THE FUTURE OF HEDGE FUNDS

(Slightly edited letter from January 2011. Nothing much has changed in the analysis. From a practical perspective, however, there have been large outflows from many FoHF’s and many of the remaining have either decreased their fees or become considerably more tactical.)

The Future of Funds of Hedge Fund

Let us start with the basic premise that in this large world there is a vast array of investors and an enormous demand for financial products of all types. Obviously, no solution set satisfies everyone. Under this umbrella statement, our conclusion is that FoHFs are, by definition, not appropriate for everyone; they can, however be very useful for certain types of investors. This letter will look into how to prioritize one’s hedge fund needs and which means of access present the most efficient and effective pathways given those preferences.

Reasons Investors allocate to Hedge Funds. Although this section might seem like a mere restatement of the obvious, we are often asked this question and, therefore, feel that setting down as many of the reasons we have been told by our broad range of contacts, might be useful.

General Diversification. In a world where we are constantly reminded that exogenous risks cause virtually all financial products to correlate on the downside when liquidity disappears, the hope exists that hedge funds can provide some real diversification. Given that many hedge funds often carry significant beta exposure, this will certainly not always be the case. However, a carefully chosen portfolio, targeted specifically towards avoiding beta is highly likely to provide some protection in down markets – obviously foregoing some upside in major surges.

Targeted Diversification. There are many specialist hedge funds that focus on distinct areas (energy, commodities, futures, MBS, etc.). Although in many of these domains there are a variety of traditional managers that offer product, the more unconstrained, sometimes aggressive approach of hedge funds can provide the most focused exposure. In an overall market downturn, however, these types of funds are very likely to lose money.

