Global Pensions gathered fund of hedge fund experts in London to discuss the outlook for the vehicle following the credit crunch, competition from replication vehicles and complaints of high fees and low transparency
Jenny Blinch: The credit crunch caused some public blow-ups in the hedge fund world - has that had a knock-on effect on fund of hedge fund performance? Des Hogan: There have been some hedge fund blow-ups and this will of course affect the performance of those funds of hedge funds that have had exposure to these hedge funds and there is likely to be some more problems in the near future.
The advantage fund of hedge funds groups have though is diversification, they invest in a number of hedge funds and, hopefully, with the benefit of their investment and due diligence process, they will limit their exposure to these situations and be even more cautious in future.
Olivier Cassin: There are probably some psychological issues with those institutional investors who are reluctant to invest in fund of hedge funds - blow-ups reinforce that nervousness. But the product has become more professional, more diversified, and clients are more informed. If the fund is of good quality, a single blow-up shouldn't have much impact on the performance.
Chris Greenall: Over 12 and a half years of running low volatility funds of hedge funds we've identified that leverage is typically the cause of these blow-ups. In the last year in the multi-strategy and levered structured credit space we've seen leverage working against a number of hedge funds in a dislocating environment. In a fund of funds you can try to mitigate that by avoiding leverage, but that offsets the ability to generate some of the returns.
So [trying] to capture returns and accept leverage as part and parcel of what they do is one way of running funds, the other is to avoid leverage within your underlying hedge funds and put more conservative portfolios together that can generate alpha, consistency of returns, mitigate beta, and ultimately, provide diversification.
Robert Howie: A lot of fund of funds had a bearish view on credit and were actually short credit last year, so a number of our clients had good returns on the back of the credit crunch. The credit crunch actually provided opportunities and continues to provide opportunities for funds that can find them and profit from them.
Laurent Seyer: All asset classes have been damaged by the credit crisis; it's not specific to the hedge fund world. I am optimistic because 2007 was probably one of the best years in terms of performances for fund of hedge funds. While this situation does create some challenges, it also creates opportunities for hedge fund managers. There have been blow-ups and will be more, but compared to the blow-ups you have with corporates in the equity markets, there aren't that many.
Manuel Echeverr'a: Clearly, the issue is leverage. What we saw it in 1994 and 1998 were periods of quick and sharp deleveraging. Those of us who have been investing in hedge funds for many years have seen this before. The periods after 1994 and 1998 were phenomenal because the excesses had been removed from the system. So investors that are able to look forward, should expect higher rates of return, and if they are with the right managers, strong performance too.
Gary Enos: The credit crunch has affected every market in the world and the goal of hedge funds is not to be correlated, so there are winners and losers. On the administrative side of the business, we see both the winners and the losers. The advantage of the fund of funds is to go out and rebalance and correct and make decisions based on what they've seen over the last few months.
Jenny Blinch: Dennis, as a pension fund trustee, what is the investor perspective on this?
Dennis Buckley: If one has a good fund of hedge funds or a good selection of hedge funds, one or two blow-ups within their funds will probably depress performance, but the idea is that you'll smooth performance and hopefully keep an absolute return. In terms of investor confidence, we are still a little sceptical of whether we can find a good manager.
Any blow-up is likely to affect the timid investor, but at our scheme we have been looking at the hedge fund and private equity space to find out whether we can gain sufficient understanding and expertise to invest. I feel that once investors have become sufficiently educated, they'll realise that this affects all asset classes and could actually be an opportunity.
Jenny Blinch: Robert, have you noticed any changes in investor attitudes?
Robert Howie: We have not seen a slowdown in terms of new money being allocated to hedge funds, because in 2007 on average hedge funds did reasonably well and there were some real winners. Everyone was up in arms in January because hedge funds had one of the worst months ever, but one of the worst months in the hedge fund world is losing 2% or 3% as an average industry, which, compared to the equity markets, almost didn't register.
Des Hogan: We certainly saw some reluctance after August last year from institutional clients who were considering investing in fund of hedge funds, but as the year progressed and as we witnessed stronger returns, those institutional clients came back with a more informed opinion of the hedge fund marketplace and were in a better position to make the allocation. In spite of the turbulence last year, fund of hedge funds had a very solid year.
