Hedging your bets

Ramona Glass
Head of hedge fund products
Threadneedle Investments
Glass joined Threadneedle in January 2006 as an investment specialist and became head of hedge fund products in December.
She is responsible for developing the
business strategy for Threadneedle’s single manager hedge fund business as well as for the product development of structured products and single and multi-manager hedge funds.

Richard Graham
Head of institutional business,
Baring Asset Management
Graham is head of institutional business, which includes responsibility for LDI solutions for UK pension funds.

Teun Johnston
Head of London investment team
Crédit Agricole Asset Management
Alternative Investments
Johnston started his career in 1994 as a member of the financial services practice at Arthur Andersen in London. In December 2000, he joined the Alternative Asset Management Group, which became CAAM AI in March 2006, as an investment analyst, based in London. In
September 2005, he was appointed head of the London investment team.

Martin Pattinson
Head of direct sales corporate pensions funds
Morley Fund Management
Pattinson is responsible for building relationships with both institutions and their consultants. He joined Morley Fund Management in 2006 and
previously worked for firms including HSBC Investments and Schroders.


Which types of hedge funds will insti-tutional clients look at first for direct allocations and which types will always be best accessed through fund of hedge funds?

GLASS: In my opinion, there is no particular strategy, which is best/better suited for direct investments.
Hedge funds should always be approached with a view on diversifying manager/system risk. Long-only products are mainly based on market risk. Therefore diversification between different managers has only a small impact on the overall performance of a particular asset class.
Hedge funds however, tend to have very low market risk. The returns of hedge fund investments are mainly dependant on the manager’s strategy working in different market environments and the manager being focused and alert at all times.
However, no hedge fund strategy works in all market environments and no hedge fund manager is at its best 365 days a year.
Nevertheless, it is the objective of a hedge fund to achieve absolute returns at all times. Furthermore, it is difficult to monitor and evaluate the hedge fund manager continuously to pinpoint the effectiveness of the current portfolio and to trade in and out of hedge funds on an ongoing basis. These problems can only be overcome by diversification.

GRAHAM: Most institutional investments in hedge funds are done through a fund of hedge fund structure with a recognised manager.
However, institutions are increasingly establishing a dual investment structure whereby they invest in both fund of hedge funds and directly through single managers. This is a natural progression, accelerated by recent poor returns from fund of hedge funds coupled with the institutions’ efforts to avoid a double layer of fees.
In my opinion, UK institutions should not limit themselves to certain hedge fund sub-strategies but they should ensure that they are comfortable with the manager, and they should also evaluate certain factors in addition to strong performance, such as the risk of “boutique” failure, capacity constraints, the degree of transparency in the strategy, and the extent of any lock-ins.
In September 2004, the Bank of New York, Casey Quirk and Acito wrote a research note entitled Institutional Demand for Hedge Funds: New Opportunities and New Standards. The paper introduces seven attributes that tend to characterise successful hedge fund firms: business management, culture of integrity, operational excellence, disciplined investment process, investment strategy innovation, comprehensive risk oversight and, a sophisticated client interface.
This checklist can serve as a benchmark for institutional clients in evaluating a hedge fund firm’s competitive position. Taken in their entirety, these attributes define a much more mature business model than has previously been required in the hedge fund industry. It will require higher professional standards and, most likely, greater scale than before from large and small hedge fund firms alike.

JOHNSTON: Long-short equity hedge funds are the obvious ones, since they are a natural extension of conventional equity investment, being merely a higher conviction, higher risk version thereof. But even if a LSE fund looks quite simple at a first glance, there are several risks embedded, such as the use of leverage and derivatives, concentration and liquidity risk, that an investor should be able to understand and to assess.
Furthermore, institutional investors will need to be aware of the key man and operational risks of investing with a boutique fund manager – if they do not have access to the sort of operational due diligence and regular monitoring undertaken by funds of hedge funds, they should avoid investing directly.
Other strategies – such as convertible arbitrage, fixed income or credit arbitrage – are too technical to be appropriate for direct investment. Not only are funds of hedge funds better placed to understand and monitor the risks therein, but they are also better placed to know the best time to invest in these strategies and how to combine them to maximise diversification and reduce the risk of the overall portfolio.
Additionally, by investing through fund of hedge funds, access and capacity with top quartile hedge funds is shared with the institutional clients.

PATTINSON: Fund of hedge funds are generally the first port of call for a pension fund considering investing in this asset class. However, given concern with the double fee structure, there is increasing interest from pension funds in multi strategy hedge funds, which have a more palatable fee structure.
A few of the very largest pension funds, which have a supportive governance structure, have invested directly in hedge funds as part of their alternatives exposure – equity hedge being the most popular strategy.
However, this is challenging as there are 8000 hedge funds with a combined market value close to $2trn (£1trn). Access to the best hedge funds is also a near impossibility for most investors due to capacity constraints. That said, interest is increasing in those hedge funds which are considered as part of a fixed income portfolio.
However, for smaller pension funds with a limited governance budget consideration of investment in hedge funds, even passive hedge funds, is demanding as the equity/bond mix remains the critical issue to address.
Those fund managers who offer single strategy funds alongside multi-strategy hedge funds are well placed to help pension funds invest in this asset class.


