Q&A with Tom Gimbel

Executive Managing Director, Optima Fund Management

Originally published in the June 2007 issue

As possibly the oldest and largest independent funds of funds, Optima Fund Management has a unique perspective on the alternative investment community. Founded in 1988, New York-based Optima's growth from a shop focused on wealthy Wall Street clients to a diverse asset management firm with a large institutional investor client base and more than $6 billion in assets under management, mirrors the evolution of the fund of funds business in general.

In an interview with The Hedge Fund Journal, contributing writer Randall S. Devere, Thomas S.T. Gimbel, Executive Managing Director of Optima, discussed his firm's development, the case for funds of funds as a whole and the challenges of evaluating hedge fund indices.

What is the case for funds of hedge funds? Why do they make sense and where do they add value?

There have been comments in the press over the last several years that funds of funds underperform hedge funds and hedge fund indices. However, I would recommend that people not consider the old-style published hedge fund indices as a very relevant indicator of performance or benchmark, because of three primary biases in those numbers.

The first one is what we call "closed fund" bias. What that means is that there are funds that are closed to new capital that have been outstanding performers, but they aren't available to investors. It's almost irrelevant because you or the vast majority of investors can't get access to them. So those closed funds are biasing upward the performance of old-style published hedge fund indices. In the past, these included superior performers like Renaissance Medallion and Caxton. So you have these exceptional hedge fund managers, and their numbers may be getting published in indices and buoying up the averages, but they don't represent the universe available to the investor. So you have that distortion.

Then you have a reporting bias, which is to say, if a hedge fund has a terrible month or quarter, it stops reporting to the index. It argues that, 'We thought it was going to be good publicity and helpful to be in your index, but it really has only been an administrative burden. We're dropping out.' So the bad numbers never appear or disappear.

The third category of bias is survivorship bias, which is just that hedge funds that go out of business drop out. There's a little bit of reporting bias in it; they're intertwined in the sense that, when a hedge fund goes out of business due to bad performance, it rarely reports its last month of negative data. It just doesn't survive and its poor performance goes away and doesn't show up in the index. So you have this overstatement that's characteristic of old-style published hedge fund indices, and various papers estimate it at 200 to 500 basis points per annum. So it's very significant, and I would say the credibility of a lot of the published non-investable indices, as an indicator of hedge fund returns, is very low except as a reference to their own historical results.

Investable hedge fund indices, in contrast, are a very relevant indicator of hedge fund performance and a potential benchmark. They are comprised of funds that are open, that must report, because the index is actually an investor in the funds. So there is no reporting bias, there's no ability of a hedge fund manager not to report to his investors, it's required by an agreement to report results to its investors. Likewise, there's no survivorship bias-if a fund doesn't survive and disappears from the index, the last month or months of performance are delivered to the investor, like it or not. Finally, I already mentioned the closed fund bias isn't part of it, because these are investable indices and they're investing in open funds; otherwise, they wouldn't be able to take the investment. So I consider investable hedge fund indices to be reliable indicators of how the industry is performing.

Then you have funds of funds indices, where the funds of funds are virtually all open to new capital. I've looked at their composition and the funds that make them up, and, to me, they demonstrate that funds of funds, even with their additional layer of fees, net of all of those fees, very consistently outperform investable hedge fund indices. As a matter of fact, I can't find a case where they haven't outperformed investable hedge fund indices. I'm sure there are cases, in certain months or years or quarters, you could have an aberration, but the pattern is extremely consistent. So, to me, the proof's in the pudding.

And it's not surprising to me, because funds of funds are bringing to the table a lot of value-added. They're bringing access to certain funds that are closed or soft-closed that most investors can't get access to. They're bringing professional management of the portfolios, particularly looking at what strategies of hedge fund investing are the most in favor in the economic and market environment that we're in. They're determining which geographic areas and countries are the right markets to be in on a global basis from a geographic weighting. And also what kind of style of fund management is involved. They're also making a quality decision on the individual managers.

Whereas, an investable hedge fund index may have certain criteria for inclusion of funds, they're different from an investment manager's criteria in determining what are going to be the best investments from a risk-adjusted return standpoint. And then, of course, the fund of funds benefits from ongoing portfolio management. If, for example, half the staff of a hedge fund gets up and leaves to start a fund of their own, and they've depleted he staff that's running the ongoing hedge fund, well that might be a reason to redeem out of the fund. Whereas an index, in all likelihood, is going to keep that fund.