Laurent Seyer: In the last six months, pension funds have come to us with detailed and precise requests in terms of building a portfolio of hedge funds with certain risk exposures. They are looking at fund of hedge funds as not only an asset class or place where they put their money - and the fund of fund is supposed to be built up as a best of breed type of product - but as a product which will give them exposure to unusual risks like volatility and correlation. The pension funds are moving towards tailor-made, dedicated mandates.
Manuel Echeverr'a: I believe that some investors will change their mandates. We have had disappointing performance in the equity markets, and disappointing performance from some long/short managers, particularly in Europe, where they have been over-exposed to market beta. We expect that some investors will want to avoid equity market risk and this will limit the universe for investment.
As equity strategies tend to use less leverage, it may push investors towards less directional but more leveraged strategies. So the paradox will be that investors may get less equity risk but more leverage risk.
Olivier Cassin: As the asset class evolves, we also see a trend towards splitting the fund of hedge funds into specific strategies. At the moment we're doing quite a few long/short equity fund of funds searches for investors looking to protect themselves against a big market downturn. Not surprising considering what's happening in the markets.
Chris Greenall: These markets are a wake-up call for fund of fund investing. You go through cycles where you get a lot of equity momentum and it takes the focus off fund of hedge funds' intended purpose, which is diversification. If you look at asset classes in 2007, the only two asset classes that delivered good returns were emerging markets and commodities.
If you think about the volatility implicit in those strategies and how quickly they can revert, then if fund of funds can post 10% returns and 5% volatility in 2008, it's going to benefit many client portfolios.
Jenny Blinch: We've dealt with the market issues, so let's move on to some of the classic fund of hedge fund issues. Fees are still notoriously high and are a barrier for some pension funds. Are they justifiable?
Chris Greenall: If you're looking for the best hedge funds, those that can generate long term consistent returns, provide true alpha and mitigate beta, you have to pay for it.
In a business where the best funds have more demand than supply, fees are set at a level that is proportionate to the alpha that is generated. If you're given a mandate for LIBOR plus 4% or LIBOR plus 6% and you deliver that within your risk framework, then clients are happy.
Des Hogan: We have to accept that for investors entering the fund of hedge funds area for the first time the fees appear high. It's up to us as consultants and product providers to explain to clients the reasons why the fees are high and what the clients get for those fees. There is an increasing acceptance from clients that they're going to have to pay to get into this area.
But we also have to explain to them that the headline fee you see written in black and white is not necessarily the fee you're going to pay, and there's the ability to negotiate with the providers to reduce those fees, in some cases significantly.
Robert Howie: I agree completely, the fees are negotiable, and when you see the published fees, there's a huge diversity in terms of the range of fees from those that look quite reasonable up to those that look really expensive. I would highly recommend to all investors that they negotiate hard on fees. Gary Enos: In the pension space you get what you pay for.
You're asking for things that are a little bit out of the norm and there's cost to deliver these types of services, in addition to the cost on the management fees. At the end of the day, you want these returns and you want that transparency so you should be prepared to pay for it.
Laurent Seyer: Fee levels have not prevented huge inflows over the years into hedge funds. I assume that demonstrates that investors appreciate the value they get for the money they pay. I believe that on top of alpha, when you invest in a fund of hedge funds, you also get exposure to alternative betas, not only traditional betas.
Alternative betas are difficult to assess, they are difficult to get exposure to, they are unusual sources of income, and this is worth paying for.
Olivier Cassin: A lot of money has been invested in these products and competition has increased, so we believe that in a real competitive environment there's evidence to show that prices can go down while the providers maintain decent margins and good value for clients.
Dennis Buckley: As trustees, we are more interested in the return after fees and stability around the absolute return mark. The problem comes if you end up in a fund that is only mediocre and you're also paying high fees. With all of our other mandates we've managed to alter our structure so that not only do we have performance-related fees, but we have underperformance-related reductions.
