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Pension funds and other institutional investors usually go to established consultants for advice about traditional investments. But where do they go for advice about alternative investments, and in particular, hedge funds? David White reports

The growth of institutional interest in hedge fund investment has been accompanied by a growth in hedge fund investment advisory businesses. One of the broad aims of these businesses is to broker an understanding between the traditionally cautious world of pension fund investment and the supposedly racier world of hedge funds.

The flag-bearer for this approach is Albourne Partners, an independent advisory firm launched in 1994. Albourne’s client list includes foundations, public and corporate pension plans, and insurance companies, among them Hermes Investment Management, Mitsubishi Corporation pension fund, and seven of the leading 20 universities in the US.

Albourne advises on direct investment in hedge funds rather than indirect investment through funds of hedge funds. “We never help anyone to pick a fund of funds. We only work to pick underlying managers,” says Simon Ruddick, managing director of Albourne Partners.

This puts Albourne at the second stage of institutions’ allocation to hedge funds. “Typically institutions start with a fund of fund allocation as their first hedge fund exposure and then in the second phase they open it up to include direct allocation and at that stage they typically get advice from us,” Ruddick says.

Some institutions are confident enough to skip this stage altogether. A classic example is Hermes, which looked carefully at the fund of funds route but decided to build its own portfolio.

Equally, it is common for institutions at the second stage to keep their fund of funds as they increase their allocation, and currently almost half (48%) of Albourne’s institutional clients retain an allocation to fund of funds.

Albourne works alongside mainstream consultants in almost a third of its mandates, says Ruddick, mostly in the US. “In the US we tend to deal not just with the board of trustees and the pension fund manager but also with the general consultant within the whole overall project.”

It advises institutions in two ways. The first is by building a portfolio of direct hedge fund investments. “If they follow our recommendations they effectively build their own fund of funds from inputs based on our selection ratings, our strategy forecasts, and our advice on portfolio construction,” says Ruddick.

The second way is through exercising two external controls - due diligence and risk management. “We have 30 people just working on due diligence, and we produce nine reports on each fund we cover,” says Ruddick. These are continuously updated.

“Likewise on risk, we’re trying to measure and monitor the risk that is in funds and in the client portfolios. If we see some action point, we will recommend action.”

The due diligence and risk management services provide a comfort blanket to sleepless pension fund boards, says Ruddick. “Institutions feel comforted seeing these control functions in place for their direct portfolio.

“They also find it quite comforting with their fund of funds portfolio. Although they’ve given control to their fund of funds they like to use us as a kind of double check as to which fund they should be nervous about or have issues with.”

Due diligence, says Ruddick, is part of the “slow march towards more compliance and ever better understanding of what you are doing. The work we do is laborious, classic economies-of-scale type work.”

Albourne says its service fit well with those of other suppliers: “Our business model suits collaboration, and we work well in situations where clients have got various people advising them.”

US clients and their advisers are familiar with this model, Ruddick says. “North American institutions have been invested that little bit longer in hedge funds and are much more progressed in the triangulation or configuration of client, general consultant and specialist consultant.

“In the UK general consultants are less comfortable with this. They know that if their clients go away from funds of funds towards direct investment they haven’t got the resources to advise them, and they lose some control.”

Albourne’s fixed fee structure helps in collaborative arrangements, he says. “When you charge a fixed fee you’re relaxed about how many other people are involved.”

The current financial crisis has sharpened institutions’ appetite for hedge fund investment, Ruddick says. “We got $600m (€410m) client money to work with in December when most people were nervous about deploying new money anywhere. Our pipeline of new clients is the best it has ever been and existing clients want to increase their allocations.

“In part this is because it’s quite hard at the moment to love equities, bonds and particularly real estate. In part, though it is because hedge funds tend to their best at the transition back to a new equilibrium.”

Spreading the message that hedge funds oil the wheels of the wider economy is one of the aims of Ruddick and his colleagues. Albourne operates Albourne Village, a free internet-based information exchange which carries hedge fund news and debates on current issues.

The name is a metaphor for Albourne’s stance, says Ruddick “We’re named after a village in the country partly because we’re almost deliberately saying we’re not the City, we’re the country.

Ruddick suggests that these refugees from the City “feel a little bit left-field, a little bit alternative,” he says. To make this point, in 2006 Albourne organised Hedgestock, the hedge fund industry’s version of Woodstock pop festival. Profits from the event, which attracted 3,000 people, went to charity.

“We have a big appetite for those type of activities because we believe with a real passion that hedge funds are not only good for our clients but are actually rather good for markets,” says Ruddick.

Albourne takes a level view of calls for greater transparency by hedge funds. “The knee-jerk reaction is that more information must be better. In practice it can be strangely disempowering to be flooded with a lot of information that you can’t harness and interpret.