Finally, most fund of funds have a fair amount of risk monitoring and risk control, and are looking at the risk exposures of a fund when they're making the investment decision, and they're also reassessing the risks on an ongoing basis to avoid high-risk funds, in some cases avoid high leverage, in some cases avoid very speculative trading, or from a due diligence standpoint, avoid potential fraud or style drift. So, there's obviously a lot of management being applied in running a fund of funds, and it has evolved to a fairly high level over the years. Fifteen years ago, most funds of funds were two smart people in a room managing a portfolio, whereas today, many firms like our own have a very integrated research and risk management staff. We have approximately 20 people on our research and risk management staff, and they have trading experience in the strategies they cover from a research standpoint.

On average, we're covering 10 funds per research analyst, and have a very rigorous process of analyzing the funds that's standardized, it's repeated, it's documented, and it's supported by a technology system that we've invested millions of dollars in. And separate to the research group, and reporting to our chief financial officer, we have a risk management team that's run by a Ph.D in engineering, with a very quantitative approach, and his co-head was at Deutsche Bank as head of proprietary trading risk, and he's in charge of operational risk, accounting controls, funds transfer controls, custodial services for the holding of securities, the accuracy of marks to market, and all the operating considerations. Separate from that, we also use an outside risk analytics provider, so it's a real belt-and-braces approach to risk management.

These are all functions that one would expect to cause an outperformance-most fund of funds have some of these, if not all of these functions, to a degree, and it's a reason for value-added. In fact, just to provide the proper incentives, many of the individuals in our firm have a portion of their compensation subject to various performance measures. We have a very developed incentive-based compensation structure that aligns the interest of our research team with the interests of our investors. I think the better funds of funds provide their professionals with the right incentives to add value, and I think the facts speak for themselves in terms of comparing fund of funds results-as represented by fund of funds indices-to results as represented by investable hedge fund indices.

Another thing that's worth pointing out is that the risks to an investor in picking their own hedge funds, and the costs of entry, are both very high. If the average hedge fund has, say, a $5 million minimum for some of the more highly regarded funds, then to put together a portfolio of 10 hedge funds-while many institutions and ultra-high-net-worth investors can do that, there are not many individuals who can do that. I think people appreciate that having professionals with experience and track record analyzing hedge fund investment opportunities adds value. If one looks at the characteristics of return and volatility on individual hedge funds, the dispersion is enormous.

Last year alone, the dispersion in long/short equity hedge funds from the top five percent to the bottom five percent was a 60 percentage points of return dispersion. In fact, on a scatter pattern of returns, hedge fund returns look a lot like individual equity results. Whereas with stocks, the mutual fund returns are very tightly patterned, they're very close, and the dispersion between different mutual funds of the same style is not very high, funds of hedge funds are somewhere in between. They're not nearly as tightly clustered as mutual funds, but they're not anywhere near as spread out as individual hedge funds. So the risk and return characteristics are ones that more and more investors find very attractive.

Another thing that's useful that the fund of funds often bring to bear in looking at hedge funds and deciding which ones to invest in, is separating alpha from beta, and going even further than that, separating alpha, beta and return on risk exposure. Too often, it's assumed that what isn't beta, what isn't attributable to a directional market move, must be alpha, reflecting the skill of the manager. But often hedge funds generate high returns that aren't beta-derived, and what they really are is a return on the risk exposure being taken by the hedge fund, as opposed to a return on the skill of the asset manager. And those risk exposures are extremely important to be cognizant of.

A number of funds of funds perform a substantial amount of stress testing on their individual hedge fund investments and on their portfolios, and they look at "what-if" scenarios, asking what can go wrong and what the results are if it does go wrong. And having anticipated what those characteristics would be would either cause a fund of funds to never invest in that hedge fund, because it's an accident waiting to happen, or to invest but be very vigilant as to what sort of circumstances should cause a sale of that investment.

The term "institutional-quality" hedge fund or fund of funds is thrown around a lot. From your perspective, what is the definition of an institutional-quality firm?

Echoing the definition used by Robert Picard, our chief investment officer, it's a firm with a professional investment philosophy that is well thought out and looks at risk budgeting and return targets and delivers for its investors what is fairly precisely understood, in terms of those metrics and others, and that has an infrastructure of people and technology that has a track record and experience and very professional training, and stability in the team of people.

Next is a process that is consistently applied, documented, supported by the right resources, available for review before, during and after the fact of investing. And, ideally, a track record-we've been doing this since 1988. I think we're the oldest independent fund of funds firm of our size. I believe the other ones I'm familiar with have all been acquired or have merged. We're owned by our partners, plus one outside 10% investor, and 15% by Mellon Financial Corp.

Risk management is also a key part of the definition. Five years ago, this was not a primary institutional consideration in reviewing hedge fund investment firms, and, rightly, it has become one. We're very pleased with our internal risk analysis and risk management approach, and the software and technology that supports our risk analytics, as well as our joint venture with Bear Measurisk, which provides us with greater levels of transparency than would otherwise be available.

