Globalisation and Hedge Funds of Funds

Navigating through a tectonic shift

GILES CONWAY-GORDON and CHRISTOPHER R WOLF, COGO WOLF ASSET MANAGEMENT

There was a provocative little graph tucked away in the January 21, 2006 issue of The Economist magazine which starkly illustrated the shift in global production from the developed economies to the emerging economies. The graph's timeline began in 1820 when the emerging economies were dominant, responsible for the great majority of the world's production. At the turn of the twentieth century the production lines crossed and the developing countries became laggards in the ramp-up of the industrial age. Now, after a near ideal investment environment from 1982 – 2000, the lines have crossed again. The emerging economies have largely caught up technologically and are, once again, the dominant producers in the world.

Global Disequilibrium

We believe the implications of the major tectonic shift underway in the global economy are under-appreciated in both their complexity and pervasiveness. Part of the process is fundamental economic growth of the kind that lifts large populations out of poverty and into the middle class. This transforming growth has shifted from where it has been for the last 75 to 100 years, which is the developed economies, and it's moving elsewhere in the world, to India, China, Russia, Latin America, Eastern Europe and even Africa. It's going to stay there for our lifetimes. This is not a short-term, reversible process. Importantly, it is not a process that the developed economies can readily accommodate, or even easily co-exist with, without tremendous and painful dislocations. The system in which the developed economies and their central banks scripted the global financial and investment scene is being replaced in part by a return to what the world used to be like more than 100 years ago (except that you had the gold standard then) and in part by something entirely new.

In any period of pervasive paradigmatic change, the world becomes more risky and uncertain. The large imbalances that we see around the globe are an indication of that and at some point they're going to have to be resolved. The near-term result of this increase in volatility is an equivalent increase in confusion. Many investors have widely (and blindly) expressed two hopeful clichés. The first is that the world is now flat. We in fact believe the precise opposite – that the world is now truly three-dimensional. It has gone from being a collection of flat Balkan trading states, with relatively comprehensible and controllable linkages, to a mountainous global terrain of manifold, new and little understood, or as yet even unperceivable, dynamic relationships. The second hopeful cliché is that in this age of instant information the world has become transparent. Again, we take a different view, believing that it has, in fact, become much more opaque and much, much more complicated.

The overwhelming amount of information, the extraneous, distracting and conflicting signals, and the generally reduced attention-span of the average investor, all add to the horizon-reducing fog. The lack of appreciation of this new global complexity leads to the unsettling environment we presently find ourselves in: a world replete with elaborate portable alpha models but little actual alpha, a world full of investment theories but low actual investment performance. How, then, should an investor responsibly approach such an investment climate?

The Orthodoxy

A turbulent market undergoing a metamorphosis would indicate the need for a broadly diversified portfolio with minimal or no leverage. Finding an outperforming global hedge fund of funds is one approach that can fit the bill. The challenge is that most funds of funds are trapped by history. They share an over-reliance on what have now become suspiciously similar, formulaic, algorithm-driven techniques. The algorithms are then applied to identifying pockets of non-correlation and the funds invest thereafter in what are generally relative value strategies. The premise is that the better you understand a manager's historical investment record, the more reliably you will be able to predict his or her future performance. This rear-view mirror approach did in fact work well during the exceptionally stable and linear markets which prevailed from 1982 until 2000.

Now, however, that approach suffers from a dangerously rigid over-reliance on linear relationships which have begun to fundamentally change. Factors that didn't correlate in the past now do, often erratically. In a world of vast liquidity, many of those relative value strategy buckets quickly fill up and the relative value, so to speak, evaporates. Returns for many funds of funds have been unsatisfactory, particularly when compared with the strong recent gains available in global markets – some investors have called them bond funds with extra fees – and some have considered the 'new full service' idea of becoming hybrid funds and consultants. This genesis would effectively free the funds of funds from the harsh responsibility of having to make money for their investors.

A Different Approach

To add value, we think you have to take a very different, more forward-looking and thematic approach; that is why we run our fund of funds more like an actual hedge fund. We start with broad and deep levels of fundamental economic research. We look at the global economy and seek to identify accurately the major shifts that are taking place now and, more importantly, those that will rapidly manifest themselves in the future. The goal is to be ahead of those major shifts. As such, the allocation of the Fund is at present very divergent from global indices. As a result, we have about two-thirds of the Fund in long/short equity-related hedge funds around the world. The proportion is not hard and fast, but global trade has reached five-year highs, we think that will continue. The remaining third of the Fund is in alternative assets for diversification and upside potential. We have exposure to real estate, soft commodities, precious metals, energy, macro, and some specialist bond funds. So it's a big diversification.

The best investment themes are often subtle. In India, for example, we are currently invested in three different hedge funds, each with a different approach and focus but which, when taken as a symbiotic aggregate, express our long-term investment strategy for the region. For us, 'subtlety', in contradistinction to the usual fund of funds' algorithmic goal of 'intricacy', is the better lens for viewingand ultimately understanding complexity.

Often the standard reaction to an increase in complexity is to try to develop ever more complex quantitative models. The irony is that the people who are developing those models and relying on them end up exercising simplistic sets of judgments at the end of their logic chains. The qualitative analytical approach is more subtle and effective in understanding the world's logarithmically increasing complexity. The point is that quantitative analysis of hedge funds and the ratios and the correlations and so forth is all very well, and something we do, but it doesn't identify the key factors that you need to be sure of. Those are qualitative rather than quantitative. How is this manager likely to behave in the uncharted territory we are entering? Can we feel confident putting our clients' and investors' money with this person? Those key judgements, both with regard to risk and to performance, are qualitative and not quantitative. However elaborate abstract quantitative assessments are. They are no substitute for ratiocination, experience and judgement.

In contrast, our investment strategy is driven by a continuously regenerated world view, based on a tremendous amount of forward thematic due diligence. One example would be Africa. We got there some while ago by following a China footprint theme. We studied the deals the Chinese were doing in various African countries, looked at the underlying equity markets, and identified the hedge fund managers we thought would most closely reflect our themes and investment style. The last step for us was to then run the computer screens to see if there were any other hedge funds investing in that area that we might have overlooked. Most funds of funds start with the computer screening and then everything derives linearly from there. Using an inverse process makes all the difference.

Giles Conway-Gordon and Christopher R Wolf are Managing Partners at Cogo Wolf Asset Management.