Dillard was previously a Managing Director in the investment banking department at Nomura, and headed up the merchant banking function. He managed discretionary and principal investments on behalf of the Japanese bank and related companies within the Nomura group. Now working alongside fellow Liongate partner Jeff Holland, he has applied his wide ranging expertise in different investment strategies, including private equity, to managing a fund of hedge funds operation.
RD: We don't have a tremendous amount of commodities or related assets in our portfolio, the reason being we're very bearish on them – they're very volatile, and we like to control the risk. They're 'toppy' and fundamentally, there will be a rising demand from commodities so long as emerging markets like India and China are able to buy them and compete with habitual buyers. A lot of the very high prices are due to the extreme amount of global liquidity, the result of exceptionally low interest rates in the US, Japan, and elsewhere. People have had access to money, and the cost of money has not been very high. They have been able to speculate in commodities at the same time that China started to get on the pitch and compete for the scarcer commodities. The belief that commodities will go down is based on the presumption that these economies will slow and stop buying, and secondly that the money supply will dry up over the next one to two years as Japan and the US soak up liquidity. There will be less money to speculate on prices. There is a fundamental case for commodities in the long-term, but over the next couple of years they're likely to be quite volatile. I think high oil prices are here to stay consistently for some time, whether it's $75 a barrel or $110 a barrel, but that doesn't mean you won't see $38 for a period. Yet the trend is very clear – it's going to go up and up and up.
We're interested in very consistent returns, very contained risk. Since precious metals, energy, and other commodities are high volatility whatever their long-term intrinsic value is, we can't have a very high weighting in them, in the way we've constructed our portfolios. It's not that they're very bad asset classes, it's simply that they're not consistent enough to provide the safety that we offer.
RD: For hedge funds to compete, they need to outperform, so long as they command fees above those asked by mutual funds. The moment they cease to do that, then they'll have to cut prices to compete, and I've seen this emerging as a bigger issue. They will ultimately have to reduce fees because there isn't enough extra outsize return that can be generated in efficient markets with the current amount of talent.
Industries always get hot, and I think you're already seeing a slowing of that exodus in the United States. It is becoming more difficult to raise money, to get seed capital. The other trend is that in both Europe and Asia there is still a lot of market inefficiency. Those funds that deploy strategies there will continue to grow and flourish for a period of time, because ultimately they're trading on some inefficiency. There is a geographic change in the way hedge funds are growing up: in the US they're going to start cutting fees. If you talk to managers over there, no matter how big they are, they're all talking about leaving America and investing in emerging Europe. The macro strategies they traditionally employ are becoming as efficient as the stock-market, due to the amount of capital deployed, and the number of players involved. If they acquire some unique market insight it only lasts for a short period of time and gets bought back in by other players – they can't make money anymore. This is why they're thinking about Europe and Asia, and while they are right in that thought process, of course they don't have a huge track record in being able to successfully redeploy their skills. Americans sometimes can't understand that.
RD: The most saturated private equity market in the world is the UK: not only do you have a lot of aggressive British and European players that appear because London is the centre of capital markets in Europe, but you have Americans who bring money here and compete, because they like living in London, they can speak English, and they can relate to England and its structure more than Germany or France. Their ability to get in and understand civil law, difficult cultural practices, even in Europe, is quite low.
RD: During the period of slow growth in 1990-98, there was so little money in the market; those who would naturally compete against hedge funds were restricted. There was market inefficiency everywhere, so generally all the hedge funds were doing well. Funds of funds were doing well too, and outperformed the mutual fund complexes. You could almost throw a dart randomly and outperform the long-only market. They were probably giving you an index return of hedge funds, mind you, although that index was very high.
What is happening today with funds of hedge funds is that there is a much more diverse environment: there is much more talent and capital, new managers, new geographies, new strategies. The differences of return with funds of funds are widening – there are more winners and losers, whereas before they were all winners.
RD: That type of segmentation is well underway for institutional investors, and it will eventually arrive for the high net worths as well. I don't think it means multi-strategies will completely lose favour: at any time there are always outsize returns in some strategies, meaning people should redeem money from the lower-performing strategies and move it to the higher ones, and there are places still where the one-portfolio-fits-all managers can execute. I certainly feel that one of the trends is to offer people baskets of specific strategies and let them take an exposure, not too different from getting a tracker where you can buy a sector instead of the whole market. The liquidity is still buying the multi-manager concept.