For Optima, which came out of the high-net-worth world, how has your client group changed, and how has that, in turn, changed the way you do business?

We started as a firm focused on high net worth investors, and many of them were a who's who of Wall Street leaders. We started in 1988 with $22 million under management, and today manage over $6 billion in hedge fund investments for our clients. The firm started as virtually a 100% high net worth client base, and today they represent 30% of our assets, and 70% from institutional investors across a broad spectrum. Over the almost 20 years we've been doing this, the process has evolved and continues to evolve, utilizing best practices wherever we find them. There is considerably more institutional standardization so that every allocation, every investment and divestiture is documented and the rationale is very clear. We're fortunate that our firm does nothing but hedge fund investment, so we're not subject to the conflicts that a lot of larger firms have to deal with. Our moderate size also gives us agility to manage portfolios on a real-time basis, and it also gives us impact from our investments as we make them. Look at a major money center bank managing $20 billion in hedge fund assets. If it receives a $100 million allocation of capacity from a top hedge fund manager-which sounds like a lot of capacity-that represents 0.5% of assets. At Optima, if we have $100 million of capacity granted to us, it really moves the needle for our client base and has a performance impact. So if we're making the right decisions, it's going to be positively impacting performance.

What are the advantages and disadvantages of being independent, at a time when so many hedge fund and funds of funds are aligning themselves with other institutions? Do you think you will remain independent?

I believe that we will remain independent for the foreseeable future. Our founder and CEO, Dixon Boardman, has a real passion for this business and fully intends to stay hands-on involved for the foreseeable future. I alluded to the complexities that can come from being embedded in a larger firm with diverse lines of business, and where proprietary trading may want very much to know what the hedge funds are doing, or prime brokerage may very much want to see a fund part of the investor portfolios in the asset management side of the business. I think these things are largely well controlled by the big institutions. But another thing is just the size issue-it's hard to turn a battleship or tanker on a dime. There are just myriad considerations that come out of a larger, complex financial institution that may have some benefits, if managed properly. But we like our moderate size.

We think we have one of the highest ratios of resources to assets under management in the business. We have spent a lot on a technology system that is one of the best, if not the best, in the business, integrating research, risk management, finance and accounting, and also investor reporting, on the same technology platform, and with many built-in checks and double-checks and backup systems for the integrity of the data and for protection in a disaster-recovery scenario. I think it's good for the industry that, as a general matter, fund of funds managers have increasingly spent time and energy and capital on risk management and on infrastructure and on improving the quality of hedge funds as an asset category. I think that's all to the investor's benefit.

Where do you see the fund of funds area in, say, five years from now, and what direction is Optima moving in?

I think that many markets, as they mature, start to segment. They start to segment both in terms of the investor groups and in terms of product types-in the case of hedge funds, the risk and return characteristics of different investment strategies. So I see a continuing growth in specificity and unbundling of hedge fund opportunities. One observation that's been commented on by our CEO, and by others in the industry, is that the institutional investors coming into hedge funds, and their focus on risk and volatility, as a general matter, has increased risk management, despite some outlying examples that we all know, like Amaranth, Bayou, MotherRock and Wood River.

But, in general, the volatility hasbeen decreased by institutional participation in hedge fund investing. And with the decrease in volatility has come, generally, a slight decrease in returns. So it's more and more important for us to be able to produce and deliver investment strategies that meet institutional requirements, which may be lower volatility and more moderate returns, and also, at the other end of the spectrum, to provide investment strategies that deliver the characteristics of hedge fund portfolios a decade ago, which had higher returns targets and, along with that, higher volatility.

So we have developed different portfolios ranging from low volatility to high return-targeting portfolios. I think there will be more and more specificity in the characteristics of portfolios that are built to meet investor demands. To move toward that higher-return side of the spectrum, we have been concentrating portfolios recently in more moderate numbers of hedge funds-not as broadly diversified or, potentially, over-diversified, and in funds, also, that are concentrating their portfolios in fewer positions but very highly rated, high-conviction positions. The goal is to deliver hedge fund returns of a decade ago and also, for the investors that are very risk-averse, very low volatility portfolios on the other end of the spectrum. So we're going to continue to see more tailoring of hedge fund portfolios to the specific requirements of the investor. And I think there will be continuing innovation.

Unfortunately, with more than 9,000 hedge funds estimated to be in existence, and a record number of new entrants, and limited barriers to entry, I think that very prudent review, due diligence and risk management is more important than ever. While they are the exceptions to the rule, we will continue to see some losers and some blow-ups in the future. Optima will continue to apply its investment and risk management resources to avoid them all, as we've been fortunate to have done in the past.