Capital Preservation. In a world where fixed income has had a major run-up and spreads are very tight on an historic basis, and where equity volatility has been extremely unpredictable, there is a premium on finding ways to preserve capital in potentially turbulent future times. Hedge funds are seen as a means for achieving this. As has been made clear over the past several cycles, ‘hedge funds’ are not a monolith, rather an encyclopedic collection of differing investment styles and approaches, among which there are subsets that have been very effective at preserving capital.
Return Enhancement. Many hedge funds can and do use leverage and/or are willing to be very concentrated and focused. For investors desirous of greater exposure to a given area for a specified level of investment, there are hedge funds that certainly fit the bill.
Improved Efficiency of Returns. Although no one can spend a Sharpe, MAR or Information ratio, their importance lies in the potential availability of principal at any given time. For an investor who will hold as long as necessary, and is not subject to regulatory or other constraints, a compounded 10% return is functionally the same, whether the volatility has been 2% or 30%. However, few such investors exist. As such, attention to the shorter and medium-term risks associated with each basis point of return is, and should be, of major concern. Over time, portfolios of hedge funds can certainly provide better risk-adjusted returns than many long-only investments.
Low returns on cash and short-term fixed income. Although not a great absolute reason for seeking out hedge funds, the lack of a better alternative (please excuse the pun) is a reasonable short to medium-term reason to look at the area. Many organizations are being squeezed by not being able to find return on any of their lower risk allocations. Looking at lower risk hedge fund portfolios can be a legitimate exercise; however, real memories of 2008 are fresh in the minds of many investors, where hedge funds dramatically underperformed expectations. If major tracking error is an unacceptable risk, this approach is probably inappropriate. As always, the key is to understand the risks both of making and not making an investment and evaluating these in the context of one’s own specific situation. Although an investment in a portfolio might not be optimal, if the risks of not meeting cash obligations through lack of current portfolio returns have even worse implications…
It was recommended by a consultant. This is not a reason, in and of itself to invest. Consultants are generally engaged to evaluate some combination of their clients’ investment policies, allocations and specific investments. A recommendation by a consultant to look at hedge funds normally results from a considered allocation policy. However, the responsibility remains with the investor to understand and agree with the investments being proposed. Hedge funds are not necessarily complex, but they can be; we always recommend that investors take sufficient time to understand the risk trade-offs being made when moving into the area, so as to avoid unrealistic expectations, particularly in terms of left tail risks.
It was requested/directed by the Investment Committee/Board. Many Boards have one or more sophisticated financial professionals as members, who see hedge funds as addressing one or more of the potential benefits discussed above. To the extent there is a distinct investment team, we believe it is important, as in taking on consultants’ advice, for those responsible for the day-to-day running of the portfolios to fully understand and agree with an investment.
Competitors do it. Although this might sound like a trivial reason, often it is not. A great deal of investment information is now easily accessible to the public and has legitimately been available to concerned constituents. Given the ‘fishbowl’ aspect to running much institutional capital, there has become an even greater need to keep abreast of new investment approaches than previously. Obviously competitive performance statistics have long been important; today, however, there is far more granularity.Greatest Risks. Before considering how best to access hedge funds, it is important to consider the various types of risks associated with this type of investment. The type of approach can limit certain risks, but each approach comes with its own set of costs.
Poor Risk-Adjusted Returns. As with any investment, the greatest risk is not to generate a level of return (over a pre-determined time period) that compensates for the levels of risk taken.
High Fees. Anything that takes away from the gross performance increases the risk of not achieving the return bogies that are set. Many hedge funds structurally cannot avoid higher fee levels, for reasons as simple as having a lower level of AUM combined with a need for top investment professionals; others charge high fees because their historic returns create sufficient demand to support them; many others rely on industry ‘norms’ that seem unjustifiable and we believe unsustainable as well.
Insufficient Alpha for the Fees Charged. Hedge funds need, first and foremost to generate returns. However, the high fee levels charged should neither be for creating beta, nor for providing leverage; they should be primarily for alpha generation. This aspect is often not sufficiently scrutinized by investors.
Potential Strategy Complexity. Although many hedge funds could not be simpler in what they do and how they execute (e.g. research companies and then either buy stock or sell it short), others can involve complexity in both conceptualization and execution. In these strategies, most investors need to rely on track record, reputation and other ‘soft’ aspects of due diligence; the strategies might indeed provide a different type of diversification, but the topology of that diversification is very hard to map. It therefore requires a certain type of risk tolerance to invest.
Shifting Liquidity. Many longer-term investors have historically been relatively insensitive to illiquidity; hence their allocations to real estate, private equity, infrastructure, etc. Nonetheless, they have structured their overall portfolios to have allocations to meet interim cash needs. For most investors, hedge funds have traditionally been categorized on the more liquid side of the spectrum. As 2008 demonstrated, this definition, although perhaps correct most of the time, might not be valid during extreme market conditions – exactly the time when investors prize liquidity the most. As much alpha remains ensconced in securities/situations that are smaller and/or potentially less liquid, taking a conservative approach in how to categorize them is probably most prudent. Having said this, UCITS-type products, promising high liquidity, have begun to proliferate. Although many of these might legitimately be liquid, this will depend on the strategy. The question then becomes one of being able to generate a sufficiently interesting return profile.
Potentially Limited Transparency. Most hedge funds do not provide full, unadulterated transparency – i.e. on-line views of all positions at any time. The general range is from weekly full portfolio distribution all the way to ‘you’re lucky we provide you with quarterly return data!’ Although the latter sounds ridiculous, 15 years ago that was among the most common of responses. Today, many funds have made considerable efforts to listen to the needs of their institutional investors. However, many also remain concerned by open disclosure of positions to a broad range of investors, given the general sensitivity of shorting, the difficulties of growing control positions and the fluctuations in liquidity. The presumption that all investors are discreet, 100% straightforward, etc. is probably naïve and can harm other investors in the fund. Many managers are simply trying to balance the interests of all concerned. On the other hand, there do remain those who refuse to disclose for no better reason than they don’t have to. Transparency is important because institutional investors face the difficult decision of needing to find alpha investments, while facing ever-growing scrutiny from their Boards, constituents and regulators.
Documentation and Legal Complexity. Although life for all sides involved would be much easier with some form of standardized documentation, this is not on the cards in the near future. This means, for each hedge fund investment, needing to review a broad range of documents and frequently negotiate side letters to gain certain rights can be arduous and normally requires a sophisticated legal department familiar with the specifics of the area. Depending on the number of investments, this can be both a time consuming and personnel-intensive process. During a time period like 2008, when many funds experienced difficulties and took a variety of ‘remedial’ actions, the level of focus necessary to protect one’s rights and obtain sufficient information can be particularly onerous.
Regulatory implications. Even prior to the market and financial services meltdown of 2008, banking, insurance and pension regulators around the world had started to reassess their definitions of risk, permitted activities, reserve requirements, etc. The large losses suffered across many investment areas in 2008 heightened their concerns and also made the issue far more public and political. Hedge funds as a group, although no real ‘grouping’ exists, are generally viewed as high risk, whether or not that is the case and the current winds would indicate that their treatment will not be favorable. Naturally, there is some chance that rules will be written by the type of underlying investment, not merely by nomenclature or legal structure but, for the moment, institutions likely to be impacted are being very cautious in their investments into the area.

Headline Risk. With the greater transparency many institutions provide their constituents, the issue of headline risk has become even more important. Although investment professionals understand risks are needed to generate return, this is not universally well-understood. There is almost no losing investment that when scrutinized ‘ex post’ cannot be framed in a way that maximizes negative criticism. When such an investment is in a household name like Citibank or General Motors, there is little push-back; however, if the losses – even if they are much smaller – are in hedge funds, the natural antipathy of the general public to the area makes headline risk a dangerous reality. Naturally, the protracted Bernie Madoff saga highly exacerbated this concern.

