The fund of hedge funds sector is moribund, isn’t it? Don’t funds of funds have low or no growth, a declining share of the hedge fund industry, and even more fee pressures than single-manager hedge funds? That is the caricature, with, as always in these things, a grain of truth in there somewhere. But each year some multi-manager hedge fund businesses grow, while the sector as a whole struggles – those businesses take market share and tend to have market-leading strategy or execution capability, and sometimes both.
One such business is Morgan Stanley Alternative Investment Partners (AIP). The hedge fund team within AIP, established in 2000, has grown each year since the financial crisis. That it has taken share in recent years is reflected in its industry ranking. According to data from Preqin, AIP was the 12th largest manager of funds of hedge funds in March 2013. In the latest industry ranking from Preqin (3Q 2015), AIP was listed as the sixth largest fund of hedge funds business in the world. In that time the firm has not made a takeover or merger of a hedge fund business, but has reached $22.6 billion in AUM.
AIP is part of Morgan Stanley Investment Management, the asset management arm of the global financial services firm. In addition to the hedge fund team, AIP also includes a private markets fund of funds team that manages private equity and real estate multi-manager strategies, and the Portfolio Solutions Group, which manages custom multi-asset portfolios. Collectively, AIP services a broad global client base that includes both institutional and high-net-worth (HNW) investors.
The Hedge Fund Journal spoke to the CIO and Global Head of AIP Hedge Funds, Mustafa Jama, to find out how AIP keeps beating the competition.
Within the hedge fund team, the investment side operates through an eight-person investment committee headed by Jama. The investment team structure is based on strategy specialisation, and there is veto power from an operational due diligence team. Each portfolio of hedge funds has a designated portfolio manager who adds and sells down hedge funds for that portfolio with the input of Jama and the Quantitative and Risk Team. “I’ve been on the sell side and the buy side,” says Jama, “and I strongly believe that someone should own a decision that has been taken. So the decision-making on the fund of funds is the responsibility of the portfolio manager, though the whole Investment Committee has to support a decision.”
“Given it is easier to predict risk than returns, our portfolios are primarily described in risk measurement terms,” Jama explains. “The risk descriptor we use most is equity beta. A diversified (conservative) portfolio may have an equity beta to MSCI ACWI of 0.15-2.0 and a realised volatility of, say, 4%. We also run more opportunistic portfolios which may have a volatility of 7%, to give you an example of an order of magnitude. The level of return is a function of the risk taken and is usually expressed in terms of basis points over the risk-free rate.”
In addition to diversified and opportunistic portfolios of hedge fund interests, the team also manages strategy-specific portfolios, including a global macro strategy, an equity long/short strategy, and a mortgage-focused strategy. One of the team’s greatest strengths is its customisation capabilities, which are increasingly in demand among institutional investors. Jama and his team also have flexibility and structuring capability to offer bespoke discretionary or advisory hedge fund portfolios to HNW clients for a certain minimum asset size.
Delivering value to sophisticated investors
It is sometimes thought that it has become difficult for a fund of funds manager to be of great use to the world’s largest and most sophisticated investors. AIP currently has sovereign wealth funds and public pension plans as clients, as well as endowments and insurance companies. When these large investing institutions are experienced investors in hedge funds, they often have the ability to tap into a variety of resources to achieve their desired level of exposure to the asset class. These may include direct hedge funds, funds of funds, a specialist hedge fund advisor and a general investment consultant. To deliver value to this group of clients, Jama and his team seek to provide them with unique investment opportunities that they may be unable to access on their own. Notable examples, according to Jama, include sourcing emerging managers, co-investments and hedge fund secondaries.
“We are not focused on introducing large, well-known hedge funds to our most sophisticated clients,” explains Jama. “We concentrate our efforts on sourcing highly skilled managers that are under the radar, pursue strategies that are viable over the medium term, and generate good returns. It is not that the investors can’t find these managers at all, but, given the resource constraints the clients have, the process of doing so can be difficult and time-consuming.”
An example of the type of manager that the AIP hedge fund team favours would be a firm running a couple of hundred million dollars: “Somebody that is not big, but has the potential to become big by scaling their team and infrastructure,” says Jama. “We are looking for situations where we can partner with managers who are strong alpha generators, and help them grow from a small asset base to around $4 billion in assets under management over a three-year period. An approach that we have taken on more than one occasion is to agree to lock up our capital with a manager for a certain period of time to help stabilise their business, in exchange for a very low level of fees and the option to obtain additional capacity in their fund at future dates.”
Co-investments and secondaries
AIP is also in position to offer clients co-investment opportunities sourced from AIP’s roster of approved managers. These opportunities arise when hedge fund managers wish to participate in specific transactions but, due to capital, liquidity or investment constraints, require additional money from an outside source in order to do so.
“Because of our size we get shown a lot of co-investment opportunities,” discloses Jama. The types of transactions vary by asset class, sector and geography. AIP looks for opportunities that fit between the seams of liquid hedge fundsand private equity, with managers experienced in the investment with interests fully aligned. The advantage to fund managers is that they have access to a source of capital with liquidity terms that are more flexible than those available in their flagship funds. The advantage to AIP clients is access to high-conviction opportunities from hedge funds vetted by AIP, typically with lower-than-average fees from underlying managers.
