Cass-CAIA Forum

Originally published in the January/February 2012 issue

By mid 2011 investors had allocated approximately $62 billion to hedge funds and total assets under management reached a new record of $2.04 trillion. During the same period funds of hedge funds saw a net withdrawal of $6.9 billion and the total assets under management remained around 20% below the peak of $800 billion reached in 2007.

To discuss these trends and explore how the landscape has changed for funds of hedge funds, Cass Business School and the Chartered Alternative Investment Analyst Association hosted a forum. Four expert panellists joined Steve Wallace, CAIA’s director of business development in EMEA, to discuss how the hedge fund industry is adapting. The November event came from a partnership between Cass and CAIA to promote education in the alternative investment area. The panel was moderated by hedge fund specialist Dr Nick Motson of the Cass Business School. The views of each panellist were personal and given in a private capacity.

The panellists included:

  • Dr Bob SwarupMember, CAIA Exam Council, and Partner, Pension Corporation.
  • Simon LeslieInvestment Consultant (Hedge Funds) at Cambridge Associates, London.
  • Daniel Capocci, PhD – CAIA – Senior Investment Manager at Architas Multi-Management Ltd, London and Visiting Professor at University of Luxembourg.

Motson: There are a series of fairly broad questions that cover the main areas of interest in terms of funds of funds and the issues they face. From the start I would stress that all of the views expressed are personal views and don’t necessarily represent their employers. Big question marks hang over the fund of funds model. The share of assets managed byfunds of funds is now slightly over 30% of total industry assets, but it was over 45% before the financial crisis. So, I’d like to ask the panel members what do they think is the main reason that investors are choosing to bypass funds of funds and invest directly. Is it performance? Fees? Liquidity? Transparency? Due diligence? The Madoff effect?

Swarup: I think funds of funds have actually been a victim of their own success. They were originally the gatekeepers for the hedge fund community for many institutional investors. I’ve been on both sides. The problem faced by funds of funds started with the marketing which emphasised absolute returns, zero correlation to the S&P 500 and the extensive due diligence conducted. Investors believed this. But then investors got caught out in recent years and they weren’t forgiving. It wasn’t just Madoff or bad performance or the fees in isolation.
Most institutional investors are very angry with intermediaries. They are angry with banks and funds of funds and private equity funds for promising high returns or low correlations and instead collecting fees for losses.

The fund of funds model has suffered. Because they grew so quickly and aggregated such large numbers of assets, the model never really had to evolve. Funds of funds were in a position where they could aggregate lots of assets, charge 1% management and 10% performance fees on them and nobody asked you too many questions, as long as there was a decent return year in and year out. When that disappeared, funds of funds had nothing to fall back on. Other parts of the financial services sector developed across different strands with discretionary and advisory arms. Funds of funds rarely did this until recently. Now they are trying to build more symbiotic relationships with institutions and the model is evolving.

Motson: Thanks Bob. Simon Leslie?

Leslie: I think the events of 2008 only really accelerated the natural process of investors bypassing fund of funds and investing directly. The hedge fund industry now has $2 trillion in assets. It’s becoming a mature industry, and those investors that started out investing in funds of funds are now more experienced, more sophisticated and they want the increased customisation and cost effectiveness that comes from investing in a direct hedge fund programme. Another reason, I think, for investors bypassing funds of funds and going direct, is that much of the increase in assets in the hedge fund industry has come from large investors, particularly pension funds.

These types of investors are generally very concerned with co-investor risk, and that’s the risk of investing alongside other less institutional investors that might want to withdraw their capital at an inopportune time, and therefore leave them (remaining investors) at a disadvantage. Instead, they’re moving to direct hedge fund investment, where they have greater control over the assets.

Capocci: I have a different point of view. I think performance and fee are key factors for investors. In most cases, what you can expect from an average fund of funds is the average return of hedge funds, in general. But in 2008, the average fund of funds was on down 20%. Investors still remember this. In the good years it was maybe plus 10-12% but the ratio leaves an imbalance in performance terms. There has also been a switch among investors as Simon says. I was in private banking before 2008 and some clients had up to 30% of their assets in hedge funds. These people lost money so they went out and haven’t come back. The new money coming in is not from the same clients, it’s more pension funds.