What are the real difficulties in adapting from running a long-only fund to running a long-short fund? Is it still possible to make money on the short side?

GLASS: Shorting requires additional skills from a fund manager as the dynamic of how positions react in relation to each other changes.
A losing short position in a portfolio increases in size and increases the risk of the overall portfolio. Effectively, losses are unlimited and liquidity in some stocks is still tight, which requires the fund manager to monitor his short book very carefully.
It certainly is still possible to make money on the short side as there are still plenty of investors, such as pension funds and institutional clients, who are bound to be investors in stocks hedge funds want to short. In addition, liquidity in shorting stocks and baskets continuously increases, which will be further fuelled by asset managers increasingly utilising the new UCITS III powers in their portfolios.

GRAHAM: There are the obvious operational and management issues to contend with, but from an alpha generation perspective I would say that most traditional, long-only managers have difficulty in identifying the catalyst or trigger that will drive a stock down.
A poor company on a purely fundamental basis does not mean the share price will fall. In fact, in a liquidity-driven rally the stock can continue to appreciate regardless of the fundamentals. Examples of this would be China H-shares in 2006 and the start of 2007, and European small caps in 2006, where the merger and acquisition activity reached high levels and poor earnings forecasts and negative newsflows were rewarded by the market making it very difficult to take aggressive short positions.
It is still possible to make money from the short book, but we prefer immature markets where the inefficiencies and anomalies remain abundant and the derivative markets are not so deep, as it helps to have fewer managers trying to exploit these opportunities. A long/short hedge strategy offers a degree of downside protection in tough markets coupled with pure alpha generation from naked shorts or tactical trading. The intrinsic volatility of the emerging markets suits an absolute return strategy ideally, and as these markets mature, borrowing costs will come down.

JOHNSTON: The real difficulty is to create alpha from shorting. Taking short positions does not come naturally to all managers. It is partly a question of temperament and partly one of un-learning ingrained habits from the long-only world. Poor longs are not necessarily good shorts, that is why solid stock picking skills on both, the long and the short side is necessary to generate consistent returns.
Furthermore while shorting a stock, the manager has to closely monitor liquidity in order to avoid any short squeeze.
While short selling shows benefits on the long run, it remains difficult to make money on the short side in times of high liquidity. LSE managers are attracted to companies with deteriorating fundamentals and weak management teams. Those companies however are also likely to be takeover targets by other firms making stock values rise after a potential bid.

PATTINSON: As shorting requires a completely different mind-set to long-only management, a successful long-only fund manager may not necessarily adapt successfully to a long–short approach.
Additionally, the potential to make unlimited losses through shorting does require an appropriate risk management approach. However, no one process has a monopoly on alpha generation and shorting expands the opportunity set.


Is the growing institutionalisation of the hedge fund industry and birth of market indices ultimately going to lead to a herding mentality as seen in traditional active management?

GLASS: Hedge fund strategies are still very diverse and are looking at all asset classes including commodities and FX. Certainly, in the equity long/short space there are sectors/stocks, which many investors are trying to short at the same time, which can have an impact on liquidity, and diminishing returns.
However, the size of the hedge fund industry in comparison to the whole of the equity market is still very small and will be for the foreseeable future.

GRAHAM: I do not see this happening, as institutional investors only account for a very small percentage of hedge fund assets and are likely to be attracted, mostly, to the more liquid markets and strategies.

JOHNSTON: As markets become more efficient, generating alpha is becoming more difficult. The key attributes of the best hedge funds remain an investment process based on independent thought, a focus on delivering absolute returns and an acute awareness of the risks associated with crowded positions.
The most successful managers over the long term are those with skills or talent, something which cannot be copied. Those managers are able to provide consistent alpha. While investing with an index, returns are driven in a large way by alternative betas of hedge funds, but tend to have a low alpha.
Hedge fund indices remain at best a rough guide to the performance of the hedge fund universe, and the fact that a lot of the best hedge funds are closed means that the only “investable” indices have generally underperformed well-established funds of hedge funds.
The hedge fund industry is a ruthless one. Funds which fail to perform to the level justifying their fees do not survive. As more hedge funds start up, the best will cannibalise not just constrained portfolios, as before, but also less skilled hedge funds. The moment hedge funds start to herd together they lose their raison d’etre.

PATTINSON: The dynamic nature of the hedge fund industry has meant there are continually new diverse and unconstrained investment strategies being developed in the hunt for new sources of alpha.
For example, as the relative market share of global macro has declined, a proliferation of new strategies has emerged, including event driven, arbitrage and distressed securities. The sheer volume of activity has ensured that the market keeps moving into new areas.
With such a diverse universe of many styles and funds, there is little chance the hedge fund industry will fall victim to herd mentality. On the contrary, we should expect to see a further diversification of strategies.
This is why hedge fund of funds and multi-strategy funds can be an attractive proposition to pension schemes as they are able to track these new opportunities and invest where appropriate.