Yet, in spite of all the risks, there is still a real need for sophisticated investors to generate return streams that provide some diversification from their traditional allocations and where the superior risk/reward characteristics add to the efficiency and performance of the overall portfolio. The question is how an institution can best access its hedge fund exposure(s). And, as is normally the case, there is no one-size-fits-all answer. The most effective approach will depend on the size, structure, positioning and governance of each institution. We will discuss the plusses and minuses of each approach.

In-house diversified trading. Obviously, creating one’s own de facto hedge fund requires both significant scale and also a governance structure that can absorb and effectively control proprietary trading risks. It also needs an environment where the levels of compensation can be sufficiently stratospheric to attract talent sufficient to justify not outsourcing to hedge fund managers. This combination of factors is rare, but is used in many sovereign wealth funds, some insurance companies, banks, endowments and pension funds. Interestingly, even with those entities, they normally use outside funds for specialty areas.

Direct investment into hedge funds. Fifteen years ago, very few institutions invested in hedge funds and most of those did so through FoHFs. At that time, there was far less information available on hedge funds – it was very much a cottage industry, with very few professionals with any real knowledge base. There was an aura created by such early luminaries as George Soros, Julian Robertson and Paul Tudor Jones that both attracted investors and scared them away. Investment approaches such as risk arbitrage, convertible arbitrage, distress and most derivative-related strategies were virtually unknown. Over the past decade and a half, the growth in number of hedge funds, the total assets they control, together with the increased dissemination of information, growth of databases and press coverage has certainly popularized the area. It has also, to some degree polarized it even further. More information also means more misinformation and many potential investors have been scared away. Nonetheless, there has been a dramatic growth both in overall understanding and demand. As more and more Boards have been educated on the uses of hedge funds and they have engaged asset management professionals proficient in the area, they have actively engaged in hedge fund investing. As they have gained experience, many, with sufficiently deep investment, operational and legal staffs, have decided the potential incremental protection of capital and shielding from headline risk, afforded by using an intermediary is insufficient to justify the extra layer of fees.

We believe there will always be a natural constituency that should and will invest directly. As existing first-time hedge fund investors become more comfortable, many will migrate in this direction; ironically, however, we anticipate many who now invest directly are likely to experience one or more problematic situations that cause them to rethink their strategy and, perhaps return to using FoHFs. For budgetary reasons, some organizations, as they restructure internal staffing might experience a need to outsource, even if the total cost is higher!

Use of a consultant to create hedge fund baskets. A number of consulting firms have established a business of creating hedge fund portfolios on behalf of clients. These range from specialist firms to some of the global full-service organizations. The services they offer range from simply providing research and due diligence services to investors who wish to invest directly, but don’t have sufficient resources, to creating actual portfolios for their clients. This is a potentially very valuable service and depends completely on the quality of the professionals they hire and the consistency they can provide. A key issue is the level of responsibility the client can/desires to take for the end portfolio. In many cases, the final decision of the composition of the baskets/portfolios lies with the client, not the consultant. For many organizations this is desirable, as they prefer to take the active role in running their entire investment portfolio. For others, this can create risks in the event of any erroneous decisions.

Use of a FoHF. For most institutional investors, using a FoHF has and still is the first step into the world of hedge fund investing. Although the general level of information flow, experience and sophistication has grown vis-à-vis hedge funds, the risk factors outlined above can be intimidating for a new entrant and, even with an experienced consultant advising, watching an intermediary deal with the issues remains a good initial approach. The question is whether investors ‘evolve’ into other ways of accessing hedge funds. The main reasons to use FoHFs are:

