The hedge fund industry has evolved over the past few years from being a niche area with specialised participants to a mainstream area for new investments. Barry Colvin looks at the new challenges
Over the years hedge funds have moved from being a closet activity to an institutionalised industry. What implications has that for the research process, hedge fund managers, fund of hedge funds managers and investors?
The industry grew up looking at hedge fund managers themselves ' a bottom up process. There was no real consistent approach to how you allocated across different strategies. Being with the best manager may not guarantee the best performance, but having the best strategy will certainly help. It is essential to focus on allocating across strategies that have strong attributes as well as not-so-strong attributes and then identifying managers to whom to allocate.
Hedge funds are easier than traditional asset classes to perform some sort of asset allocation on. You can look at spread relationships in the various classes and look at the downside risks. An example is distressed securities, which has received a lot of fanfare recently. As default rates have stabilised, if you are going to allocate to credit-based strategies ' distressed securities and high yield ' the risk/return dynamic at this stage is probably better than it has been for the last five or six years so that is certainly an area to overweight.
Areas to neutralise are for example fixed income arbitrage. Returns have been strong, and as you see capital flow into that area, it is probably a good time to start underweighting that area.
You also have to look at the downside risk as it refers to the correlation between strategies. Convertible arbitrage is what I would consider a short volatility strategy. Most people think it is market neutral. It is not. Convertible arbitrage is a combination of holding a bond, which is a credit instrument, and shorting the underlying stock. What happens to a credit instrument when volatility increases dramatically? Well, the prices of those bonds usually drop, so convertible arbitrage managers, because they hold the bond long, experience a decrease in value. It is important to understand that convertible arbitrage is a slight short volatility strategy.
If somebody asks me what I expect in terms of returns from one of these strategies, I do not know. No one really knows. The only thing that is in your control is to decide what kind of risks you are prepared to take to generate those returns. You cannot control forward-looking returns, only the risks.
Identifying managers is is a combination of art and science. I wish I could tell you it is extremely quantitative but it isn't and in fact quantitative approaches detract from the overall process if you rely on them too heavily. Using quantitative measures to try to identify managers who will perform well going forward is a process of negative selection.
You need to have an optimum mix of managers in your portfolio. There are different schools of thought here, whether it is 30, 40 or 50 managers. We do not believe you need these numbers. We subscribe to the view that if you have 15 to 20 then you have the optimum number. There are merits to holding a slightly larger number of managers, for example, 25-30 ' you get diversification across managers. But the biggest reason to hold a large number of managers is to minimise manager risk. This assumes any one of the managers that you select has a chance of 'blowing up.' But if you do your due diligence right, then you will minimise business risk and you can optimally construct your portfolio with a smaller number of managers.
Most people look at the manager's style and strategy. This is not the biggest risk to hedge fund investors. Any manager is a combination of two things ' the investment process and strategy and business. Your managers have to be able to hire people, keep smart people, compensate them well, have the business infrastructure that is necessary, have the legal grounding to structure themselves and be able to choose a domicile.
It may be boring, but it is important to look at private placement memorandums, the agreements that people sign when they subscribe. Look at the fees, the terms of the investment and the expenses, not only the management fees but also the underlying fund expenses. No one looks at these, but sometimes the underlying fund expenses can be 5%- 7% of the NAV because some managers are putting every one of those expenses into the fund.
It is also essential to look at the timing of the issuance of the documents. There are some managers who do not issue their tax reporting requirements until nine or 12 months after the year end.
Performance is of course important, but this is the last thing you should probably consider. You should make sure that your managers can run a business, have strong credentials and are well-qualified before looking at the performance on both a quantitative and a qualitative basis.
If you compare two managers side by side and one has returns that are substantially higher than the other, you will need to ask why this is rather than just discounting the one with lower returns. Maybe the one with lower returns has less leverage and a more diversified portfolio which may be an advantage for you.
Another important issue is that of measuring performance. Different managers have different levels of accuracy and frequency of performance updates. The performance a manager shows in the previous month and at the start of a month can change significantly as time goes on, so they re-estimate their performances.
You would expect that in distressed securities and convertible arbitrage, where it is a negotiated market and it takes a while to firm up valuations. But in other areas such as long/short equities you would expect very little revision. So you will need to understand what is behind these differences.
This is very much part of the institutionalisation of this business. Research the background ' who owns this business, in what percentage, how they are paid and what their investment philosophy and approach is.
This business is not terribly complicated. Your understanding of what makes things tick is your best tool in the investment business and certainly the hedge fund industry.
If performance in a fund was strong in the past but all of a sudden the managers are giving autonomy to the traders then the future performance could be quite different ' a lot of managers have migrated towards this. They used to make all the decisions themselves and now have a large team, allowing their convertible manager the ability to make decisions and giving the event driven manager the ability to make the decisions. This is great but this will change the dynamic and the performance going forward.
And of course you need to understand the assets under management. They need to run some money to stay in business but they can't run too much money. You need to know what those constraints are and they vary by strategy. In fixed income, you need at least $250m to $500m gain the economies of scale necessary; in long/short equity, $100m is certainly enough. There is little barrier to entry in that strategy.
You should only monitor managers based on all the due diligence you have already done up to this point. If you like their approach and process, monitor them based on what you understand from that manager, and do not throw arbitrary constraints on them. We recommend you visit managers at least four times a year and call them once a month. There is a study that says more frequent monitoring than this is a deterrent to performance because you make bad decisions if you try to monitor on a weekly or daily basis.
The dispersion of returns is high among managers and so identifying valuable managers really does count. Of the new hedge funds launched in Europe in last few years, a number of those closed down over the last six to eight months because asset sizes did not grow fast enough.
But, nonetheless, the performance of these new funds is quite strong compared to the overall CSFB/Tremont index. So it does pay to identify managers early on. It does pay to stay consistent with these managers, stay consistent with the process and the philosophy. If you do identify managers early who are very strong and are capable of running businesses well, year after year these managers will tend to perform quite well compared to the rest of the industry.
Distressed securities is a strategy to look at overweighting while areas to underweight include fixed income arbitrage.
Any manager is a combination of two things ' the investment process and the way the business is run.
It does pay to identify managers early on.
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