That hasn't been possible with the fund of hedge funds, but the way we've done our hedge fund investing, which is through a basket of alternatives, we've said to the manager we will pay you a flat fee and if you underperform you'll be paying that underperformance, not us. The manager accepted that so in a sense there is room for negotiation, but in reality the best funds do close and they can charge a premium.
Jenny Blinch: Laurent, you were talking about the various kinds of betas available through funds of hedge funds, perhaps you could expand on those?
Laurent Seyer: I believe the performance of a fund of hedge funds can be split into three components: traditional betas - and that's what replicators try to pursue; non-traditional betas or alternative betas, for example exposure to volatility, correlation, risks that are going to deliver returns but which are not easily accessible through traditional investment vehicles; and alpha.
That's why I believe the investment process of a fund of hedge funds should be top-down driven rather than bottom-up. Historically, many funds of hedge funds have been built as a best-of-breed type product. I think these times are probably over and investors now are looking for institutions with a strong view on the top-down analysis.
Olivier Cassin: I agree with what's been said and you can see it from a tiny minority of funds of funds, but at the moment amongst funds of hedge funds you see high correlation and that doesn't mean that there is no alpha created, it means that as a whole the fund of hedge funds community tends to behave the same way.
Chris Greenall: I tend to disagree that the top-down approach is the best way to run money. Market timing in traditional markets is difficult enough, but where you have monthly or quarterly liquidity schedules, the ability to effectively time the market is removed.
That is why we look for managers that can generate returns consistently across market cycles while making only gradual shifts in asset allocation depending on broader themes in the markets.
Importantly, within the marketplace, fund of hedge funds' betas range from 0.2 or 0.25 at the low volatility end up to 0.7 or 0.8 at the high volatility end. It's a lot easier for those in the low volatility space to de-risk and decouple from the markets when the markets have a downturn, which introduces the concept of good beta and bad beta.
If you can capture the beta when markets are going up and if managers can take risk off the table when markets are going down, that is what people are looking for in fund of hedge funds, not something that has a high correlation to the upside, but then reverts back with the downside when equity markets go south.
Manuel Echeverr'a: Managing funds of funds through a top-down approach can work in certain cases. However, when you are investing with multi-strategy funds, and you are giving the manager the decision to allocate according to strategies, you are not able to manage the allocation process.
Some of the global traders that function as diversified, multi-strategy businesses, for example, Brevan Howard, have done a phenomenal job in allocating capital appropriately. If we had a pure top-down approach, we probably would not have invested with a manager like that.
Robert Howie: Of the managers that we cover, we're happy to put our clients into about 5% of the funds, and that's not because we don't do our homework, it's because we don't find the quality out there in most of the funds that we research. That 5% we do believe add considerable value and bottom-up and top-down both have an important role to play in adding that value.
Dennis Buckley: You want hedge funds to protect on the downside and gain on the upside, but there's no way you can gain the maximum alpha on the upside if you're protecting heavily on the downside. We take the view that hedge funds should be providing stability and lowering risk overall, but it is worth looking at the markets they're in, and therefore the assumption must be that you want them to provide alpha, especially in a falling market.
Jenny Blinch: I'd like to hear everyone's thoughts on replication vehicles.
Manuel Echeverr'a: In my opinion they don't work. The markets change too quickly, there are too many variables, and a passive approach will not work consistently through different cycles. At the end of the day, investors are not just looking at one cycle, they are investing their pension funds for the long term, and those types of strategies are not adaptive.
Robert Howie: I think the idea is one of the most interesting ones to come out of the hedge fund industry in many years. I always thought investable indices were a bad idea, but replication strategies are a completely different animal and if we can be comfortable that there are some risks that have a risk premium attached to them and these replication strategies can access them, then they offer a cheap way to invest passively in those risks in the same way that you can cheaply invest in equities and get the risk premium at low cost.
I do, however, think there needs to be caution, because it will take some time for the thinking to be clear, for the products to emerge, for the track records to demonstrate that this is possible.
Des Hogan: An important question is, what's attracting clients to these products? There are some large institutional allocations to replication and the prime driver seems to be the fee argument. Clients want the fund of hedge funds risk/return characteristics but at a much lower cost, and in time - and if they produce the results - the replicators might force the fund of hedge funds to become more competitive on fees.
