Wednesday, January 6, 2010

Hedge Funds Going 'Mom & Pop'?

Eleanor Laise of the WSJ reports that Hedge Fund AQR Goes 'Mom & Pop':
AQR Capital Management LLC, which was among the first big hedge funds to launch a line of mutual funds for mom-and-pop investors, has raised more than $1 billion in assets in less than a year, a potential challenge to the struggling mutual-fund industry.

AQR is set to launch Wednesday its seventh mutual fund, a managed-futures portfolio that seeks to take advantage of trends in commodities, bonds and other markets. The fund is called AQR Managed Futures Strategy Fund. Last week, AQR rolled out a global-stock mutual fund.

The Greenwich, Conn.-based hedge fund firm built its reputation by managing quantitative funds for wealthy and institutional investors. But it stumbled along with other quant funds in the summer of 2007 as the credit crunch began. After peaking at $38.5 billion in 2007, AQR is down to $24 billion in assets under management.

Rival hedge-fund firms also are targeting the mutual-fund business. The hedge-fund industry saw record amounts of overall investor selling, or outflows, and poor performance in 2008, leaving many managers with an appetite for the less profitable but "stickier" assets of mutual-fund investors.

Among the hedge funds embracing mutual funds, Rady Asset Management LLC launched Rady Opportunistic Value Fund in October, and Bull Path Capital Management LLC in June introduced Bull Path Long Short Fund. Legg Mason Inc.'s Permal Group, a major fund-of-hedge-funds provider, started Legg Mason Permal Tactical Allocation Fund in April.

Attracting small individual investors in addition to institutions "builds a more stable business," says David Kabiller, AQR co-founder and head of client strategies. Many institutions in 2008 had money tied up in less-liquid private-equity holdings, "which made it difficult for them to make new investments," he says. "Individual investors didn't have that problem."

Hedge Flavor

Investors in 2008 also pulled about $155 billion from hedge funds, marking only the second year since 1990 that the industry saw an outflow, according to Hedge Fund Research. But with small investors looking for greater diversification away from traditional stocks and bonds, the number of new hedge-fund-like long-short mutual funds launched in 2009 nearly doubled to 26, from 14 a year earlier. Investors poured $8.7 billion into these funds in the first 11 months of this year, up from $4.6 billion in all of 2008.

With the new AQR Managed Futures Strategy Fund, AQR is diving into an investment niche that has lately been hot and cold. The Barclay CTA Index, a broad managed-futures benchmark, gained 14% in 2008 but was up only about 1% in 2009, its weakest annual performance since 2001.

The funds tend to perform well when there are clear, strong trends in the market but less well when there are many trend reversals. In such markets, the funds get "whipsawed," or caught on the wrong side of a trend when it reverses, says Nadia Papagiannis, alternative investment strategist at investment-research firm Morningstar Inc. "Investors shouldn't time these strategies because they're going to get killed."

While there are a handful of other retail (small-investor-oriented) products pursuing the strategy, managed futures funds have traditionally been confined to wealthy or "high-net-worth" investors and institutionals.

The AQR managed-futures fund, available to both retail and institutional investors, will use the firm's quantitative models to identify trends in prices of futures contracts. Once those trends are identified, it will take long and short positions in futures tied to commodities, currencies, bonds and stocks.

Diversifying Pays?

"We think there's a lot of value to the strategy in terms of portfolio diversification benefits," Mr. Kabiller says. Indeed, since January 1980, the Barclay CTA Index has shown low correlation to the Standard & Poor's 500-stock index as well as U.S. and global bonds.

AQR initial steps into the mutual-fund world have generally been timely. AQR Diversified Arbitrage Fund, launched in January 2009, appeared at the beginning of a good year for arbitrage strategies and gained about 9% from its inception through Monday.

The fund has climbed to nearly $240 million in assets, according to Morningstar. That's "two times more than we expected," Mr. Kabiller says.

While more and more hedge funds are delving into the mutual fund space, sophisticated pension fund managers are scrutinizing their alpha managers. Cecilia Valente of Reuters reports that Barclays pension fund puts heat on fund managers:

The 16 billion pound ($25.60 billion) pension scheme of UK bank Barclays is stepping up the scrutiny of its fund managers as it seeks to shake-up its investment portfolio, CIO Tony Broccardo said.

The scheme said it has beefed up its manager selection team by hiring Nick Stacey, who formerly vetted external fund managers at hedge fund firm Man Group.

Stacey reports to the head of manager selection Andre Konstantinow, himself appointed last year, and will focus on sourcing managers for appraisal, performing investment due diligence on new funds and monitoring existing investments across the fund's investment portfolio.

Pension funds have increasingly paid closer attention to the fund managers running their money after market volatility in the past two years helped unmask those just riding on the coat tails of a bull market.

The Barclays pension scheme trustees handled fund manager oversight themselves until Konstantinow's appointment. Stacey's arrival comes as Broccardo prepares to review the scheme's existing stable of fund managers, seeking out strong players among larger houses and boutiques.

"I would expect a degree of rotation, particularly as we continue to strengthen the underlying roster of (fund) managers.

"We think skill is available, but it is rationed, so our team will be ensuring we work with the strongest managers," he told Reuters.

The scheme profited last year through an investment in distressed credit, Broccardo said. He declined to elaborate on the size of the investment and the returns, but said the investment had been helped by having access to the relevant talent at the right time.

"Clearly opportunities do not hang around for long; we made some very strong investments into the distressed area of the market which made the fund a lot of money.

"That's an indication of what is going to happen in the next few years; there will continue to be macro-economic uncertainty that will provide opportunity for skill managers and therefore we will allocate more to skill-based strategies," he said.

The fund has gradually expanded its investment horizon and is now "highly diversified", Broccardo said, adding it had about 15 percent of its assets in hedge funds.

Broccardo is the fund's first chief investment officer and was appointed in 2008.

The pension fund operates through a three-leg investment process involving a manager selection team, an implementation team, and an asset allocation unit, which Broccardo leads and for which he wants to hire over the first half of the year.

Recall what I wrote in my Outlook 2010:

...2009 was all about beta. Any monkey could have made money being long corporate bonds, stocks, commodities and commodity currencies. That's why I am not impressed when large pension funds like CPPIB come out to boast about their performance, because it really all boils down to the beta boost.

I might add that the same goes for most hedge funds. The ones that survived the crisis and the calls for redemptions did very well in 2009 because most of them also benefited from the beta boost. Going forward, alpha will be the key to making money in these markets. And very few hedge funds or pension funds know how to deliver true alpha, ie. returns above a proper beta benchmark.

I can't overemphasize this last point enough. There will be big beta moves in the bubble sectors but true alpha will come from top performing skill-based managers. Unfortunately, the majority of hedge funds charge alpha fees for leveraged beta. And there are plenty of dumb pension fund managers investing billions into hedge funds without understanding that in most cases, they're paying fees for beta. They're being robbed blind.

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