Monday, April 16, 2012

Time to Give Funds of Funds Another Go?

Harriett Agnew of Dow Jones Financial News reports, It’s time consultants gave funds of funds another go:

Funds of hedge funds has become a dirty term since the financial crisis. The industry has struggled to shake off the mistakes of 2008: investments in funds of convicted fraudster Bernard Madoff, liquidity mismatches and underperformance. Memories of funds of funds forced to sell their best investments to stay afloat remain painful.

But those who dismiss funds of hedge funds as a spent force are overlooking a far more pressing issue: the problems presented by the rapidly rising power of investment consultants.

According to Deutsche Bank’s 2012 Alternative Investment Survey, the proportion of respondents using one has doubled in the past year to 60% and tripled since 2002.

Since 2008, institutions have increasingly bypassed funds of funds and invested directly in hedge funds, advised by investment consultants.

As a result, the fund of funds industry has seen net redemptions in every year since the 2007 peak, according to Hedge Fund Research.

Mainstream consultants have shifted from being hedge fund doubters to advocates, driven by relative hedge fund outperformance in 2008 and the diversification offered by some strategies. Just as their predecessors once emerged starry-eyed from meeting Mercury Asset Management, the current breed are in love with the household names of the hedge fund industry.

But this power shift throws up other issues. So enamoured are the consultants with direct investment that they have bulked up their in-house hedge fund research teams to meet increased demand for hedge funds from pension fund clients. They have become experts in hedge funds for business reasons, often making decisions on behalf of clients through the fiduciary model.

However, you can argue that this model presents potential conflicts because consultants are incentivised to encourage clients to invest directly, but draw on advice from their internal team.

Their use of external funds of funds is becoming increasingly rare. But in recommending that clients invest directly when putting together a hedge fund portfolio, mainstream consultants are effectively constructing their own fund of funds. And it is here that they are likely to fall short of their rivals.

Consultants may tout independence, but their fiduciary responsibility fosters the least risky options – and they have no skin in the game, something they always like to see from the managers they put forward. In sharp contrast, fund of funds managers put their own money to work, alongside their pension scheme clients.

Rather than taking a measured risk on a star or emerging hedge fund manager, the large consultants are more inclined to bet big on managing downside risk, picking “safe”, household names that will not get them fired if something goes wrong, as happened to Mercury.

Mainstream consultants have no track record of investing in hedge funds. Funds of funds have produced and managed performance and they were far from alone in struggling during the credit crisis.

Consultants argue that few fund of funds managers add enough value to offset the second layer of fees they charge. But the larger managers say they can negotiate fee discounts from quality hedge funds more effectively than consultants.

That said, the fund of funds industry has only belatedly realised it must justify the fees it charges. The over-diversified, low-turnover, multi-strategy fund of hedge funds has had its day. Those that remain in business have evolved their models and now differentiate themselves by offering bespoke mandates, advisory work or managed accounts.

Quality funds of funds can twin that with trading overlays, access to scarce strategies, genuinely uncorrelated returns or emerging talent. This is where the extra layer of fees can be justified.

The very best of these funds of funds go one step further and provide seed finance to new managers, the lifeblood of the hedge fund industry.

Do consultants bother with such funds, given these managers’ lack of a track record? Of course not.

Great article, touches on some of the key points I already alluded to in the 'placebo effect' of large hedge funds.

Once again, problems arise in the cover-your-ass pension governance model underlying most U.S. public pension funds where board of directors and pension fund managers exclusively rely on clueless pension consultants who just blindly shove them in 'brand name' hedge funds and private equity funds.

But as cynical as I am of pension consultants (some good ones but most of them are truly clueless and even dangerous), I'm equally not impressed with a lot of funds of funds that charge an extra layer of fees. They might have skin in the game but their performance is lousy, especially when you add that extra layer of fees.

In December 2008, I wrote a comment on funds of funds facing extinction, stating the following:

...for all those pension funds that continue to pile into funds of hedge funds, make sure you are carefully selecting your funds of hedge funds by focusing on those that align of their interests with those of their clients (ie., they are not just huge asset gatherers) and make sure they conduct rigorous operational and risk management due diligence.

But whoever you choose, keep in mind that in this environment, most funds of hedge funds will be reduced to road kill.
Back then we were in the midst of an unprecedented credit crisis. Hedge funds and funds of funds were getting slaughtered, especially those relying on highly leveraged illiquid strategies.

The name of the game since 2008 is risk management. Sophisticated pension funds in Canada are much more aware of the need to manage liquidity risk. They too got hurt in 2008 with their hedge fund investments but have since learned to manage liquidity via managed accounts that offer them full transparency and liquidity. No more closing the gates of hedge hell on them.

But there is a difference between sophisticated pension fund managers in Canada investing in hedge funds and the pension herd in the U.S. which blindly follows the recommendations of their pension consultants that shove them in 'brand name' funds where they typically get raped on fees and are now finding that alternatives are not paying off for them. In Canada, and the Netherlands, pension fund managers are compensated properly, and the very best of them have industry experience and know how to discern true alpha from leveraged beta.

One of the best hedge fund managers in Canada is Ontario Teachers' Pension Plan, which delivered 11.2% in 2011. A lot of the value added (alpha) in 2011 came from internal and external hedge funds. Ron Mock, Senior Vice-President, Fixed Income and Alternative Investments, knows his stuff as he previously managed a large fixed income arbitrage hedge fund before joining Teachers' (that experience made him keenly aware of managing operational risk). Ron also has some of the very best portfolio managers in the industry who can slice and dice any hedge fund strategy to discern whether an investment is warranted.

Are Ron Mock and the folks running hedge funds at OTPP 'gods' of hedge fund investments? Hell no! I love talking to Ron and his team but don't always agree with them. They don't walk on water and they're definitely not invincible, but they're damn good at what they do and will selectively consult a few trusted consultants and invest in a few funds of funds when they require expertise they don't have internally. The buck, however, stops with them: they're responsible for portfolio construction and are careful never to pay alpha fees for a beta strategy they can replicate internally.

Finally, I have personally met with representatives of some of the world's best funds of funds. Out of the 50 or so I met, maybe 4 or 5 of them truly impressed me and it was because the people running them had extensive trading experience and knew what the hell they were talking about on portfolio construction and strategies The industry has evolved since then. There are now funds of funds specializing in strategies that cover commodities and a broad range of other sectors/strategies.

But even though the industry has evolved, one truism remains: the best funds of funds are truly competent, deliver alpha and are not in the game to become large asset gatherers. The very best of them are well plugged with the best hedge fund managers and are also well plugged with emerging alpha managers that deserve to be seeded.

I'm a true believer that in this environment, institutions should use selective funds of funds to seed emerging alpha managers but they need to make sure they find the right fund and make sure these funds have their best interests in mind when negotiating all the deal terms (not just fees but a lot more!).

Below, another reason why I'm bullish on commodities, especially the coal sector. Bloomberg's Alix Steel reports that hedge funds reduced bullish bets on commodities for a second consecutive week as the Federal Reserve signaled it may refrain from more monetary stimulus, increasing concern that growth will slow and curb demand for raw materials. She speaks on Bloomberg Television's "In The Loop."

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