Performance issues

Motson: Thanks Daniel. That brings us to performance. (A recent study) concluded that only 5.6% of funds of funds did better than a randomly selected portfolio. So, if I’d thrown darts at a board, 95% of the time I’d do better or equallyas well as these funds of funds. They studied 1300 funds of funds, meaning that only 74 of them are actually adding value for investors. Is it likely that there’s a mistake in that study, or is this realistic?

Swarup: I’d probably ask how they chose their random portfolio. With funds of funds in general, the problem is that there are some good ones out there, but there are also a lot of very poor ones. For a long time, a lot of funds of funds were run by people who simply picked funds that had the best performance on a sheet of paper. Due diligence wasn’t genuine; it was very confirmatory.

All due diligence comes down to three questions. One: how do you make money? Two: Why do you make money? Three: How do you not lose money once you’ve made it? If funds of funds had asked those questions, I think there would be more of them that would be actually adding value. The future of funds of funds is a bit like a utility, and that’s really how they need to evolve.

There is a huge investor universe now going direct. I query to what extent they all can necessarily do that well. It is one thing to go direct and make investments. It’s another thing to actually know what investments you’re making and how to pick good managers. Amongst the flows that go into hedge funds, something like 95% go into the top 5% of managers. That sounds like herd mentality to me. The danger is that if one of them goes down, losses are felt across the board. Funds of funds can add value by adding knowledge to that mix.

This is what I mean by saying the model needs to evolve. For example, the advisory part of a relationship can be just as lucrative. It’s more a volume business, that’s the only difference. As an asset gatherer, a fund of funds has a limited size it can get to. So, I think it is right to say that funds of funds probably haven’t added that much value, but I think they potentially could.

Leslie: Before I joined Cambridge Associates, I used to work in funds of hedge funds. I think funds of funds do add value, but that the fees and costs associated with them are generally too high. Above a certain level of assets, funds of funds are making pure profit. There are huge economies of scale. There’s a very strong case to be made for funds of funds reducing fees, or specialising in certain areas, perhaps being providers of niche hedge fund strategies or investing in smaller hedge funds. Concerning the study, I’m not sure if 5% is the right number (for funds of funds adding value), but it’s probably not too far off. There are a very small number of funds of funds out there that generate alpha net of fees.

Capocci: The 5% figure seems very low. To me 15-20% sounds normal. With my PhD, I covered a few thousand individual funds over various time periods. I found that only around 20-25% of the single manager hedge funds create value over time. With funds of funds this number may decrease to some extend but 15% of them should be able to add value. Not everyone can make money, neither on the individual fund side nor the fund of funds, but there are some people that do and do so consistently.

Adding value is complex

Motson: In the traditional world, equity portfolio managers basically can only add value by security selection or market timing. Investing in hedge funds is much more complex than investing in equities, it’s not as liquid and market timing is more difficult. Rather than trying to almost track one of the indices and overweight long/short equity, should funds of funds rotate through strategies and time the market in that way? Moreover, can they really add value by picking funds?

Capocci: I think a fund of funds can add value, not so much by timing the market, but by selecting good managers. For me the most important element is portfolio construction. That is the difference between buying five big hit names and somebody building a fund of funds. A portfolio manager combining different strategies, risk profiles and different managers can build a portfolio in a smart way. This is the way to justify fees.

Leslie: The main way funds of funds can add value is through the quality of their manager selection and the due diligence they do. Another thing, though less important, is throughLY understanding the drivers of individual hedge fund strategies and how to position themselves in those strategies over time. Certain hedge fund strategies are cyclical. For example, credit or distressed debt strategies are very cyclical, and returns ebb and flow with the economic cycle. Capturing returns as default rates move up and as credit spreads widen, is another way in which funds of funds can add value.

Swarup: I think, in some ways, that funds of funds can add value through market timing. There are cycles in the hedge fund world and these cycles are created by herd behaviour, though I appreciate many managers will hate that assertion. The more hedge funds that are out there, the more pronounced the cycles will be in every strategy. And someone studying lots of different strategies and the managers within it will be able to figure out the cycles and advise people on how to time those cycles to some extent. You only have to look around the world to see different opportunities. Within Europe, for example, there are opportunities currently in macro, distressed debt and so on. Funds of funds can add value in timing in that sense. And that timing relies on institutional investors who are not looking to trade in and trade out in a day, but are looking for three year trades, five year trades or perhaps ten year trades.

