2004. Our experience so far is positive, with returns of around 700 basis points over Libor (net of fees) in 2003. This is a very interesting area, but you must be careful. You need insight into what your manager is doing. You don’t need to know all the underlying assets, but you do need to know the exposure to certain sectors (credit, risk, and equity) and the investment themes. The alpha insight is very important. Where do they get their returns from? What risk are they taking? What is the downside risk? Where we see a fund of funds manager cannot learn from the underlying managers, we won’t employ him.”
ABP’s hedge fund exposure is currently approximately two-thirds fund of funds, one-third direct. It plans to increase the latter further, while stressing that it might need to appoint three direct managers for the same amount that would go to a single fund of funds. This in itself introduces additional monitoring difficulties. ABP’s overall advice? “It depends on the scale of assets under management,” says Mensonides. “If it’s small, look to a fund of funds manager. And you must ask yourself what is the original idea behind doing this, and answer honestly. Is it bona fide asset-liability management, or is it because your neighbour’s doing it? If you’re bigger, go direct. Convince your board of trustees. And ensure that your own organisation has the calibre of staff needed to manage this type of activity.”
Once the decision has been taken to invest in hedge funds, how should an investor choose the best institution? The rise of the brand name has been one of the most arresting phenomena of the past decade, providing as they do a shorthand for and a shortcut to the provision of the required service at the required level and at the required cost. This is as true of hedge funds as of other areas of human purchasing activity, with the added twist that hedge fund brand names like Man, Quellos and Tremont are significantly different from those in other parts of the financial services industry. The big international investment banks do not dominate the landscape. Yet.
“The capital flowing into the hedge fund market in recent years has become more discerning. Investors realise there is a growing disparity between the best and worst managers and new funds without a proven track record in hedge fund investing have and will find it increasingly challenging to raise capital,” notes Pinnavaia of Goldman. On the other hand, says Jamie Murray, “many of the providers in the hedge fund world are not very well known names; word of mouth remains the best recommendation in a fragmented industry where capacity will become more of an issue as more money flows in.”
Size is not the only consideration, however, and the final word goes to Mensonides. “We focus on the quality of the people and sustainability of the business, not on the brand name,” says. “We will of course use brand names, but only where they can deliver what we want. It is more important to look for uniqueness of investment strategy and what a particular firm can deliver.”