It has been IAM's recent observation that institutional investors, who are starting searches for a hedge fund component to add to their portfolio, are still using traditional performance targets and risk/return measures in their search and selection process. This is despite growing concerns regarding the suitability of these measures (Bares & Djanogly, 'Asset Allocation in Hedge Funds: Myths, Facts & Difficulties', IAM, 2005).
Additionally, the institutions recognise that there are various risks associated with investing into an area which is inherently complex and diverse, fast growing and fast moving. They are looking for ways to lessen certain aspects of these risks (without losing too much on performance) and continually need to provide assurance to their underlying trustees, regulatory bodies etc that all the appropriate steps are being taken to address any concerns in these areas.
Unsurprisingly, asset management firms have responded to these demands by providing a selection of products all of which are designed to appeal to the cautious institutional investor by allaying their fears of the perceived risk of a lack of diversification and aiming to deliver results according to the traditional sets of performance objectives.
Indeed, on paper it seems that any one of three options is able to satisfy the concerns regarding diversification across managers and provide returns in line with expectations for volatility, returns, sharpe ratios etc.
1. Single strategy fund of hedge funds
2. Multi-strategy single hedge fund
3. Multiple strategy funds of hedge funds
The challenge for the institutional investor is to achieve diversification, yet deliver returns. However, it is essential when aiming to achieve diversification to develop an understanding of what may restrict it. What the pension fund managers and trustees need to understand in a diversified portfolio is the true measure of the dispersion or conversely the internal correlation of the underlying investments. These areas can 'hide' risk and are a dimension of the portfolio which is not immediately visible to the pension fund investor when using performance measures relative to traditional benchmarks. It takes sophisticated quantitative and qualitative analysis to be able to conduct the necessary correlation analysis and stress testing of the underlying holdings in a portfolio to ensure that it is as robust as possible and able to survive significant market shifts and shocks.
By understanding the profile of the various categories it is possible to see more clearly the potential areas of risk and aspects to consider when combining these assets into a broader portfolio.
Single strategy fund of hedge funds invest in a selection of single hedge funds all of which operate within one particular strategy area. In general, hedge funds operate across a wide range of financial instruments and markets and these can be divided into 4 broad categories – namely Tactical Trading Strategies Equity Hedge Long/Short Strategies, Event Driven Strategies, and Relative Value Strategies (see Figure 2 for definitions). These categories span a risk spectrum ranging from 'low market risk' relative value to 'high market risk' tactical trading strategies (see Figure 3). The most important aspect of the single strategy fund of hedge funds (FOHFs) is the increased level of risk resulting from specialising in one particular type of strategy. Clearly the use of many managers will improve diversification along one axis of the risk matrix (see Figure 1 – x-axis), however the choice of strategy will greatly influence the potential risks.
There is a wide range in the size of the markets within which various strategies are trading, with the result that for some strategies there is a limited selection of managers from which a fund of funds asset management firm can select the top performers. Of necessity the quality of the portfolio may become compromised, with potential issues increasing a fund allocation should an investor wish to invest further in a successful portfolio.
Additionally, within some strategies there is a potential for herding in the trading activity which may result in a level of internal market correlation existing between the underlying hedge fund managers held within the portfolio which would be hard to detect (see Figure 1 – z-axis).
Single strategy FOHFs are specialists with fund of fund strengths in respect of diversification, flexibility and strength of analytical resources but they are more susceptible to market shifts and to capacity issues where there is a very real danger in some strategies that a short-supply of top-level hedge funds will limit investment capacity. Additional risks lie in the levels of correlation between the hedge funds where it becomes more important to mix manager investment styles and geographic allocations to mitigate the risks of several managers being involved in the same trades.
These differences are inherent with the product as far as they are specialising in one particular investment area. But within this there will be variations dependent on particular strategies eg equity long / short is a large sector and unlikely to suffer from the same issues with respect to capacity, leverage or pool size as a more specific sector strategy such as relative value funds.
The differences do not make a single strategy FOHF more suitable for, and attractive to, different kinds of investors, if anything they tend to highlight the risks attached to making the more specialised investment. It is appropriate for pension funds to view single strategy FOHF's as a replacement rather than a complement to their overall portfolio allocations. For example a long / short equity FOHF should be viewed as a replacement for traditional equity allocation.
Some hedge fund managers offer multi-strategy hedge funds which aim to achieve the same level of market/strategy diversification as the FOHFs. However, with the multi-strategy hedge fund the investors are exposed to the risk of a single organisation running the investments, with inherent management and operational risk factors.