I'm not necessarily a supporter of the replicators at this moment in time as they can only be judged on their results and most haven't been investing for long enough.
Olivier Cassin: Another feature that investors are looking for is better liquidity terms. We conducted research recently where we compared active to passive, and within passive there is a need to split passive and replication. Our clients started with the idea of going passive for cheaper products and better liquidity terms and we found that passive products, excluding replication, are not necessarily cheaper and the liquidity terms are only marginally better, but there's huge dispersion.
Replication is cheaper and offers better liquidity terms, however, if you look at the real track record, it's short and on average much worse than the backtesting seems to have suggested.
Des Hogan: A couple of these funds have been out for two and a half or three years and not only has the performance been disappointing, but the volatility figures have been much higher than a client would accept in a typical fund of hedge funds, in some cases twice as much.
Gary Enos: All these things are just reflective of the mounting pressure in pension boardrooms. Asset liability monitoring is getting tighter, so I don't think there'll ever be anyone that will not listen to a new idea in those boardrooms at this point in time.
Chris Greenall: This is still a relatively new industry for institutional investors in terms of the levels of capital being committed. In the last five years we've seen theme after theme, whether it's the multi-strategy taking over from the fund of funds, investable indices, portable alpha, the dual investment model, which is the combination of fund of funds and single managers. We run the risk of product proliferation and confusing the clients.
Jenny Blinch: A lot of pension funds in the UK are adopting LDI strategies. How would they use fund of hedge funds within that approach?
Dennis Buckley: My view is that most pension funds have been doing LDI, but perhaps not labelling it as such, since they started. A number of managers have tried to package so-called solutions, which do work in some cases, but they're not necessarily generally applicable.
I'm all in favour of involving funds of hedge funds and hedge funds in our strategies, but as an LDI-type product, I'm not convinced that it's not just marketing hype.
Robert Howie: LDI in the UK is mainly pension funds investing in more matching products, so bond-based products which align their portfolio closer to their liabilities. Few clients do that for 100% of their portfolio, they usually have a bucket that's there to generate decent returns.
If you've got a lot of your portfolio matching your liabilities and only a smaller part to play with, making that diversified and including hedge funds makes sense.
Laurent Seyer: LDI is just a packaging story. Having said that, increasingly we are seeing pension funds coming to us and saying, ÔPlease build up a hedge fund portfolio for me which is as decorrelated as possible from my existing portfolio.' They want a hedge fund portfolio which will give them exposure to alternative types of risks and sources of income.
Manuel Echeverr'a: We are finding that pension funds have just one alternative bucket, with a defined mandate, and it needs to be lowly correlated with other asset classes. We have done a lot of work with pension funds and have shown them that they can also use funds of funds in other parts of their portfolio, to improve performance and reduce risk.
For example, they could use European long/short funds of equity funds to complement their European equity mandate, improve performance and reduce the market beta. But we are often told, ÔThat's not in my mandate, my mandate is to look for just one bucket of alternative investments.' This has been one of the challenges. Dennis, what's your view?
Dennis Buckley: Well the point you make is quite germane to what we're doing. At the moment we're looking at Asia-Pacific in general, we're going to increase our allocation to the region from about 18% of our return-seeking assets to 23% or 24%. One of the four 6% buckets is likely to be a long/short fund in the Asia region. We're looking at at least two absolute return products, one of which may be a long/short product and one which may just be an absolute return-focused long-only mandate.
I agree there is a place in a regional portfolio or in a portfolio of any sort where long/short may be added, to continue having the alpha but to reduce the volatility or the risk, and that's a line we're actively investigating.
Olivier Cassin: If you look at Swiss pension funds such as NestlÅ½, they have been implementing this strategy for ages now, and not only in the long/short equity space, but in the fixed income space. That means reallocating fixed income long/short into their fixed income bucket and that takes time and you probably need as an investor to have already invested in multi-strategy diversified funds of funds to get up the learning curve.