Calculating diversification

Motson: Let’s canvas views on how many funds are required to be diversified. Also, is there a cost to that?

Leslie: We think that between 18 and 25 managers is sufficient to diversify away the organisational risk of investing in hedge funds. But then, within that, it’s important to diversify across investment styles, across managers and, also, across geographies. With regard to over-diversification, I would say that it’s very costly. Creating a hedge fund programme with too many managers means that it simply ends up looking like the hedge fund index. The goal is to create a hedge fund programme that’s going to outperform the relevant hedge fund benchmark or perhaps an equity index over a full economic cycle.

Capocci: The best number would probably be something like 20 to 30. The top 10 managers would be 50% of the book with the smaller positions more niche and helping to diversify the return stream. The more diversified book Provides more returns for the same level of risk. It may also keep the volatility the same but increase the return potential.

Swarup: My tack is slightly different. My first question is why bother diversifying at all? Simon mentioned that it’s tailored to investors’ requirements and I think that’s the most important thing. For example, many pension funds have a lot of fixed income elsewhere in their book, so the one thing that the alternatives portfolio is supposed to do is most definitely not correlate with that. Now, that means, by design, you will have a portfolio that, by any metric on its own, may look highly odd. It is directional, it is concentrated and it has some unique strategies within it. I see nothing wrong with that.

Diversification is one of those wonderful mantras that people go on and on about, but I think diversification can suck. Averaging down to the mean has not helped people in equities. I don’t think it helps people in most strategies. It comes back down again to the fact that if you’re in an industry that is rapidly becoming something that is effectively a herd mentality across the board, then diversification simply means you move with the herd.

When I look at any manager, guess what, you’re competing withlots of other asset classes, you’re all exploring potentially similar opportunity sets, and I’m going to pick the person who gives me the best risk adjusted return and at the lowest cost for that risk adjusted return. Funds of funds like everybody else need to understand that. They need to ask what a client wants and tailor their service. An endowment, a pension fund, a charity and a private bank all have very different requirements in terms of assets and liabilities. Some deeply care about downside protection, while there are others who deeply care about upside gains. Diversification, to me, is actually the last point. You only decide to diversify if you believe that’s what the client wants, not necessarily as a starting point.

Risk management

Motson: Having told me that diversification sucks, I dread to think what you’re going to say about standard deviation and VAR. They didn’t do a particularly good job during the crisis. They certainly didn’t estimate the risks of some of these portfolios. What risk management techniques are funds of funds using now to measure risk?

Leslie: The most important way in which investors can understand the risks in hedge fund portfolios is not by focusing on a single metric, like standard deviation or VAR, but by really doing their homework and by doing thorough due diligence. Investors need to understand hedge fund managers’ portfolio, what securities are being traded, what specific bets are being taken and how the manager is managing risk. The quant side, in my opinion, helps to inform that process, but most of the work needs to be done on the qualitative side. Some investors probably went wrong by emphasising specific metrics too much.

Motson: What you’re saying is understand what the manager is doing and understand the strategies.

Capocci: The most important is to talk to the manager to understand what he’s doing. But at the end numbers are there, too. It is important to be sure that what you understand is in line with what the numbers tell you, because if it is not in line, then you have a problem. Quantitative analysis is a tool that you should use. It is much more than simply a fact sheet with three numbers.

Motson: Any additional comment?

Swarup: Anyone using just standard deviation or VAR is guilty of lazy risk management. The point is there’s lots of soft, fuzzy things about risk management, which are things like people, operational risks and liquidity, which quantitative methods aren’t very good at capturing. Before I went into finance, my PhD was in Cosmology. It teaches you to be very sceptical of numbers, for the simple reason that you can spend 40 years of your life working on one theory, only to find at the end of your career you were completely wrong. And that scepticism is important, because models, fundamentally, are all broken. Though it is easy to quantify things like volatility, a lot of us take that as the simple way of looking at risk, but it’s not.