We have done some work on the largest funds of funds, and you find that the correlation they have to the fund of fund index is very high, in the nineties. Most of the top 20 largest funds of funds are tracking the index. A lot of the largest funds of funds have not changed, they have not adaptedtheir strategies. The index is not the thing to beat – investors can measure the index today, while three years ago there were indexes that were not reliable. The key objective of the fund of funds is to outperform the index, to be less correlated to the index. You have to measure a fund of funds in those terms of success. If a fund of funds cannot compete with the index for a time, and instead ends up replicating it, he is either going to have to cut his fees to the level of the index fees, or find some other way to compete. You could buy the HFR index [Hedge Fund Research] on the whole, and not be taking that much more risk.
Large funds of funds today are selling themselves more as diversifiers because they are starting to understand that they're not creating a lot of extra value in terms of profit for their investors, especially institutions. Some people outperform, but what is clearly not the case is that large funds of funds are outperforming.
RD: That's exactly the kind of thing that's happening. In terms of single hedge fund manager strategies, from under $1 billion to above $25 billion, that's 72% of the market [see chart]. If you're a large hedge fund of funds, because of your constraints, not being able to get your money into smaller managers, because otherwise you won't be diversifying sufficiently, you'll be reverting to the mean; you're probably only looking at a universe of 25-29% of the whole market. You don't want to be too big, in terms of the percentage of capital, into any one fund, so you start to overdiversify, because you can't put very much money in there, and thus the returns become fairly de minimis. What they find that they're doing is not focusing on the single hedge fund managers that are truly out-performing, but focusing on those that can accept their capital, funds that can take their capital, and [the funds of funds] end up acting as little better than an asset gatherer, and are limiting the universe to one third of its potential, simply because of size issues. By keeping our size in check, we can run through the whole universe of possibilities. A lot of funds of funds can't compete in terms of access, because it's simply not interesting to them.
I would say you lose competitive position as a fund of funds after $1 billion, because the most interesting single managers, which have an increasing return on capital, are too small for you to take a position. You end up missing a lot of interesting possibilities as you over-diversify in order to get your money in.
RD: The ideal would be $200m to $600m. These are actually our bars, and they bar up that way because they are usually new funds that have been launched with established management companies, which we often find outperform. If you don't want to be in an emerging manager fund of funds, taking on the start up risk, about $200m is what you want to think about being in, and usually after $600m you want to start monitoring them for a decline in returns on capital, on average. It's not a hard and fast rule that's true everywhere.
The other thing you want to do, and this is what we realised, is that a lot of the process by which funds of funds think through their allocations to strategies and managers is exceptionally slow. If you take the very largest, they will set their strategy in January, review it again in June, and maybe change a little towards the end of the year as well, for example. The problem with that is that noone has a crystal ball that will let them see the whole of the year when they sit down in January. They are implicity market directional, and they are also frozen interms of what their views on the markets and strategies are in January, and for almost the rest of the year. You can do that at a time when everyone is making money, but markets change daily, weekly, monthly. If you can't change the composition of your portfolio to reflect that, it's a bit like pin the tail on the donkey. It's much better to adjust your portfolio each month to reflect the market environment of what's working, and what's not working. Over the course of the year we probably change 2-4% per month – in a very big market, maybe 5%. It translates into a strategy shift of about 45% over the course of the year. We're not trying to be directional: all it is in each month is reflecting the realities of the marketplace, and adjusting a little bit to account for the obvious. You can't think about that only at the beginning of the year. Changing around brings a lot of efficiency and extra return as well.
RD: No, because in mutual funds, they charge you entrance and exit fees, giving you the equivalent of agency trading costs. When you're dealing in a razor thin market, that can add up. In hedge funds generally you can get your money out without fees, and most of the time you can negotiate your exit. But they do have lock-ups sometimes. There can be a penalty fee if you try to redeem before the lock-up. What they won't try to do is give you an agency trade fee on top of that. There can be a cost if you're effectively breaking the investment time horizon you've already agreed to.