Jenny Blinch: There are diversification merits to funds of hedge funds, but these could also arguably be offered by multi-strategy hedge funds. From the point of view of an investor who perhaps doesn't know much about it, why would a fund of hedge funds that charges a double layer of fees be better than a multi-strategy hedge fund with only one layer of fees?
Chris Greenall: A multi-strategy fund which is a single fund takes on single-manager risk, so if you have that as a sole core investment, there are significant risks if it goes wrong. Additionally, most multi-strategy funds tend to have a house view and a top-down asset allocation call, and they can get it wrong.
In terms of what we look at from a multi-strategy fund of hedge funds, we're investing across a lot of different strategies or sub-strategies, whether it's directional, long/short, relative value, specialist credit, or something more in the event-driven space and
I'd struggle to name one individual provider who could map across all of those strategies and provide the diversification that you'd get through a fund of fund. So whether there's an extra level of fees for that diversification is a judgement call that investors have to make.
Manuel Echeverr'a: Peloton was a multi-strategy fund that did phenomenally well last year as they were short sub-prime sectors. However, they decided to do some funky things to fund the negative carry of their short sub-prime positions by buying a substantial multiple of what they considered the superior sub-prime tranche.
That was a house view and it ended up being a manager risk. So if you invest in a single multi-strategy manager, you are still taking a lot of individual manager risk. We saw a similar situation with Amaranth. I believe it's too risky for the trustees to make that call.
Des Hogan: If a pension scheme's investing in a multi-strategy single manager, they have to accept that the manager is not going to be the best manager in all the different strategies at the same time. With a fund of hedge funds we would typically expect a manager to be turning over about 25% of the underlying hedge funds in their portfolio in any given year, so you know they will be changing managers who they don't want and replacing them with better managers.
But with a multi-strategy fund, the client is accepting they're going to use only one house and only the managers within that house in the various different strategies, irrespective of the manager quality. Recent surveys have suggested there has been better net of fees value in funds of hedge funds than multi-strategy funds.
Robert Howie: Multi-strategy funds are a viable option for some investors, not least because of the cost savings. I do agree with the comments about the loss of diversification because funds have a house view. The business model of a multi-strategy fund is also problematic in some ways, because if you have one team that's doing well and one team that's not, there's a possibility that those teams might break away.
That said we have identified a few multi-strategy funds which we think are decent investments on a standalone basis, but investors need to size those appropriately. There is a place for multi-strategy direct investments by pension funds, but it's more at the margin.
Dennis Buckley: I would've thought you do get value for money because you're in principle able to de-risk substantially by having a fund of hedge funds rather than a single-strategy fund, as Rob was saying. If you can find the multi-strategy manager who's going to be right at the top of the top quartile, that's different, but no one yet has guaranteed that to me, therefore a fund of hedge funds sounds like a much less risky proposition.
Olivier Cassin: Maybe the question needs to be re-phrased, because I don't know of any institutional investor who would replace a fund of funds with a multi-strategy single manager. To me the question is twofold; can it be replaced by a selection of underlying hedge funds and managed cleverly by the institutional investor at a lower cost?
It depends on the structure and level of sophistication of the investor. Something that's emerging as a competitor of multi-strategy fund of hedge funds is multi-manager products, so generally investment banks would put together ten or 15 traders trading different strategies, and offer just one layer of fees for that product. I am not suggesting it's a better option, but it's now part of the competitive environment and in terms of diversification it's a credible offer.
Jenny Blinch: Transparency is traditionally another big thorn in the side of hedge funds, is it still perceived as a big issue? How can investment through a fund of funds help mitigate this transparency issue?
Manuel Echeverr'a: There are strategies where the managers will be less transparent because they don't want to be copied, because they are taking market bets that are more directional, and they have to be early in and early out. But there are strategies in the arbitrage world that are very transparent. Sometimes that difference can be hard to explain to investors.
I feel that in times of crisis, such as the one we are currently going through where we want to have more transparency, investors like ourselves have an edge as we have long term relationships with our fund managers and this leads to more access and better transparency. In particular, crises like the one we're going through give our investors and ourselves as investors a big edge in terms of demanding more transparency.
