The big battalions arrive
The explosive growth of the hedge fund industry has broadened the scope of investors from the original sophisticated high net worth individuals and family offices to the mainstream institutional arena. Firms as disparate as Schroders, EIM and Fairfield Greenwich are all reporting that the major impetus for growth in their multi-hedge fund offerings during the last six months has been the institutional sector. There are however a number of issues for trustees of pension funds, and issues for hedge fund of funds as to how they can reach a modus vivendi that can preserve the vitality and indeed aggressiveness of the underlying hedge funds whilst packaging portfolios of hedge funds into a form that is digestible for institutions with fiduciary responsibilities to their beneficiaries.
For most pension schemes, hedge funds represent less than 5% of their total assets. The volatility of hedge funds would hardly affect the volatility of the total portfolio compared to a small shift in the value of the 50% of their portfolio in the mainstream equity markets. Despite this, discussion of hedge fund investments can take up a disproportionate amount of time in trustee meetings. Issues such as benchmarking performance can be a major area of controversy. The key concern for trustees is often not the return and volatility of the investment, but the reputational risks and potential legal risks to them if the hedge fund portfolio lost substantial value through an operational failure of some kind and this can influence the choice of supplier. Research our firm has done amongst institutional investors indicates that there are five distinct approaches that are being looked at:
1). A fund of funds from an independent firm
2). A fund of funds from the subsidiary of a known brand;
3). Tailor-made portfolios of hedge funds either using in-house staff exclusively, or more likely, with the help of an external specialist.
4)Internal fund of funds from known brands;
5) Use of a hedge fund index to construct a portfolio at reduced cost.
The foray into institutional markets has been led by independent firms such as FRM staffed by teams with blue chip investment banking backgrounds that enabled them to achieve credibility without having a brand presence. Whilst this focus meant they were behind the curve during the 1990s, they are now well positioned to benefit from the institutional interest and consultant support for the asset class.
The initial hedge fund portfolio strategy that has appealed to institutions has been low volatility with an emphasis on risk control according to Mark Reinisch of FRM. John Parkin at Schroders has also found institutional interest predominantly in their flagship low risk fund of funds. Such funds tend to be marketed as alternatives to cash with an emphasis on low volatilities, low maximum drawdowns and offering a cash plus up to 6% return target. Whilst such returns can be attractive compared to bond returns, it is important to decide where in the portfolio hedge funds should fit since they would look unattractive against the double digit equity market returns of 2003. Product offerings typically then move onto more aggressive funds which then raise issues on the most appropriate benchmark comparisons.
The one-size fits all approach in pooled hedge fund of funds does not however satisfy all institutional investors. As Hilton Supra of EIM finds, once a pension scheme has invested, they “lift the bonnet to see what they have bought”. The more sophisticated schemes are conscious of where the investment fits in with the rest of their portfolio. One of the UK’s largest schemes for example, just teetering on the edge of taking hedge funds seriously, have the view that they would want to agree the return, the volatility and the correlation with the rest of the portfolio and then expect their provider to come up with a tailored solution that fits and takes them through the reasoning rather them leaving them with a black box.
BT have recently announced their intention to invest in a portfolio of hedge funds with Hermes constructing a portfolio using external advisers. Firms such as EIM specialise in constructing tailor made segregated portfolios and have built up their institutional business around this proposition.
Credibility and ideally the comfort of a strong parent can often be key points when it comes to choosing a fund of fund supplier. As a result, many schemes favour at least initially, the comfort of having a strong brand name. Independent firms that have thrived in the high net worth marketplace can find it tough reaching the bulk of the institutional marketplace and the obvious reaction that we are seeing is the purchase of many of the more successful boutique fund of funds by blue-chip firms with a strong institutional presence such as Gartmore where these fund of fund operations may exist alongside internal hedge funds.
Cost is often a concern for institutions and there are two approaches that offer cheaper routes to gaining strategy and manager diversification. Hedge fund indices are one way of approaching the problem; the drawback is that the only advantage of being included in an index for a hedge fund is the potential of raising funds. The index providers need the hedge funds to provide regular performance data for inclusion in the index. The more successful hedge funds do not need this extra source of investment and may therefore not be included. Another lower cost approach that has been adopted or is being looked at by some multi-product firms is offering a range of five to ten of their own internal hedge funds which gives strategy diversification without an extra layer of costs. Against this has to be put the disadvantage of greatly reduced strategy diversification compared to a typical fund of funds with 25 or more funds, no manager diversification and more insidiously and dangerous, the lack of quality control when the firm can automatically seed corn every new fund idea without any track record. An alternative approach is that adopted by Fairfield Greenwich who enters into joint venture agreements with 10-15 selected hedge funds in a multi-manager structure that does not involve an extra layer of fees for institutional clients. Richard Landsberger of Fairfield Greenwich sees this approach as unique, enabling them to negotiate dedicated capacity with a range of managers chosen after strict due diligence encompassing both large institutions as well as entrepreneurial boutiques.
For large firms, there are two issues, should they set up their own hedge funds or should they set up or acquire a hedge fund of funds to leverage their institutional distribution capabilities. There can be problems if it is perceived that the hedge fund activities cream away the best ideas and the best managers, effectively degrading or destroying the mainstream business. By not setting up hedge funds they run the risks of their best staff leaving and setting up their own boutiques, although many high calibre managers would not want to take on the operational and marketing challenges of running their own firms. Indeed, one of Fairfield Greenwich’s criteria on their selection of managers according to Landsberger, is that “the investment staff are focussed solely on investment opportunities rather than the day-to-day business complexities that are a natural by-product of larger organisations.”
Developing a strategy for the hedge fund business can be very complex. Whilst institutional take-up of hedge funds overall may still be low, the last six months have seen rapid growth. For them one deciding factor in choosing a manager may be who has been doing it for longer than four years, since the longer they have been around, the more confidence in their process. That favours the more established independent players and mainstream fund managers with strong institutional presence are left devising strategies to ensure they are not left behind in any major institutional moves into the sector. Schroders, for example, has so far concentrated on developing a highly engineered internal fund of funds alongside its own internal hedge funds whereas Gartmore took the route of buying an external boutique with an established presence having built up a highly successful internal series of hedge funds.
The question for many mainstream institutional fund managers is whether the prices for independent hedge fund of fund players with $1bn (€845m) or more and over four years old are too high. Should they pay less for a more recent entrant with a good process relying on their own distribution to build up assets quickly, or alternatively hope to build up their own internal fund of fund capabilities fast enough before the demand for hedge funds becomes saturated.
Before they commit to such decisions, perhaps they should consider taking soundings in the marketplace to reveal whether their brand and their product proposition can truly add value in this space to generate the growth required to justify purchasing an independent or whether they would be better off developing in-house capabilities at a slower and more measured pace.
Alan Briefel and Joseph Mariathasan are with London-based advisory firm Stratcom