Hotel California revisited

Motson: On the risk theme, let’s look at liquidity risk. Paul Marshall, talking about the funds that put up gates in 2008, described it as a ‘Hotel California’ moment, which is you can check out any time you want but you can never leave. The issue is that funds of funds are often investing in funds with three month liquidity or longer, yet their investors are asking them for monthly liquidity or shorter. How are funds of funds adapting to this? Are they asking for shorter liquidity from their managers? Or that they’re not offering more frequent liquidity to their investors?

Leslie: Funds of funds have definitely adapted since 2008. They’ve done that simply by trying to match the duration of their liabilities, their capital bases, with the duration of their assets, the hedge funds they’re investing in. Particularly in Europe, funds have tightened up that relationship.

Capocci: I have switched from the offshore funds of funds world to working with absolute return funds. The opportunity misses some strategies like distressed, some credit and the other less liquid strategies but what you get, on the other hand, is liquidity, daily or weekly usually, though some can still gate. Even in UCITS, you will have a potential gate in the prospectus, but this gate is daily, so it means an investor can go out in a few days, not months. If it’s a 10% gate you will get your money back in 10 liquidity dates that will be 10 days.

Swarup: Funds of funds have basically started to learn the lessons of asset liability management. One set of liabilities are your redemption cycle, but the other liability is also invester expectations. Having said that, I think a lot of funds of funds are moving towards shorter and shorter liquidity. And I think some of them should look at, perhaps, bifurcating there, as well, towards things that are less liquid and things that are more liquid. One of the problems today is a short term investing mentality but that can create opportunities. The real returns now are there for people who can afford to wait, say, a year, two years or three years. Funds of funds should also look at going the other way on liquidity as well.

UCITS growth in focus

Motson: UCITS compliant funds and managed accounts have grown rapidly. Given what has been in the press about MF Global investors are worried about where the money is. Are UCITS and the managed account platforms going to continue to grow?

Capocci: UCITS isn’t big today, but it is growing and you see not only the bigger names but interesting names coming to the sector. There is a market for it. Liquidity and transparency are the benefits. But there is often a swap, and in some cases, I think, it’s not always so clear to investors what is at the back of it. The counterparty has to provide the return (from the swap). But the collateral can be something completely different from the fund you’ve invested in. So, there are some risks that are not clear to everybody.

Leslie: I would agree that the UCITS fund structure is growing in popularity. But we haven’t seen much demand for UCITS compliant funds. And where clients have invested, it’s been primarily to fulfil a specific requirement, namely to take advantage of the tax benefit of investing in a UCITS structure versus an offshore fund. UCITS vehicles are generally highly liquid vehicles but that liquidity comes at a cost, returns are lower, and the investment universe is much smaller.

Swarup: I think UCITS and managed account can both be useful tools fulfilling different investor needs. The important thing is that there’s a danger that a lot of investors use them as a byword for due diligence of some sort. That’s something people need to watch out for.

Consolidation ongoing

Motson: If funds of funds are going to have a smaller asset base than previously and fees are going down, is there a question on the economic viability of smaller funds? Will we see more consolidation? Do boutiques have a future?

Leslie: I think there is a place for smaller funds of funds that are independent and boutique-like. But it’s important that they specialise, that they have some sort of competitive advantage, whether it is investing in niche hedge fund strategies or perhaps focusing on investing in smaller hedge funds. Smaller funds of funds with weak business models will continue to go out of business, and others will attempt to benefit from the economies of scale by merging or acquiring other funds of funds. We’ve seen that recently with some London-based funds of funds.

Capocci: There is room for smaller funds of funds, though the market for these has been affected by UCTIS funds of funds launching. Of course the market is tough, even for the larger names. ButI’m sure that if people do a good job over time they will be able to attract assets and grow.

Swarup: I think small funds of funds will find that they have more of a place in three or four years’ time. A lot of institutions are now taking hedge fund programmes in-house and are on a learning curve. What they’ll probably find, after three or four years, is that they all don’t necessarily want to invest in the manpower or necessarily have the allocation size to go and target, say, emerging market managers or niche strategies. The requirement to find someone to fill these niches will see a lot of investors use funds of funds.