Some of us have larger teams now, with people focusing exclusively on operational risk, investment risk and pure quant work. The challenge is demonstrating to investors how thorough that process is, so that they are comfortable with a fund of funds offering.
Des Hogan: Transparency is still perceived to be an issue for the institutional investor. It's important that the client is clear how much transparency they require when they start their manager search, so that both sides are fully aware of what is required and the appropriate level of reporting is agreed. Very detailed transparency requirements may limit your initial selection universe, but even this level of transparency is possible for large allocations.
Robert Howie: That's a good point. For a client I worked with recently, the final comfort factor on going into hedge funds was when they saw the sample reporting they'd be getting from the fund of fund manager, which was probably better than what they were getting from the traditional equity manager. The blue chip institutional funds of funds provide their clients with good reporting, in my experience investors understand how their portfolio's being managed.
Gary Enos: It all goes back to the risk/reward trade-off. There's a cost to the transparency and whether that cost is in the amount of your allocation or in the cost of your own infrastructure, it's there and it's different to what you have in your traditional equity and bond strategies.
Chris Greenall: As a fund of funds investor, you spend a lot of time researching managers, looking at how they stack up in peer group terms, if their operational infrastructure is robust, and whether they can provide an investment edge that's sustainable. From our perspective, we just want to make sure that they do what we've employed them to do, hence we spend significant resources collecting leverage data, sector data, geographical data, asset class data and the managers' top positions and trades. The client ultimately wants to see how all of this gets packaged up across the fund of funds. The challenge is how you take all this information and consolidate it. But in terms of regular consistent transparent reporting, it can be done if you've got the infrastructure in place.
Olivier Cassin: The sophisticated investor doesn't necessarily require 100% transparency: they want the right level of transparency to allow them to make a decision to redeem from a manager.
Laurent Seyer: On our managed accounts platform, transparency is one of the key features. At the platform level, we get full transparency from the managers. As Manuel mentioned, that's an awful lot of information, we've got 170 managers which makes about 45,000 positions daily, which we value every week independently, so you need huge infrastructure and proper systems.
Of course, investors are not interested in getting all the daily positions of all the managers. We provide them with aggregated reporting on the risks they are exposed to, and that's important, because the risks taken by hedge funds are volatile and extreme.
Des Hogan: One benefit for an institutional client who's investing in a fund of hedge funds that is transparent is that it's a good resource from which to get information on the rest of the investment market. The fund of hedge fund world is innovative, reactive and there are benefits for the institutional client in receiving information if it's clear and the pension fund can understand it.
Dennis Buckley: When we first started looking at hedge funds and funds of hedge funds, the perceived wisdom was that transparency was a real problem. However, by the end that wasn't a major concern to us. You pick your manager, you give them parameters and if they can report on what they're doing and why they're doing it then that seems to me to be sufficient. We certainly couldn't deal with streams of information, that's what we're paying our extra fees to the manager for, to deal with that and to alert us to problems and to provide us with a succinct report.
Manuel Echeverr'a: I have a question for Laurent. How often would you actually call the manager and say, ÔWe see here a concentration that we don't like?'
Laurent Seyer: We monitor it every week, but we don't do it in order to advise the manager of what he should be doing, we're just picking up the phone where we see something which was not part of the contract. Most of the blow-ups or the problems that we have seen in the hedge fund world you can summarise in two words - style drift.
We feel that our role with the managed accounts platform is to provide investors with this additional layer of security, check that the managers are doing what they are supposed to do, and that the investors are effectively exposed to the risks they believe they are exposed to and report back to them.
Jenny Blinch: How often do you review the hedge funds in your FoHF portfolio?
Chris Greenall: We get weekly estimates from all our managers and conduct detailed reviews on a monthly basis. We go over the leverage, exposure to market, what they're holding in terms of geography, sector and asset type, their positions, what's changed in their businesses. We meet the managers on a four-monthly basis to review the reasons we originally invested, to see what other changes are going on in their business, and we look at all the funds on a six-monthly basis from an operational due diligence perspective. It's a continuous process and if there are any issues out there that cause us concern we pick up the phone.
