Hedging your bets

by Tracey Pearson-Tullet on Tuesday, 01 May 2007

Investors today are faced with an array of investment choices and possibilities, ranging from simple cash deposits through to investment in equities, bonds, property and commodities. When building an investment portfolio the choice an investor makes will depend upon a number of factors including his or her investment objectives, time horizon and appetite for risk.

Of late there has been a lot of interest in hedge funds and debates as to whether investors should seek to include hedge funds in their portfolios. But it is only since the mid-1990s that hedge funds have really grown in popularity, with the value of assets increasing from less than US$186bn in 1995 to nearly US$1 trillion at the end of 2005.

Despite the sector's rapid growth over the last decade, the value of assets under management is still dwarfed by traditional asset classes. The hedge fund industry is still the newcomer, particularly in comparison with equities and bonds, and there remains a fundamental lack of knowledge and understanding about the concept in both the institutional and retail marketplaces. A survey by JPMorgan Fleming Asset Management in 2005 suggested 12% of pension funds allocated on average 4.8% of their portfolio to hedge. However, this figure is on the rise and allocations to hedge are growing in size each year.

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So what exactly are hedge funds? In their simplest form, hedge funds operate using traditional assets - equities and bonds - in non-traditional ways. In a bid to reduce the risk of adverse price movements of a security, the manager will take an offsetting position in a related instrument - thereby achieving market neutrality. As such, hedge funds have the ability to make money in falling and volatile markets and can offer a low correlation to traditional investments vehicles. However, the statistical, strategic and informational tools needed to hedge a position are by no means simple with the result that 80% of returns are generated by the skill of the manager, with just 20% stemming from the market. As a result, hedge fund managers are notoriously secretive about disclosing their methodology.

As a method of countering this lack of transparency and providing an element of comfort for investors, hedge managers usually invest a significant proportion of their own wealth in the fund ensuring that the manager has a vested interest in protecting not only investors' money, but also his own. They also typically receive a significant portion of their total remuneration through performance fees - thereby their success is allied to the success of the fund.

Investing in hedge funds

Despite the massive expansion of the hedge universe in recent years, it can still be very inaccessible to the everyday investor. Just as the scale of assets under management in the hedge fund universe continues to grow rapidly, the number of funds operating in this arena has also rocketed.

The Hennesse Group LLC reported that from just under 3000 hedge funds in 1995, the industry has grown to nearly 9000 funds in 2005. Many funds are domiciled in less regulated environments, such as Cayman Islands or Bermuda, to ensure that the managers are able to utilise their less traditional investment techniques. However, this can often mean that the funds cannot be promoted easily, particularly in more strictly regulated countries.

So how does an investor even become aware of a good manager?

Hedge fund investment is also still very much geared towards the large financial institutions and the wealthy investor, therefore the price of entry into most funds remains high. Hedge funds can be very difficult to buy and sell, and funds are often closed to new investors. Hedge managers often impose what are called ‘forced lock-ups', which means investors have to wait long periods before they can withdraw their money.

Moreover, private investors simply don't have the time or expertise to research the fund universe, diversify across strategies and continuously monitor their portfolios.

Fund of hedge funds

The fund of hedge funds offers an alternative for those private investors. The pooling of several hedge funds under one fund aims to provide access to the best talent (even those with minimum requirements that are too high for single investors) and pledges to undertake all timely and costly due diligence. It pools the underlying funds into portfolios that can significantly lower return volatility and increase risk-adjusted returns through the benefits of diversification - thereby providing both strategy and manager flexibility. Finally, most fund of hedge funds offer this service at accessible minimum investment levels and in this way have opened the door to an increasing number of investors.

Merits of fund of hedge funds

For many investors the convenience and simplicity for them of investing in fund of hedge funds has enabled them to gain a slice of the growing hedge fund industry. This has meant that investors who would have not normally been able to consider hedge funds for investment are able to.

However, it is important to understand why many investors look to invest in fund of hedge funds as opposed to investing directly in hedge funds. As with all investments, the time consuming process of researching hedge funds is daunting for investors and many investors do not have either the resources or the skills needed to undertake such research. Fund of hedge funds allow investors to outsource such time consuming necessities as due diligence to a team of dedicated experts, who are skilled in the high levels of research necessary to ascertain whether a hedge fund has the potential to be a sound investment.

It is also the role of fund of hedge funds managers to take into account new developments in the marketplace and construct their fund of hedge funds in such a way to allow investors to utilise new strategies without exposing them, or the fund, to unnecessary levels of risk.

The skill of a dedicated fund of hedge funds manager can be demonstrated when looking at how they buy a hedge fund. These managers have extensive knowledge of the hedge fund universe as they are constantly monitoring styles, strategies, cultures and performances. When a fund of hedge funds manager decides to purchase a hedge fund there is an extensive due diligence process the hedge fund must go through before being added to a ‘Buy List'.

The process identifies the best available managers in the hedge fund space, which is usually achieved through a combination of quantitative and qualitative disciplines. Based on this a portfolio is constructed and then constantly monitored to ensure consistent performance.

Another of the resounding benefits of fund of hedge funds for investors is the price of entry. Most hedge funds make investment prohibitive to smaller investors due to the amount they have to pay to enter a fund - often around the US$1m mark - whereas fund of hedge funds create the opportunity to pool investments therefore making the entry price much lower than investing directly in hedge funds. Additionally, pooling underlying funds into portfolios can significantly lower return volatility and increase risk-adjusted returns through the benefits of diversification - thereby providing both strategy and manager flexibility.

How to build a fund of hedge fund

One of the key activities a fund of hedge funds takes on is that of due diligence. These funds enjoy the benefits of a team that is dedicated to the goal of finding the best available managers in the hedge fund space, which is usually achieved through a combination of quantitative and qualitative disciplines. The first stage sees a quantitative research team undertake an initial screening across various hedge fund databases, to filter out the best funds in each strategy from a risk return perspective. Funds passing this relative screening would then be reviewed in isolation - considering all relevant hedge fund statistics and ratios.

It is only funds that pass both these quantitative screens that are then researched by a qualitative team to ensure full understanding of the manager, team, process and risks. Such a process would typically involve site meetings and/or conference calls with the manager which consider all aspects of the organisation, fund and team, reviewing pricing, accounting, back office, compliance, administrators and counter parties.

Once a fund has passed through both these processes they can be added to a ‘Buy List'. Using the list (which is continuously updated and amended) the next consideration becomes portfolio construction. Obviously, this process is dependant on the type of strategy being considered (ie whether it is a single strategy or multi-strategy fund of hedge funds.) Additionally, the methodologies used by different fund of funds houses will vary. For the purposes of this article, we will be considering a multi-strategy approach undertaken by Forsyth Partners.

Typically the factors Forsyth Partners would consider include the following: Qualitative rating; liquidity; strategy risk and market risk factors.

This is designed to produce diversification and therefore a balance within the portfolio.

Having identified the best managers and constructed a portfolio, a fund of hedge funds continues to add value with ongoing monitoring. This not only incorporates regular contact with underlying managers, but also regular performance updates and ongoing quantitative and optimiser analysis.

Multiple strategies through the fund of funds approach

One of the main complications for investors considering hedge fund investment is the range of strategies available.

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