Andrew Gibson argues well diversified multiple strategy funds of hedge funds are the best way for pension funds to access hedge funds in these turbulent times
Achieving stable or positive performance during periods of market volatility depends on the skill of the hedge fund manager in managing stock, sector and market exposure, its discipline in risk management and the appropriate use of leverage. For multi-strategy managers, the rapid redeployment of capital across strategies is a further means of protecting capital during periods of volatility.
An experienced investment team will approach current markets with a cautious and conservative investment style, placing heavy emphasis on due diligence, risk management and monitoring.
From this perspective, there is no doubt some hedge fund strategies' current conditions are very difficult. This is due in part to the subprime fallout and to significant capital chasing too few attractive investment opportunities. Some managers have employed levels of leverage and adopted strategies which, with the benefit of hindsight, have not produced the desired results. This will lead to the withdrawal of capital and some further market discomfort (although this in itself can provide opportunities). Finally, there have been some new hedge fund launches of questionable quality that have attracted significant capital at a very early stage. It is precisely these factors in the current markets that are contributing to the highly persuasive rationale for choosing a diversified (rather than specialised) approach to hedge fund investing.
Investors are initially attracted to the hedge fund arena to provide a level of diversification within their portfolios. Hedge fund assets offer low correlation to traditional markets and consequently contribute to better risk-adjusted returns. However, having made the decision to diversify into hedge funds at the portfolio level, it is essential to select the most appropriate hedge fund vehicle. Asset management firms have responded to these demands by providing a selection of products, all of which are designed to appeal to the cautious institutional investor by allaying their fears of the perceived risk of a lack of diversification and aiming to deliver performance with an appropriate level of volatility. Three of these options are analysed below.
Single strategy fund of hedge funds
Single strategy funds of hedge funds (FoHFs) invest in a selection of single hedge funds, all of which operate within one particular strategy area. These categories span a risk spectrum ranging from 'low market risk' relative value to 'high market risk' trading strategies. The most important aspect of the single strategy FoHFs is the increased level of risk resulting from specialising in one particular type of strategy. Clearly the use of many managers will improve diversification along one axis of the risk matrix, however, the choice of strategy will greatly influence the potential risks.
Single strategy FoHFs are specialists with fund of fund strengths in respect of diversification, flexibility and strength of analytical resources, but they are more susceptible to market shifts and capacity issues, where there is a very real danger in some strategies that a short supply of top-level hedge funds will limit investment capacity. Additional risks lie in the levels of correlation between the hedge funds where it becomes more important to mix manager investment styles and geographic allocations. This then helps to mitigate the risks for 'herding' in the trading activity, resulting in a level of internal market correlation existing between the underlying hedge fund managers.
The differences highlight the risks attached to making the more specialised investment. Investors should view single strategy FoHFs as a replacement rather than a complement to their overall portfolio allocations, eg a long/short equity FoHF should be viewed as a replacement for traditional equity allocation.
Multi-strategy hedge funds
Multi-strategy hedge funds comprise a combination of different strategies and aim to achieve the same level of diversification as the FOHFs within one product. However, with this strategy the investors are exposed to the operational risk of a single organisation running the investments.
The multi-strategy category is emerging as a 'catch-all' category of hedge fund strategies, and is increasingly applied to managers who are stretching their original classification and seeking opportunities in new markets. Style drift is a key concern when monitoring managers and the evolution of the multi-strategy classification allows a manager the flexibility to explore various markets.
The risks rest primarily in the operational area, with one organisation providing all the investment expertise. In addition, with all the skills residing in-house, there is both a risk the quality of the in-house managers is not optimal or the choice of invested markets is limited by the expertise available and not truly flexible.
Well diversified multiple strategy funds of hedge funds
IAM believes that the optimal solution lies with a well diversified multi-strategy FOHF where there are several underlying hedge fund managers across a range of six to 12 investment strategies. Consequently they provide the potential for strong positive (alpha) performance in variable market conditions across a wide range of markets.
The FOHF firms' strengths lie in their greater resources able to focus on risk management and control, but these must be matched with confident and active management. Well diversified multi-strategy FOHFs are good for those investors with very specific risk requirements who plan to use hedge funds to complement their existing portfolios, optimise risk and deliver consistent returns as a form of risk control.
- l Risk management - FOHFs control risk at the selection stages of manager analysis and, once a portfolio is constructed, they manage the risk exposures of the portfolio through robust stress testing, correlation analysis and detailed quantitative measures at the portfolio level;
- Consistent returns - Actively managed FOHFs are able to contribute to the overall portfolio in all market cycles, aiming to preserve capital at times of market turbulence;
- Diversification - FOHFs can use diversification within a portfolio across both the strategies and the individual managers to manage the levels of volatility or return an institutional investor requires;
- Expertise - The FOHF manager has networks of industry contacts and access to investment opportunities which would be hard to match on an independent basis. This is combined with experience and investment expertise provided by a team of research analysts and risk management specialists, supported by advanced proprietary systems;
- Flexibility - The investment manager can actively manage the FOHF portfolio in an opportunity driven style, a key factor when responding to changing markets.
Where the multi-strategy single hedge funds are constrained to use in-house managers for the various strategy sections of the fund, with the potential result of a sub-optimal product, the FOHFs are able to invest independently and with the best managers available. They also have the flexibility to move their investments when the underlying managers do not perform or when there is a better alternative.
In dealing with the FOHF investment firm, the pension fund is dealing with the equivalent of another institutional investor who will implement the same high levels of due diligence and rigorous operational risk management to ensure the investments are successful. The interests of the FOHF manager in undertaking detailed analysis and selection are very closely aligned to those of their clients.
While it is critical the FOHF manager maintains the expected risk/return characteristics,it is important to keep in mind that these are medium to long term investments and performance targets should be measured over three to five years. In current markets, pension funds should ensure they look at investment managers with the following criteria:
- Extensive experience of different market cycles;
- Proven ability in managing well diversified portfolios along with a strong and long track recor
- Demonstrable flexibility of skills and commitment to active portfolio management;
- Dedicated resources for research, monitoring and operational risk management;
- Strongly held commitment to communicate regularly and openly with clients. This communication should include access to hedge fund managers for occasional meetings and market briefings, and ability and willingness to undertake educational training to ensure the growth of understanding and comprehension.
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