Manuel Echeverr'a: We also get a lot of information on a weekly basis. We have specialised teams that divide the coverage by hedge fund strategy consisting of analysts and portfolio managers. Because the hedge fund space has become a lot more specialised, we too are creating more and more specialists, by style and market. In the current situation, credit is what's moving the most. Our analysts are talking to managers at least weekly, just to understand what is happening.
Robert Howie: From an investor's perspective, this links back to our discussion on fees, and one of the things you're paying the fairly high fees to the fund of funds to do is to be completely on top of the underlying funds almost all the time. That means that as an investor, your monitoring is less onerous. We find most pension funds will review their portfolios on a quarterly basis rather than monthly, but the review will be more focused on understanding broadly where the portfolio's positioned and how it's being managed.
We also find that meeting with the fund of funds managers is important and talking through their ideas and the funds they're investing in and challenging that in the same way they would monitor their traditional equity or bond portfolios.
Des Hogan: But you can only go to that depth of questioning if you have some transparency. We suggest to our clients that they should, with our help, find out the reasons why investment decisions were made, why decisions are going to be made and what areas the fund of hedge fund is currently concerned about. You can only ask those questions if you have the necessary information.
Olivier Cassin: It's an area that regenerates itself rapidly, so we believe you have to be in the market constantly and there are hundreds and hundreds of funds that you need to look at. Good stories five years ago are not necessarily the best stories going forward, so being in the market and seeing all the funds and the evolution of the different players is important to us.
Des Hogan: There is confusion between quantitative information and qualitative information. Quantitative information can hide a whole series of underlying risks, and we've seen this even with brand names like the Bear Stearns high grade structured credit strategies funds, where returns were particularly good until the credit problems occurred. There has to be a balance between looking at the quantitative information and having some qualitative understanding of the underlying risks as well.
Olivier Cassin: I agree and being in the market constantly, meaning being more open to new ideas, ideas with a shorter track record, means you have to consider qualitative aspects because you don't have much quant data to rely on.
Chris Greenall: We also have to be more aware of our competition and ensure that when we're talking about our funds, we provide the niche that we think we play in and clearly differentiate ourselves. I have heard that there may be 2,000 funds of funds out there competing for the 10,000 underlying hedge funds. In that sort of commoditised, overcrowded space if you don't have something unique you're really going to struggle.
Dennis Buckley: I would've thought that most institutional investors would have to rely on their consultants. We certainly do and they've been quite frank in saying that this is a newish area, so the data on who's going to be good long term is difficult to come by. You've got to know when to get in and out and we would use our advisers in helping us pick any manager, but a fund of hedge fund manager in particular.
Des Hogan: We accept the fact that you're not always going to, as an institutional client, pick the very best fund of hedge funds, but the intention is that you'll still choose one that will meet your objectives. What you don't want is a significant change to occur within that fund after you've made the investment without you being aware, so ongoing monitoring is necessary and this is where the investment consultant's skills are required.
Jenny Blinch: In terms of pension fund appetite for funds of funds, the larger pension funds tend to be more sophisticated, so you might expect them to have bigger investments in this space, but does geography play a part?
Robert Howie: In the UK market, we've seen the big investors either make investments a few years back or decide not to make investments, and most of the work we're doing today is with medium-sized clients that are in catch-up mode. In the rest of Europe, we've seen a growing interest from German clients.
Chris Greenall: Yes, in the UK there's much more activity from local authorities, particularly from those making their first investments into hedge funds, which favours the low volatility approach. The more experienced investors are looking for niche, or specialist strategies, hence we are seeing lots of interest, for example, in dedicated funds in the distressed space or in the restructuring space, where many have identified that there may be an illiquidity premium for those willing to accept non-standard liquidity terms in funds of funds.
Gary Enos: In the US, what we've seen mostly is the big pension players moving from just using funds of hedge funds into managing some selected managers and, in some instances, even moving towards direct hedge fund strategies themselves. That's a situation where they self-manage their money, they're comfortable in that space and they've been there five or six years. Investors are also recognising that allocations of 2% or 3% aren't going to make a difference, so they're either freezing or doubling their investment.
