The Psychology of Investing

The current hedge fund investors' perspective

Originally published in the November 2007 issue

Investor profile

Based on our profiling of investors of all kinds, we find that interest in direct hedge fund investment is more prominent overall than interest in fund of hedge fund investments. This is partially due to the fact that many of the investors themselves are fund of funds looking to invest in hedge funds. Aside from this, we see significant interest in hedge funds from wealth advisory firms and family offices whom we have found express preference for single hedge funds twice as often as for fund of funds. These two types of firms make investments on behalf of high net worth individuals and families of exceptional wealth, underlying investors that may not have the asset size needed to absorb the additional layer of costs associated with fund of hedge funds investments. These investors are also more likely to be willing to take on the increased risk and potential for reward associated with direct hedge fund investment.

On the opposite side of the coin, fund of hedge funds provide greater diversification and less risk than most hedge fund products, making them an attractive option for groups who can afford the extra layer of fees but might not have the capacity to research potential hedge fund products. Consultants and their underlying investors are the number one group of fund of hedge fund investors, investing in fund of hedge funds almost twice as much as in single hedge funds. Though they might consist of a large analyst team or only a few employees, Brighton House defines consultants as advisory firms whose clients include pension funds, endowments, foundations and other institutions with large asset bases. The diversity, consistency, transparency and liquidity provided by most fund of hedge funds makes them an attractive investment option for these particular investors.

Choosinga strategy

Just as with choosing an alternative vehicle, investors choose strategies that are appropriate for their asset size and provide returns, risk and liquidity that are appropriate for their asset security and cash flow needs. For example, a wealth advisory firm might have the capacity to make long-term investments that promise high returns on behalf of a high net worth client whereas governmental investors such as pension funds generally look for low risk strategies that provide steady returns. Likewise, socially responsible strategies might appeal to endowments that are responsible to their university communities and alumni bases while a well-known insurance provider might avoid activist strategies for publicity reasons. However, most investors are opportunistic to a certain degree, and their interest and willingness to invest in certain strategies fluctuates in accordance with promising opportunities in the market. Over the last few months, Brighton House analysts have reported that emerging markets and niche strategies are most in demand.

Emerging markets

Emerging markets investments provide hedge fund managers and investors the opportunity to profit from the consumption of certain goods and services that are being introduced to these economies for the first time or that have not historically been adopted by the general population. While some investors are looking for exposure to just about any developing regions and countries including Latin America, Eastern Europe, Africa and the Middle East, the majority of the investors we have spoken with tend to take a particular interest in the Asian markets. Brighton House has found that institutional investors are most likely to invest in diversified emerging markets fund of hedge funds as opposed to concentrated single manager hedge funds. For institutional investors, the primary goal is to achieve an absolute return with low risk because they are investing on behalf of a large number of people that have contributed to a common pool. Investing through a diversified emerging markets fund of funds vehicle gives these investors access to a group of managers that trade a variety of instruments in a variety of emerging markets, creating risk and return streams that are independent of one another.

Some institutions even prefer to invest in region-specific emerging markets funds, especially those in Asia, but most are not willing to invest in a fund concentrated further than this. This is especially true for foundations, government pension funds and those universities that manage their investments in-house.

Brighton House has also found that concentrated emerging markets hedge funds are in greatest demand by fund of hedge funds and large wealth advisors. In many cases, funds of funds have established their own global diversified emerging markets vehicles and are therefore looking for more focused, country-specific and strategy-specific funds to add to their portfolios. For example, a very attractive investment for a global emerging markets fund of funds is a hedge fund focused on long/short equity in China or India.

Wealth advisors also have the opportunity to invest in more concentrated hedge funds depending on how their investments are structured. Wealth advisors that pool their capital into vehicles similar to fund of funds are looking primarily at region-specific funds that are either focused or diversified in trading instrument. An attractive investment for a wealth advisor may be an Asian emerging markets hedge fund diversified by strategy or an Asian hedge fund focused on fixed-income arbitrage.

Niche strategies

Typically more volatile, less liquid and uncorrelated to the overall market than traditional hedge fund strategies, niche strategies provide an opportunity for above average returns. The term 'niche strategy' is broadly defined, as many investors consider a niche fund to be anything besides vanilla long/short equity funds, while others limit the definition to sector specific long/short equity funds, such as healthcare, technology or energy. Many investors that Brighton House analysts speak with define 'niche' simply as a strategy that is uncorrelated and not easily replicated by other managers. Investors also seek out niche strategies that are considered special situations, for example a fund that extends capital to commodities producers in emerging markets.

Many prospective investors have recently said that they were actively pursuing these funds due to market conditions such as set-backs in the credit markets, the weakening US dollar, the US housing crunch, worries over inflation and potential fears of a recession in the US economy. Investors are also interested in diversification in their investment portfolio, and niche strategies fill that need.

Investors pursue niche strategies for qualitative reasons as well. They want to hear new ideas from managers that stray from the herd. Over the past two months, the niche strategies that yielded the most frequent searches were Asian funds, ABL strategies, credit strategies, volatility arbitrage, PIPES and energy trading. Investors exploring these niche funds are not as focused on a manager's minimum AUM as they are on the manager's pedigree and track record. If an emerging manager has a track record and is carved out of another fund, they will have the interest and buy-in from prospective investors. Due-diligence is usually a longer process for managers employing niche strategies.