RD: Quite a lot of hedge fund managers are open to this. They are realists. Each day they buy and sell bonds and stocks. Why stick with a pound that's invested for three or four months when it's not going to yield any return? That's the mentality of these underlying hedge fund managers. If you can speak with them in the right way, and they know what you're doing, and why you're doing it, and maybe you're not so large in their fund that your withdrawing capital is not going to affect their business, you're able to do that. But if you've given them $100m, and you need to take that 10% away, then they'll have to sell some assets, and shrink by 10%. The idea is that you don't want to be such a large part of the fund that a withdrawal will make them testy, when it causes them trouble. But the mentality of "come stay with us, grow with us," is simply not the mentality of a hedge fund. People who say "stay with us, don't trade and incur agency trading fees," this is the mentality of a razor thin market. Don't spend too much money on trading fees. Hold. The thought process is correct, but it is correct in a very efficient market. In an inefficient market, and particularly with hedge funds, you do want to reallocate to inefficiencies all the time. There is global deployment of money. There are always better ideas and geography out there.
RD: Finance is not that much different from selling vegetables, honestly. And in fact it's not surprising to me why former vegetable sellers ate a lot of people's breakfasts when the Big Bang came in the 1980s, because they were hungrier and closer to the vegetable market in some odd way. It was a time when London had fixed commissions, which meant no competition, because you couldn't cut price. Broken up, it lowered barriers to entry for other players who could compete in the same area. It all changed. The thing about what you do in finance, at least in some form, in the capital markets, is that every day you're selling types of fruits and vegetables; but instead of apples and oranges, if you want money for a day, there's a price. If you want money for a week, there's a price. If you want money that doesn't pay interest – equity – there's a price. And if you stay long enough in the grocery market, you develop a feel for the price differences between apples and pears and oranges.
One key is survivorship: the average stay of a managing director in a City investment bank or trading house is actually about 18 months. The average entry stay is about 18 months too. Turnover of experience is actually quite high in the City. Most choose voluntarily to leave because they don't like the lifestyle, and some because they make a mistake or get caught in a cyclical crunch. This means that few people get the opportunity to see a number of cycles, and on top of that, those who can get into a management position and can see and manage multiple strategies are statistically finite too, especially if the capital is very large.
I survived long enough to get to a management point where I could look at multiple strategies. I got to see a lot of different types of transactions, capital market strategies, traders, marketmakers, research, sales, and it is the perfect experience for assessing managers and strategies for a fund of funds, with a greater bonus for me in that I don't have to manage assets and risk positions daily, I just have to select good managers, good strategies. The core driver of it is being able to listen, to synthesize information that hedge fund managers tell you, to understand where the risks are likely to be in that strategy, and to explore whether they are managing and know those risks, and be able to put that up in the portfolio.
You need to look at the profit potential in a strategy, and also their business set-up. Seventy per cent of the risk that a single strategy hedge fund manager is making is the fact that he's running a small business, and that he's come out of a trading environment where there was a legal team to do his legal, a back office to do his settlement, risk management was independent and imposed limits on him, and he never had to think about how to run things. Maybe he was a good trader at Goldmans, and now he's out, and maybe he's having to manage a start-up business. Risk management reports to him, because he's the owner; he gets to select his auditors; he's got to run a business. Not only is there lower oversight, but for the first time he's having to run a business, and be a risk manager as well as a trader. If you have managed traders before, and have looked at the risk management, and understand all the pitfalls that can happen in the business world, it's very, very helpful for looking at things.
It also helps to have a background in private equity, because when you walk in and look at the operations, you can look at it not just as a guy who used to oversee traders, but from the private equity side of how they're running the business. Does it look loose, or ill-formed, or are there signs of very good management or very bad management, which allow you to assess the business?