Good FoHFs have spent years building a strong team across all necessary areas and have already made a considerable number of mistakes, thereby hopefully helping their investors avoid making those mistakes.
For investors looking to deploy relatively small amounts, a FoHF still provides a good way of gaining diversification.
Because of their relationships, and in some cases, by working with smaller managers early on, FoHFs can often get more capacity with managers that are soft closed or approaching that level. This remains the case for most investors, but larger institutions can certainly achieve the same results.
Because of a combination of the size of their aggregated investments and the length of their relationships, they can often negotiate better terms with managers. When this relates to fees, it helps offset FoHF costs; with regard to liquidity and other technical terms, it is hard to directly measure the benefits.
It is easy to fire a FoHF. In the event of bad performance or, even worse, a Madoff-type incident, the majority of the responsibility can be legitimately deflected. In the ‘fishbowl’ environment in which most institutions now operate, the level of distraction caused by an erroneous investment, no matter how insignificant in relation to the overall portfolio, can be a massive distraction and can even have more serious consequences.
In the event of another 1998 or 2008, when many hedge funds failed, gated, etc., the number of issues that need to be dealt with increase stratospherically. Although there is a perception that direct investment into hedge funds provides more liquidity, this is often not the case. The amount of time and effort it takes to work with hedge funds (on a friendly or more litigious basis) to retrieve assets, once they have become illiquid is enormous and winding down a portfolio can literally take years – something most institutions neither want nor, frankly are set up to do.
Although another ‘transparency filter’ is often cited as one of the strikes against FoHFs, many offer their investors access to the same materials they would get if they invested directly. Plus, because of their relationship with the managers and in-depth understanding of some of the specific subsectors, FoHFs can obtain and process additional information that actually can add to an investor’s understanding.
FoHFs are particularly useful for tracking down and evaluating lesser known hedge funds and for conducting ODD on those funds (small or otherwise) located in more unusual locations. Except for the best-staffed institutions, this represents a practical problem. To the extent more money flows into the hedge fund sector, much of it will flow into larger, better known managers, thereby most likely impeding their alpha generation; much of the interesting activity is likely to be with managers running more constrained levels of capital.

Offsetting these benefits are three concerns we hear voiced most frequently.

Cost. This is by far the most serious concern. Adding what historically have been significant fees on top of the high fees of the underlying hedge fund managers, means much of the alpha being generated does not reach the end investor. Fee models have already started to change and we would anticipate there will continue to be more thoughtful fee structures going forward. It is very important to note, however, the cost of running an institutional quality research, operational due diligence, portfolio management, operations and investor communications process is not inexpensive. In order to maintain a diversified portfolio of 30 managers, a minimum staffing of two research analysts in research, one in ODD and two in operations/legal/compliance, etc. would be required. Top professionals on the research and portfolio management side can cost well into the six figures. Travel and other expenses are also not insignificant. Naturally, to have a full-fledged research area, with full institutional capability requires far greater staffing.
Inefficacy. Many FoHFs invested in Madoff and several of the other troubled funds of 2008. As such, if these intermediaries can’t avoid the big problems, what is the need to engage them? There is certainly merit to the concerns; however, as in any form of investing, there are few sure things. We all operate in a world of probabilities and percentages. The reason to use the best possible professionals to help make investment decisions is to increase the odds one will succeed. By definition, one will not reach the desired outcome 100% of the time. The key is to conduct the best possible due diligence upfront and choose the group(s) in which one has the most confidence – not necessarily the one that promises the most!
Distancing from information. Many FoHFs do not provide full transparency. Even if an institution engages one that provides considerable information, there is a material difference between communicating directly and receiving information from a third party. Regulators are certainly focusing on this issue. In the end, however, so much depends on what information is sought and how it is absorbed. The wrong person getting the right information is often worse than the right person receiving it through some filter.

Use a Hedge Fund Index. In principal, this is a good idea. However, there is a huge difference between theoretical indices and investible ones. Given the capacity limitations, liquidity/rebalancing constraints, etc., investible indices are very constrained in which funds they can use. As such, most such indices are little more than static FoHFs.

Hedge Fund Replicators. The concept of looking historically at the principal drivers of return in various hedge fund styles, applying rigorous statistical analysis and disciplined trading is very appealing. And when it works, it can be an efficient way of getting some differentiated types of exposure. However, as in the debate between passive and active investing, the real question is whether there is value-added in finding off-the-run situations and in timing entry and exit points. If one believes in the latter, going directly into hedge funds will be more appealing, even if the fees are higher. When a provider of replicators is willing, instead of selling replication to investors seeking hedge fund index exposure, to offer a true index while using its replicator to hedge itself, then we shall know replication has truly come of age!

Structured Notes. These are merely wrappers that take the solutions outlined above and either add leverage, protection or merely regulatory/tax solutions. They are neither inherently good nor bad – they simply add an additional frictional cost one needs to evaluate in making a decision.

ETFs There are ETFs which will try to implement the long side of hedge fund-like strategies e.g. the current risk arbitrage universe or firms aggressively buying back shares. The absence of an incentive fee gives these funds some performance cushion relative to the hedge funds with which they compete, their expenses may prove lower and their liquidity is certainly better. At the same time, they require the investor to actively manage their commitment to the sector, a function exercised by many underlying hedge fund managers,

and they run the risk of over-diversification. In addition, they are unlikely to exercise judgment in sizing individual positions based on the manager’s well-informed opinions.

CONCLUSION

It is a big world and there is no solution that will fit every investor all the time. Hedge funds will be more or less popular at different times, as will consultants and FoHFs. The key, as in all good decisions, is to carefully frame one’s goals and the risks associated and to choose the methodology that reaches those goals most effectively.