I wanted to get everything right before launching, and therefore allowed the set-up process to take time. We are based in Port Jefferson, Long Island, not far from where I spent 12 years working at Renaissance Technologies’ Stony Brook headquarters. The difficulties afflicting the hedge fund industry extended the timeline of the set-up, but in the process I learned a lot of lessons on how to manage a fund of funds, including how not to manage one.
The idea to launch a fund of funds business arose not long after my leaving Renaissance in 2004 to found and direct the Quantitative Finance program at Stony Brook’s Applied Mathematics department, but the real work with building FQS did not start until 2008 after the end of my three-year separation from Renaissance. Though many hedge fund industry leaders may have called it quits, I decided to return to the hot seat of managing money armed with the experience of having worked closely with Jim Simons for 12 years.
Even though I am in my mid-50s I am definitely not ready to walk into the sunset. It was the intellectual challenge and interest in problem solving that brought me into the hedge fund industry in the first place and that is why I’ve decided to now return. That I was fortunate enough to accumulate some wealth along the way has not changed my desire. I was careful to take time setting up the business and tried to do everything right from the outset. This included, among other things, defining the investment process, building proprietary portfolio systems and databases, and recruiting the right people. Fortunately, FQS had the ballast to weather the storm that roiled the global financial markets throughout 2008 and early 2009. During the 18 months spent setting up the business, some very valuable lessons were learned about the behaviour and performance of the fund of funds sector during this tumultuous period in financial markets.
To be honest, I was not surprised by the massive redemption wave of late 2008 and early 2009. Several firms dug their own graves in the way that they built their investment processes and treated investors. With few exceptions, most firms were not ready for a combination of qualitative and quantitative factors hitting their net asset values simultaneously.
My work with Jim Simons included developing key components of the Medallion fund and assisting in the founding of Renaissance’s Equimetrics and Nova funds. I was also a member of the management committee that developed and managed Meritage, Renaissance’s internal fund of hedge funds. From the vantage point of this experience I see three main flaws in the traditional fund of funds business model:
– the tendency for top-down, macro and financial market data-based analysis to play second fiddle to bottom-up manager analysis and due diligence;
– the tendency for the risk management team to assume a post-investment control function rather than being involved in the decision process;
– the lack of transparency to investors.
My aim in setting up FQS as a fund of funds was to pay specific attention to rectifying these shortcomings. The firm takes a scientific approach to hedge fund investments through a hybrid quantitative and qualitative investment process. Investment allocation and rebalancing is designed to be an ongoing, collaborative and well-organized effort with built in checks and balances in which portfolio decisions are subject to multiple stages of independent review before they are finalised. Concretely, it means that we have married quantitative, top-down analysis and portfolio management with bottom-up manager research and operational due diligence, and the risk team is a part of the investment process from start to finish.
The top-down, quantitative components are based on proprietary models that are designed to maximise the portfolio’s long-term return potential while protecting it from short-term market volatility. The main modular components interpret historical macro and price data, some of it stretching back to 1870, and translate this into theoretical hedge fund strategy and sub-strategy allocation profiles. When these are applied to FQS’s hedge fund database, a theoretical portfolio is generated.
It’s not a black box process, though. The names in the quantitatively generated portfolio are treated as selection guidance. The real value added on the selection side is provided by the research and operational due diligence teams. Quant models are great for defining what strategy space and sub-space exposures the portfolio should have, but at the end of the day, the only way to figure out if a manager is good at what he does or not is to let real people analyse his alpha-generating capabilities by dissecting his business and meeting his team. This is where the qualitative aspects of our investment process come into play.
The bottom-up, manager research-driven process that follows and complements the quantitative analysis sources manager candidates through the investment team’s networks, while performing in-depth qualitative analysis and operational due diligence. This process is fairly traditional as far as hedge funds investing goes, save for the fact that the risk management team is part of the process every step of the way. Chief Risk Officer Pacome Breton, who reports directly to me, can veto the inclusion of a manager in the portfolio at any point in the process if he perceives that factors such as diversification, exposure, P&L attribution of an underlying candidate manager’s portfolio, linear and non-linear behaviour vs. traditional market factors are not in line with the risk profile of the portfolio.
The end result of this allocation process, in the current market environment, suggests a lower exposure to long-short equity strategies and a higher allocation to global macro, managed futures and distressed strategies than a traditional fundof funds. The portfolio, which will eventually be comprised of 20-30 managers, will have a 10-15% return target with 7.5% volatility and will be rebalanced relatively infrequently.
FQS takes a different approach to manager selection. If your portfolio has the right mix of managers with the ability to generate returns within their respective investment strategies to begin with, there is no need for extensive rebalancing. This is sub-optimal for several reasons, a major one being the relationship with the underlying manager. If we decide to go for a manager, we are sure that he has what it takes to produce returns in the long run while still respecting occasional market volatility.
FQS’s launch line-up of 15 people includes investment manager Penny Aitken (formerly head of research with IAM), CRO Pacome Breton (formerly with Pioneer) and Head of Operational Due Diligence Eric Lazear (formerly with IAM and FIM Advisors). Roughly half the team is based in London with the rest posted in Long Island. We expect to grow to 20 people by the second quarter of 2010.
At the end of the day, manager research, operational due diligence and risk management functions are people-driven, which is why I paid such close attention to the recruitment process. I want senior talent on board, people with exceptional skills in their respective fields, people that are not afraid to question me and my views and thereby make a contribution to improving the investment process.
Our staffing and infrastructural ambitions come at a premium, and the management fee-based breakeven point of the firm when staffing and the multi-location operational footprint are accounted for is estimated to be around the $200 million AUM mark. With an anticipated initial AUM of $350 million, however, FQS will have more than adequate cost coverage. The initial investor base is made up of around 50 high net worth individuals and family offices, many of which were investors in Renaissance Technologies and committed to FQS when the business was still at the idea stage.
We’ve certainly had a great start in raising assets and we expect the majority of the initial investors to be with us for the long-term. My aim is for us to keep developing our business so that we will be able to access institutional capital as well. A key component of this is providing investors with transparency on the investment process as well as the underlying managers in the portfolio. In order not to compromise the proprietary components of FQS’s business, the firm shares data with its investors through a high security data service, the same used by the M&A industry and the US government. The system allows FQS to disclose sensitive material and portfolio components to its larger investors on a view-only basis. We hope that this will soften the need of institutional investors to have a 24- or 36- month track record before they will consider investing. FQS has been built with clear institutional ambitions. Obviously, we still have a long way to go before we achieve all of them, but considering what we have been able to do so far and the talent we have attracted, we are definitely on the right path.
The fee structure of the Frey Multi-Strategy Fund is the traditional 1% management fee and 10% performance fee. Despite reports of hedge fund investors pushing for lower fees, we have not met any resistance. Our investors are clearly fee conscious, especially after last year’s exodus from funds of funds. At the same time, however, they are ready to pay for exceptional investment talent, risk management, R&D and infrastructure.
We see our competitors being top-down focused firms like Stenham and Liongate as well as quantitatively driven firms like Financial Risk Management. We definitely feel that there is space for another ambitious player like FQS to develop as a major force in this part of the market.
Too many people have entered the fund of funds business only to become pure marketing shops. As long as markets were stable, they got away with generating returns with a bare minimum of investment infrastructure. History now shows that the only way to consistently perform is to focus on risk management while combining top-down and bottom-up portfolio management. To quote Publilius Syrus: ‘Anyone can hold the helm when the sea is calm.’