The multi-strategy category is emerging as a 'catch-all' category of hedge fund strategies, and is increasingly applied to managers who are stretching their original classification and moving into new markets. At the heart of hedge funds is an entrepreneurial flair which is continually aiming to find new investment opportunities. However, a critical concern when building a portfolio is gaining an understanding of the external market influences which would, in turn, impact the holdings in the portfolio. Style drift is a key concern when monitoring managers, and can move a manager onto watch lists or lead to them being redeemed. Consequently the evolution of the multi-strategy classification allows a hedge fund manager with skills in various markets to utilise the opportunities in alternative markets and instruments and not raise concerns with the investors. Frequently multi-strategy funds are launched by the larger hedge fund firms who have in-house teams or individuals with skillsin different markets. The multi-strategy funds enable these firms to grow assets under management in a single vehicle but internally to divide the assets into smaller segments, which continue to be run by individuals who operate in the markets they know best, but with asset levels that enable them to keep nimble.
The skills lie in ensuring that the resulting mix generates good returns for the investor. The risks rest primarily in the operational area, with one organization providing all the investment expertise. In addition, with all the skills residing in-house there is both a risk that the quality of the in-house managers is not optimal or that the choice of invested markets is limited by the expertise available and not truly flexible.
IAM believes that the optimal solution lies with a well diversified multi-strategy FOHF where there are several underlying hedge fund managers across a range of 6 – 12 investment strategies. Consequently they provide the potential for strong positive (alpha) performance in variable market conditions across a wide range of markets which would have been extremely time consuming to research and analyse on an independent basis by the institutional investors.
For the FOHF firms, the strengths lie in the increased focus on risk management and control but these must be matched with active management. Well diversified multi-strategy FOHFs are good for those investors with very specific risk requirements who plan to use hedge funds to complement their existing portfolios to optimise risk and deliver consistent returns as a form of risk control. The investor base can range from a complex institutional investor to a sophisticated retail client.
Risk management – FOHFs control risk at the selection stages of manager analysis and once a portfolio is constructed they manage the risk exposures of the portfolio through robust stress testing, correlation analysis and detailed quantitative measures at the portfolio level.
Consistent returns – by delivering strong alpha returns the actively managed FOHFs are able to contribute to the overall portfolio in all market cycles, this is of particular importance to pension funds and other institutional investors with liability obligations to meet.
Diversification – FOHFs can use diversification within a portfolio across both the strategies and the individual managers to provide the levels of volatility or return that a pension fund requires. They have networks of industry contacts and access to investment opportunities which would be hard to match on an independent basis.
Flexibility – the investment manager can actively manage the FOHF portfolio in an opportunity driven style and bring industry experience and investment expertise as well as proprietary technical systems plus a large team of research analysts and risk management specialists.
The only close alternative is through passive investment in an investable hedge fund index but it has limited flexibility, different (less rigorous) 'qualification' criteria since the same levels of due diligence are not applied to the selection, survivorship bias, scale issues etc.
Where the multi-strategy single hedge funds are constrained to use in-house managers for the various strategy sections of the fund with the potential result of a sub-optimal product, the FOHFs are able to invest independently and with the best managers available. They also have the flexibility to move their investments when the underlying managers do not perform or when there is a better alternative.
In dealing with the FOHF investment firm the pension fund is dealing with the equivalent of another institutional investor who will implement the same high levels of due diligence and rigorous operational risk management to ensure that the investments are successful. The interests of the FOHFmanager in undertaking detailed analysis and selection are very closely aligned to those of their clients.
To effectively manage expectations and to achieve the desired levels of diversification, detailed guidelines should be used (see figure 4).
While it is critical that the FOHF manager maintains the expected risk/return characteristics it is important to keep in mind that these are medium to long term investments and performance targets should be measured over 3-5 years. However, do consider if the current portfolio construction and strategy asset allocation is fully achieving the best results at the appropriate levels of risk. Undertake some stress testing – look at what might happen if there were crunches or crashes. Undertake some holdings analysis and look at the internal correlations and weightings within the FOHF and between the underlying funds and other assets in particular markets. IAM does not think that it serves pension funds in the long run to keep out of hedge funds just because of the latest set of alarm bells.
When considering a new investment pension funds should ensure that they look at investment managers with the following criteria who will best serve them in this area.
By following these steps the journey to diversification and alpha returns can be accomplished with lower risks and clear expectations and the confidence that it is certainly a path well travelled, well signposted and well lit.
IAM is a specialist, independent fund of hedge funds firm, with over 15 years experience in creating well diversified, multiple strategy fund of hedge fund portfolios.