“We think a practical solution is semi-transparent risk information where hedge funds provide summarised key exposures. That makes it easier for investors to monitor and integrate the risks into their other risks. It also places a responsibility on the hedge funds to summarise the risks correctly.”

Ruddick feels the role of investors, and the firms that advise them, are the best regulators of hedge fund practice, the subject of a recent review by the UK’s Hedge Fund Working Group report.

“We think that investors and firms like us can play a really key role. Collectively we hold the carrot of capital, which is more effective than the stick of regulation.

“It’s not about outright conflicts between investors and funds. It’s about finding the middle ground and continually improving the terms of business. That’s great for the funds as well as for the investors because it’s their chance to build what is genuinely an institutional quality business.”

Will consultancies like Albourne remain independent or will their specialist skills be absorbed by the general investment consultancies? In traditional investment consultancy, the trend has been for generalists to absorb specialists. In hedge fund consultancy, the trend has been rather different, says Ruddick.

“What has tended to happen is that firms that started off in advisory roles have switched to becoming fund of funds managers,” he says. “We categorically never will run a fund of funds.”

Other hedge fund advisers have developed differently. Allenbridge Hedgeinfo (AHI), part of the Allenbridge Group, an investment research and analysis company, was set up in 2000 to focus on hedge fund research. It currently acts for both the buy-side and sell-side, providing research for hedge fund investors and ratings for the hedge fund industry.

Most of Allenbridge’s institutional clients have chosen the fund of funds route into hedge fund investment, says Christopher Miller, the chief executive of AHI. “Our experience of clients and the industry is that pension funds tend to prefer the fund of funds route, even at the very large level.”

Examples include North Yorkshire and Dorset county councils, local government pension funds that have allocated between three and five different funds of funds respectively. As pension fund trustees and other investment consultants become more familiar and comfortable with the products, they will probably take steps beyond the safe zone of brand name funds of funds.

AHI’s manager research tends to be based on a pension fund’s own criteria. “Some pension funds view their hedge fund investment in isolation, and don’t want a correlation matrix against their other investments. They’re not trying to optimise their overall strategy beyond wide investment groupings. We’d always encourage an overall review but it’s not always possible.”

Apart from manager research, AHI’s hedge fund rating service is its flagship product, says Miller. “It’s our public face, and it demonstrates our understanding of what hedge funds are doing.

“The rating research flows into the manager selection process. It gives investors confidence where no other due diligence is performed, and a lot of pension funds aren’t comfortable with spending a lot of money on proper due diligence themselves.”

AHI will advise pension funds on the suitability of particular hedge fund strategies, says Miller. “Some funds of funds have particular fortes. A market-neutral fund of funds like Gottex may fit a particular need where a pension fund wants to get very stable returns, and wouldn’t feel comfortable with a higher-octane product.

“But equally you might have a fund of funds with much more investment flexibility, which gets stronger performance with more volatility. It’s whatever sort of returns the pension fund is comfortable with.”

AHI’s closest competitor in the ratings field is Standard & Poor’s. Miller says it differentiates itself from S&P by its detailed research-based approach to ratings. This is demonstrable by the thickness of an AHI report, if by nothing else,” he says. “We believe that analysing in quite a lot of depth should give confidence that we’ve been doing our job properly, at a time when many investors are sceptical about the way ratings have been done in areas like CDOs.

“The fact that Allenbridge has both sell-side and buy-side clients is helpful,” he says. “Because we’ve got buy-side clients to keep happy, that, by itself, should keep the independence of the rating very high.”

On the sell-side, hedge funds see AHI rating reports on their strategy and performance as a useful marketing aid, says Miller. “We’re very careful to keep our independence, and we don’t take sales commission. Not every hedge fund manager dares to open up its procedures and books to scrutiny unless they are very confident that their systems are good and their performance is good. If that is the case, they’re happy for people to know what they do.”

AHI reporting has to strike a balance between the investor’s need for transparency and the funds’ need to protect confidential information, says Miller. “There are certain things that we need to see, such as the manager’s portfolio, that we wouldn’t disclose in our report because of confidentiality issues.

“There has to be a balance between the client’s understanding of what it is the fund is doing and the fund’s ability to operate in a commercially viable manner. If funds disclosed their investments on a day-to-day basis, it might be possible to replicate what they were doing. So we allow the manager to designate what is confidential information, and consider whether that level of commercial confidentiality is justified in the context of their strategy.”

Ironically, the buy-side may not always acknowledge that they use the research in the way that they say that they use it, says Miller. Pension funds often give mandates to AHI rated funds without giving due credit to the rating.

“But as long as people are still commissioning the research and as long as people are still registering and asking to receive it then I guess we’re doing a good job.”

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