Searching for new underlying strategies

Hedge funds are fast becoming a part of the investment mainstream. Estimates from Tass Tremont have put the amount of worldwide assets invested in hedge funds as high as $1000bn (E810bn), with up to half of this invested in funds of funds. Numbers of underlying strategy funds are estimated at 5000 plus.

Changes in regulations are gradually making it easier for retail investors to access hedge funds, particularly funds of funds. A liberalisation in the rules governing the marketing of funds of hedge funds has occurred in Germany, France, Italy and Ireland. While all these countries still have restrictions – such as high levels of disclosure by underlying hedge funds in Germany – this liberalisation means a further step towards these funds entering the mainstream.

But just as retail investors have become more interested in funds of hedge funds, so there are growing concerns about prospects for this asset class.

Hedge funds have always thrived by being relatively small and taking advantage of trading opportunities. While hedge funds still cap the amount of assets they manage to maintain performance, a growth in the number of funds may reduce those trading opportunities or the length of time they are available.

Difficult year

These concerns have coincided with a year when it has been more difficult for hedge funds to deliver strong positive returns. But it can be argued this has more to do with the fact that, with the exception of oil, there has been a lack of direction and volatility in all asset classes. Hedge fund strategies, such as long/short equity and managed futures, tend to need these two factors to generate returns.

Nevertheless, despite the difficult conditions, the average hedge fund has still outperformed stock markets since the start of 2004, and apart from managed futures all the strategies have delivered a positive return, according to the Tremont Hedge Fund Index.

From the start of 2004 to the end of July, the Tremont Hedge Fund Index returned +2.61 per cent compared to +0.43 per cent by the MSCI World and –0.92 per cent by the S&P500. The best performing strategies have been dedicated short bias (+7.73 per cent), distressed (+6.55 per cent), event driven (+5.23 per cent), global macro (+5.21 per cent) and fixed income arbitrage (+5.09 per cent). The one strategy to have a negative return is managed futures, with –5.54 per cent.

This outperformance is reflected in the fact that all the funds of hedge funds in the accompanying table have delivered positive returns over the past one, three and five years, with the exception of one fund that showed a negative performance last year. So far, the increase in inflows does not appear to have had a significant detrimental effect on performance.

Michael Goldman, manager of Momentum All Weather, says the lack of direction in markets as well as lower volatility, liquidity and corporate activity have made it more difficult for hedge fund managers.

“These have been major factors behind the tough year that managed futures funds have had,” says Goldman. “To some extent, you have a better chance of success outside traditional markets in this environment. Those strategies that use equity markets have found it harder because of the lack of liquidity.”

Funds of hedge funds, however, have to adjust to the changing market conditions. Mr Goldman, for example, says that in the past about 18 per cent of Momentum All Weather was allocated to merger arbitrage as it was a relatively liquid strategy. But with the dry up in deal flows due to less corporate activity, merger arbitrage now only comprises about 5 per cent. Mr Goldman adds that in the past, long/short equity has comprised as much as 33 per cent of his fund of hedge funds but it is now down to around 9 per cent.

Mr Goldman does not believe the strong inflows into hedge funds are having a detrimental effect on performance but he admits it can cause problems in particular strategies when liquidity is relatively low. Obviously, this makes it difficult for hedge fund managers to place the money.

This leads to underlying managers and even fund of hedge funds, such as GAM Diversity and recently Momentum All Weather, closing to new investments. Goldman says another option is for fund of hedge funds to extend redemption periods. Those funds that allow redemptions every month might lengthen this to three months and funds that trade every quarter might change this to every six months. “If the hedge fund industry is less liquid than in the past then fund of funds need to be less liquid as well.”

As a result, Pioneer Alternative Investments has launched Momentum All Weather Two. Goldman says it is still possible to find good hedge fund managers that are open to new investments but “funds of hedge funds have to work harder than ever before. There are more hedge fund managers so we need to spend more time analysing them and searching for the good ones. But there are still good new managers entering the industry and managers who have been running hedge funds for a while that have come onto our radar.”

Strong performers

With more fund of funds and other investors searching for these good hedge fund managers, there is also pressure on them to discover strong performers earlier than ever before.

Kris De Souter, manager of the Dexia World Alternative Alpha fund, says: “It is not harder to find good quality hedge fund managers but it can be harder to access them as they protect portfolios by closing them to new investments.”

It is for this reason that funds of funds are exposing themselves to managers with shorter track records. “Hedge fund managers often perform better in the first two years of their existence. This is probably because the managers are motivated and they have to perform well to attract investors. When their fund size gets to E200m or E300m, managers may get more defensive and delegate responsibility. This can dilute the investment process without the hedge fund manager realising it. As the fund size grows, it can also be more difficult to exploit inefficiencies in a specific market segment.” As a result, Dexia World Alternative Alpha has three tiers of investments. Mr De Souter says its core holdings of underling hedge funds each comprise between 3 and 6 per cent of the portfolio. It then has two levels of satellite funds. The first comprise holdings of between 1 and 3 per cent while the second, which are new hedge fund managers, have holdings in the portfolio of less than 1 per cent and an overall maximum of 10 per cent.

Alexander Lowe, investment manager at Man Investments, agrees that hedge fund managers tend to perform best in the first six years. But he adds that there are exceptions to this rule, citing the AHL fund which was launched 15 years ago. “The deterioration in performance could be attributed to a number of factors, such as a fund raising too much money or not adjusting quickly enough to changes in market conditions. If a merger arbitrage fund has $500m in assets, it is much harder to adjust to a change in the market environment than a $10m fund.”

Two options

He adds that a multi-manager has two options in coping with the new environment. “They can wait to see if a hedge fund manager survives before investing or invest relatively modest sums and hope to grow with the successful managers. The second option enables investors to gain access, negotiate capacity agreements with fund managers and benefit from lower fees than later investors. If a fund of hedge funds is a key investor at launch, he will be able to ask for a percentage of future capacity.”

Paul Meader, director of Dawnay Day Milroy, which invests in single and fund of hedge funds for client portfolios, says it has become fashionable again to “bash” hedge funds. “Funds of hedge returns since the start of 2004 have been disappointing by previous standards as the average has been flat.

“This has been the result of a number of factors. There has been de-leveraging around the world, which has led to correlation between asset classes where previously there was little correlation. Aggressive hedge funds performed well in 2003 during the recovery in equities but have suffered this year.” Mr Meader says this is a short-term phenomenon.

Chris Mansi, head of the hedge fund research team at Watson Wyatt, says he has concerns about the rapid growth of the industry but that the best fund of funds can add value to client portfolios through diversification away from traditional asset classes.

“Delivering returns is not as easy for hedge funds because of the higher number chasing the same opportunities,” says Mr Mansi. “The key is in finding the most skillful hedge fund managers, understanding the risks and blending them together.”