The secondary market for hedge funds is smaller in scale than the private equity secondary market, but continues to offer opportunity for AIP. Clients with longer investment horizons have benefited from the careful selection of illiquid hedge fund interests acquired at significant discounts to net asset value. Transactions in the secondary market are often highly complex, but Jama believes that the scale of his team and the resources of Morgan Stanley enable them to find and capture the value that is available. Jama notes that there are not many organisations which can value, say, 30 different illiquid investment funds in a bundled transaction.
Turning to specific hedge fund investment strategies, Jama has taken a strong line on distressed investing. “We launched a distressed fund at what turned out to be the absolute bottom of the cycle, in 2009," he says. "At that point spreads were blown out, and we raised three-year money from clients and it was done. We started liquidating that strategy and returning capital more than two years ago – investors got their money back and we believe that they were very happy with the returns generated.”
Lately, Jama has not favoured credit investing.
Quite a few managers of European credit – oftentimes American firms with a European arm in London – have raised what they described as opportunistic strategies to invest in European distressed assets over the last two to three years. “We have looked intensely at the opportunity that has been presented,” says Jama, “and at no point in the last two-and-a-half years have we liked what we saw. We were negative.” The combination of the aftermath of the financial crisis, tighter capital adequacy rules for European banks, and potentially a willingness by bank management or bank regulators to allow or force state-supported banks to disgorge assets looked superficially like a great environment for distressed investing. Jama believes, however, that the supply of available capital chasing the opportunity completely overwhelmed the actual value of assets for sale.
Jama feels the general conditions for an attractive distressed opportunity set are plenty of inventory of defaulted debt and generally wide spreads. The strategy operates with the rhythm of a cycle. Those conditions applied in March 2009. To what extent have they applied to Europe in the last five years? The European Central Bank has been giving money to European banks so that they did not have to relinquish assets. The banks have raised equity and quasi-equity themselves. That means there has not been the widespread sale of discounted assets that was anticipated – inventory has disappointed. Secondly, the terms on which assets have been sold (often in competitive bidding situations) have not represented wide credit spreads.
With spreads being tight and bankruptcy rates at relatively low levels, Jama advises patience towards distressed investing strategies at this time. “There are pockets of opportunity in energy-related assets,” he says, “but in general there has to be a premium for illiquidity and there is not enough of a premium to justify getting involved now.”
“We like statistical arbitrage and high-hedge equities now. This has been our general view for the last five years,” says Jama. “We have made a lot of effort to understand what is going on in the space, and we believe that our expertise is as good as anyone investing in this area now.”
The team has worked hard to source new opportunities to actively allocate to statistical arbitrage, an investment strategy which always has a lower capacity ceiling than large and medium-cap long/short equity managers.
To find new capacity in this strategy, AIP has been proactive in identifying managers with the expertise, infrastructure and operational processes to successfully engage in stat arb investment strategies. “We might ask these managers to consider trading an expanded set of securities or to extend their trading frequency to see if we can find some competitive returns in this area. In this context a Sharpe Ratio of 2.0 and above is good.” To Jama it is partly about the fee basis. He is looking to score what would rank as good to high returns for the strategy, without having to pay the extravagant fees that some famed computer-driven traders have looked to charge.
As a stat arb-type manager you need scale to minimise the costs of frequent trading. The transaction costs in these strategies can eat half of the returns, so it is imperative to control them tightly. Partly this is a function of the manager’s own dealing technology and IT systems infrastructure, but it can also be a function of how the stat arb manager is connected to the dealing venues and exchanges, and the transaction volume the investment process generates. Scale can help to reduce the fixed cost part of the charges paid away in dealing costs.
Before AIP gets involved in systematic investment strategies, including CTAs as well as stat arb managers, the firm runs its own tests to verify the viability of the investment strategy concerned. Jama explains: “We have proprietary models that run specially constructed indices to test whether we can get close to replicating the return history (including losses, drawdowns and volatility). So if a lot of people are implementing, say, a 180-day break-out strategy, then we can determine whether the investment strategy is readily available to us, or if it is adding value compared to what we can already achieve. We don’t want to pay premium fees for a vanilla strategy. We strive to identify alpha, measure it and ensure it is what we are paying for.”
The testing described is conducted by the quantitative team at AIP. They apply the same rigour to investigating the return histories of large “quantitative macro” and CTA managers as the smaller stat arb firms. According to Jama, too many strategies he sees can be reduced to market momentum models that can be simply replicated.
Finding areas of opportunity
AIP has been a recent conspicuous success in a sector, funds of hedge funds, that had its relative peak (in terms of having its highest proportion of the industry) in 2007. There are a number of reasons for AIP’s ascendancy. Although branding may be initially useful, the substance behind the brand – how the firm works with clients and the results achieved – are always more important. By delivering value on a consistent basis across a number of dimensions, AIP is able to strengthen and build on its relationship with its clients and attract new capital to its strategies.