Being older also helps: there's a lot of younger guys who go out with a form they're going to tick and bring back to their bosses. They're not as well-informed about that strategy as the manager themselves, so the gauge is how much information about return and risk they can absorb. The main way to assess the profit potential and the risk of a hedge fund manager is to encourage him to talk truthfully about his business, and he only talks truthfully about his business if he believes in his heart it is not going to hurt him, because you won't invest or you might bad-mouth him about the way he runs his business. Therefore you have to build up trust for him to talk knowledgeably, and he has to believe that you are sympathetic to the pressures that he's under, of getting return, of managing risk. The more truthfully he talks to you, the better you can assess his potential. A lot of that is about meeting the owner of the capital, and communicating to him that you understand the risks and the pressures of his business, maybe helping him with things he is concerned about, talking about it, and ultimately getting him to open up. When you can get it to such an open level, you can get a much better insight into the information he's trying to sell you. That means you have to travel a lot, you have to have physical presence.
RD: We do have managers all over the world [see chart]. Normally, in mature markets like Japan, where the country doesn't exhibit a lot of risk, we prefer to find managers in the country itself. For example, in Japan, the Japanese managers are better. In emerging markets, I don't like to locate the managers in Brazil or India, for example, as it is very difficult to monitor their holdings, and maintain sufficient oversight or scrutiny. My emerging market managers tend to be located in New York or London. They do give up return for that, but I take solace in the fact that if they can't manage the business properly, they'll get their arms hurt.
It was built up over time. The correlation between the managers is very low, and also to the Nikkei and the TOPIX. Fundamentally it's an interesting place to be. Our segmentation is primarily on specific issues: there's a lot of consolidation and corporate change going on; the other is Chinese cross-trade issues. This was built up and reached a peak in August last year, and has been very profitable for us. One of the best places in the world to be on a risk-adjusted basis was in Japan last year. You can't really call the end of the market, and there's no overriding reason to be out of Japan right now, but you may want to reduce your weightings because returns are up so high, and you want to take it back in. The idea is to be constantly moving to capture investment efficiency. I say that, even though it is so obvious, but if you take the top 10% of the funds of hedge funds, only a handful will actually do that. It's really common sense in implementation, and keeping your size and flexibility.
This is the way that all funds of funds are going to have to go: the party's over, the game of throwing darts at the board and everybody gets rich has ended. If they don't adapt to more competitive strategies, then they're not going to compete, and they're going to have to reduce their costs a bit. That's something that is going to happen all across the board.
RD: It doesn't mean that you ignore the qualities of the manager, because they could create losses or they could underperform, but a lot of fund of funds have decided that they can add value by checking due diligence, getting in with the managers, staying with them over time, but that was a time when the market was static, and highly profitable. All managers were profitable, so being with the most profitable managers was a successful, competitive strategy. But the reality is, in the current world, most single managers have outsize returns for three to four years emotionally, or when they have a competitive edge, then they live on branded names, or they have too much capital and can no longer deploy it in the way they did before. You do need to change, and when you change to keep the strategy mix profitable, that's top-down.
RD: I certainly see they get noticed when they do. I think that's going to become more and more prevalent as the time they have spent in a hedge fund gets longer. The other aspect is that people who have competed successfully in securities houses and gone on to start their own funds, have done it already. The barrier to entry is survivorship to get experience, and opportunity to manage and see something beyond a narrow trading screen; it means you've had to climb up and spend a lot of time in a capital rich environment. These people are getting fewer and fewer, the really top managers who are going to start hedge funds have probably already done it. The ones who typically come out securities houses now are mid-level, they've had a great trading record for three years and think they can make more money by bouncing out. When you have more and more quality of trading in hedge funds, and the duration, then the number of people who will spin off, and start, will increase. The interesting ones that we see aren't from the US, from the likes of Goldmans, but the ones with more solid backgrounds who aren't in the US but in other markets with a great return profile, like Italy for example, or Germany, or Central Europe. Right now one of the most interesting markets is Russia, because of the commodity strategies. If they are professional, have integrity, and have a knowledge of those markets are commanding a premium. People underestimate how much time it takes to start a business up – there's a lot of preoccupation of time in the first year.
The average institution or high net worth institution shouldn't be in the business of putting a fund of funds together unless they have a lot of capital and commitment to selecting them. Every day the risk and the return profile is changing – the dedication to stay on top of that is very high. You should never concentrate your risk in just a few single hedge fund managers. Quite apart from whatever market risk you're presenting, there is always this operational risk you can never get rid of. It is best dealt with by funds of funds, whether it is by strategy baskets or a larger, multi-strategy that feeds on whatever's working, but always keeps it safe and diverse.