Des Hogan: We have seen pension schemes looking at funds of hedge funds for the first time and also those looking to increase existing allocations. We have also started to see some larger pension schemes considering direct investment in single hedge funds as a means to reduce ongoing fees.
In a lot of situations, they've decided this is not what they want to do right now, but they may invest in single hedge funds in the future. Therefore we think it's an important part of their selection process that they find a fund of hedge funds that is aware of their long term objectives and is willing work with them to achieve their goal.
The reward for the fund of hedge funds is that the overall allocation will increase and they will still probably retain some investment relationship with the client.
Gary Enos: Yes, I don't think we'll see them getting into the breadth of a multi-strategy situation, but certainly the toe in the water is there for 120/20 or 130/30 to get used to the idea.
Manuel Echeverr'a: A question to the consultants. In the context of the current market conditions and assuming that some of the private equity investments made in the past two years are not going to look as great as they might have looked on a mark to market basis, do you expect big pension funds to move towards funds of hedge funds? Or do you think the allocation between private equity and funds of hedge funds will remain static?
Des Hogan: There's a general acceptance that private equity returns will not be as exciting as they were in the past. We are currently seeing higher allocations to funds of hedge funds than private equity, but whether these allocations would have been invested in the private equity space is hard to tell. Clients are also wary of being locked in and being unable to redeem from private equity funds should they become dissatisfied.
Jenny Blinch: Have any other trends emerged recently?
Laurent Seyer: I believe dispersion in fund of hedge fund performance will increase. It already increased last year, especially if you look at the Sharpe ratios. There are high profile funds of funds which posted significantly below 10% returns and there are a few that posted 12% to 14% returns with volatility around 5%, so that will continue.
Secondly, at the single manager level, the mortality rate will increase. We don't need 10,000 hedge funds; there is a flight to quality amongst investors so there will be a concentration of assets in the best managers and therefore mortality rates will increase, which means investors will need to be even more cautious when monitoring the risks when they invest into hedge funds.
Lastly, I believe the requirements from investors for quality of reporting will continue to increase.
Olivier Cassin: We could expect more money to pour into the alternative bucket as a whole and therefore funds of hedge funds should benefit. As a function of that, there's more segmentation. We're seeing high volatility and niche strategies or single strategies on a fund of fund basis. If we look at the most sophisticated managers, at what's being done in the US or in Canada, some clients are thinking seriously about going direct for some strategies.
Manuel Echeverr'a: From a top-down perspective, we are currently living in an enormous bubble that is in the process of bursting. There will probably be lots of opportunities in the credit space as we have seen in past crises, and hedge funds will play a key part.
I believe that allocations from fund of hedge fund managers, such as ourselves, to managers in the credit space will increase and the multi-strategy managers will probably move away from equity strategies to credit. I expect the liquidity situation will get worse and we are going to have to assist our investors in understanding that situation can actually be for the long term benefit.
Chris Greenall: If the bad news solves itself in the next three months with banks and counterparties illustrating what losses are on the table, then it could be a particularly good year for funds of hedge funds. On the event-driven side and the distressed space in particular, normally cycles like this favour that type of strategy.
Robert Howie: Investors expect their fund of fund manager to deliver returns in excess of cash after fees. If this year turns out to be a complete disaster, they'll be looking for their manager to protect capital, at the very least.
Des Hogan: I agree, this is going to be a more volatile year as far as markets are concerned and it's an opportunity for funds of hedge funds and hedge funds to deliver on what they say they can deliver, and that's to limit the downside. This year we'll see more promotion of hedge fund replication products and - as I said earlier - pension schemes need to be cautious about investing in this area until the funds have experienced some sustained real returns. On the distressed debt side, I think we'll see some opportunities towards the latter end of the year.
Gary Enos: I don't think investor confidence is going to be shaken in this sector. Every year we see the annual article on whether the hedge fund bubble or fund of funds bubble will burst. I expect we'll see those articles again, but the fact of the matter is people are still at low levels of allocation to alternatives in general in the pension space, and I would expect those to increase based on the fact that the other sectors are underperforming and they're looking for alternatives.
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