Timing an allocation

As the hedge fund industry expands throughout all geographic exposures, it has become increasingly difficult for managers and investors to complete the due diligence process. Completing due diligence is merely a stepping stone towards what may turn into a long process of reviewing subdocuments, PPMs and credentials. In the allocation process, the research and initial introduction are very important; however, these things take time and differing schedules, and time constraints on the part of investors and managers can complicate the process.

For hedge fund managers, allocation is broken down into eight significant days throughout a calendar year. These eight days are the first day in all months beside June, July, August and January, as it is less likely to conclude an allocation process during one of these months. As investors often dedicate the first and final weeks of each month to research, the most optimal time to contact investors is the second and third weeks of a month when they will be more available to field calls.

Furthermore, with the due diligence process typically lasting six to twelve months, the additional time it takes to complete subdocuments and PPMs is often overlooked as a hindrance to speedy allocation. With the weeks already divided between researching potential investors and contacting individuals responsible for manager selection, it is very difficult to devote time towards subdocuments. The legal wording and detail of a subdocument may be changed numerous times before completion. In addition to the minor edits the length of the process increases when factoring in time zone differences. Investors are faced with an entirely different set of difficulties when trying to manage their time and allocation cycle. The problems are compounded if they are an endowment or pension that is responsible to a public entity as well as a demanding board or investment committee. For these investors due diligence goes well beyond performance and book checks. They often hire private investigators to research the background of a manager, paying special attention to the ethical character and nature of a potential fund manager over the course of his entire career. Investors are looking to allocate millions into hedge funds or fund of funds that are, at best, loosely regulated by governing bodies and that may provide more than limited transparency on their funds transactions. The inherent lack of information within the industry, coupled with the trillions of dollars invested, creates an environment where investors must be scrupulous in their due diligence.

After a substantial background check of a potential manager, institutional investors must provide the results to a committee board for review. Additionally, several university endowments will perform quarterly reviews of manager performance and hold annual meetings to determine the quality and character of managers after a twelve month cycle. While endowments understand that manager performance is best reviewed over several years, they conduct small-scale due diligence procedures to ensure that their initial assessment of a manager was accurate and that the manager has not deviated from the prescribed course of his or her investment strategy.

Brighton House Associates (BHA) provides a service designed to increase the productivity of the hedge fund marketing and sales process

Screening a manager

Once investors have chosen the correct vehicle and appropriate strategies for their portfolios, they enter the process of manager screening and due diligence. This process often starts with a review of a manager's track record, investment background and in some cases personal background and most often involves dialogue and in-person meetings.

Before allowing a fund manager the opportunity to seriously present his fund, investors will consider and review a manager's pedigree. Pedigree is thought to be the history or relationship a manager has with a well-respected school, financial institution or fund. While many investors outwardly place a high value on pedigree, further discussion of the topic has shed light on the attractive features that underline its importance. A manager with a good pedigree, it is presumed, is more likely to structure his organisation in a manner similar to the scalable, positive features taught at his well-respected school, financial institution or fund. More importantly, investors tend to treat pedigree as a quality control screen.

However, through discussing pedigree with several investors BHA analysts have concluded that at a basic level most investors are not primarily concerned with pedigree per say but rather with how 'unique and compelling' a given manager's strategy is-even for the most fundamental hedging strategies. Even more pressing is a manager's ability to convey what exactly makes his fund unique and compelling to managing directors and investment committees that may be reviewing several funds with similar mandates.

Investors expect that managers who do not have a particularly strong pedigree transform their operations as best as possible to mimic those who do. A manager must internally ensure that a proper infrastructure is in place (systems, organisational structure, etc), that responsibility sourcing is allocated suitably and that risk controls are observable, balanced and efficient enough to actually execute the strategy well. Investors must be convinced that a manager can handle their investment before considering allocation.

While a background with a well-respected firm or institution may provide a certain degree of quality assurance and may allow a manager to easily get his foot in the door of a prospective allocator, the lack of such a background rarely proves to be a deal-breaker so long as the manager is able to prove that he is on par with the best of breed.

Aside from his ability to gain the confidence of investors, a manager's affability is the only aspect of evaluation the manager himself can directly control. To investors, what is most impressive about a manager is his ability to demonstrate that he understands the investor's point of view. Investors are entrusted with a great deal of responsibility and turn to managers to assist in alleviating some of that burden. Any manager who fails to acknowledge their shared responsibility with investors will inevitably be unsuccessful if awarded a meeting.

Additionally, managers must ask themselvestwo questions that investors have consistently put to us: What is my purpose for increasing the size of the fund? What is the projected capacity of the fund? Without being able to submit convincing answers to these two questions, a manager is at a good deal of risk and will have trouble receiving an allocation.

Managers must be willing to entertain constraints that reflect a mutually beneficial relationship. A good start, investors tell us, is for the manager to produce a written procedure to deal with extreme losses that evidences his commitment to the investor. As strategies become popular and mean reversions of returns occur, a manager can always rely on his understanding of investor perspective to serve him well through the allocations cycle.