Investment Management: Portfolio Diversification, Risk, and Timing--Fact and Fiction (Wiley Finance)

The Wiley Finance series contains books written specifically for finance and investment professionals as Investment management: portfolio diversification, risk, and timing—fact and fiction / by Robert L. Hagin. p. cm. ISBN .
Table of contents

In looking at the total size of the hedge fund industry, the correct benchmark must be to consider total market exposure, not total equity or total assets invested in funds. This represents the capital at risk for on—balance sheet positions, not including off—balance sheet derivatives or credit default swaps of other leverage vehicles. In reviewing the fund of funds industry, the story is a bit skewed. Clearly, as investors gain access to hedge funds, fund of funds have gained the greatest share. We have posed a different question that many investors have raised: The existence of high fees or a second level of fees is the most often cited barrier to investing.

This comment continues to be made quite vociferously in light of the Madoff mess. However, fraud aside, longer-term fund of funds investors generally seem to be more satisfied than new investors. We believe that criticism of the extra layer of fees, while based on reality, is unfounded given that seasoned, committed fund of funds organizations play a vital role in portfolio management for a diversified pool of hedge fund strategies.

Of course the Madoff situation has caused many to question whether and how managers allocate assets. While fees are always a sticky subject, we say once again that the only people complaining about fees are those who cannot charge them. In short, you get what you pay for; therefore, make sure you pay for what you are buying and vice versa. Even if the fee issue is not enough to deal with, the other major concern is transparency. There are too many views on this subject to comment completely about it in this chapter. We will deal with transparency later on; however, it must be said that transparency is important and cannot be overlooked.

Therefore, you should ask questions, get answers, and make sure you understand what is being said. If not, you could end up in a Madoff situation, a Tremont situation, or a Fairfield Greenwich situation. And while the jury is still out on the last, everyone knows, unfortunately, what happened with the first. CHAPTER 4 Hedge Fund Investing T he crossover or convergence of hedge funds and private equity has provided new opportunities for investors and managers to work together and extract profits from the markets.

However, as the convergence has occurred, investors have raised many questions and concerns about how their money is being managed. Managers will generally use pricing obtained from publicly available sources as well as from proprietary sources from the prime brokers or administrators. The Wall Street dealer community also provides pricing data to the manager. In less liquid or illiquid positions, the challenge is different.

Description

The purpose is to reduce the risk of mark to market bias by managers by addressing three issues: This is easy for companies that are quoted on a stock exchange. Level three may require using a model to price the position and to consider when selling the position. This would include taking the current market pricing and liquidity into account for the pricing, even though the position may have no market and no resulting liquidity. Most hedge fund managers would argue that the value is unchanged, given that there is no known market and the value has held up, because no deterioration of the credit has occurred despite the change in market liquidity.

Illiquid Securities The greatest challenge for hedge fund investors traditionally had been the pricing of illiquid securities, but the introduction of FASB in presented a new wave of issues for hedge fund managers and the U. Now being holders of private equity comparable to longer locked positions, investors who seek liquidity have found pricing to be a major issue. This was never more evident then in the waning days of and the early part of , when investors who experienced massive losses from pretty much all investment strategies demanded redemptions for their underlying hedge funds and fund of funds.

Many large hedge funds chose to limit or suspend redemptions, stating that the prices in the marketplace were simply not correct or that fund managers could not execute sales at prices that were acceptable or at reasonable price levels. Many fund managers put in place a little-known item in their private placement memorandum called a gate.

The gate provision allows a manager to limit or shut off redemptions for any investor, based on the idea that to allow one investor out, he or she could be wreaking havoc on the portfolio and causing other investors to suffer. The suspension of redemptions and the use of gates caused quite a stir in the popular press and, more significantly in the hedge fund investor Hedge Fund Investing 33 community during the second half of and the beginning of Apparently, many investors believed that managers were not necessarily acting in the best interest of investors when they used their ability to gate the fund and suspend redemptions and were really only acting on behalf of themselves.

It remains to be seen how investors will react to fund mangers who used gates or suspended redemptions. The reality is that some managers will suffer for their decisions and others will thrive. It comes down to their ability to communicate why it was necessary to take the action in the first place. With the press continuing its vicious attack on hedge funds by publishing successive negative reports on these investment vehicles and the wizards who run them, many hedge fund investors seeking refuge from the onslaught from their own peers have started to separate the myth from the reality of hedge fund investing.

Unfortunately, we have found that no discussion of these soughtafter investment vehicles is complete without listing a few of the most important, influential, and interesting myths that prevail in the marketplace. With most fund of funds averaging more than 20 different manager positions, a wide range of exposure to different strategies, sectors, and managers provides a riskreducing tool for fund of funds investors. When Amaranth imploded, the rest of the capital markets barely yawned because of the wide diversification of exposure.

During the final three months of , hedge funds globally were selling massive amounts of securities across all asset classes to meet year-end redemptions, but traditional long-only investors were dumping as well as investors who sought the safety of cash. The reality is that because each and every market is so intertwined, there is probably no single fund or group of funds that could cause the financial markets to collapse.

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Even though the Madoff affair provoked considerable discussion and debate among investment professionals, the staggering losses it caused did not move the markets. However, it is fair to say that as the markets become more and more intertwined, large fund complexes can move markets—and that they do. Total and utter destruction is not something that is likely to be created by a fund manager; most managers simply have decided to leave that up to their respective governments.

Hedge Funds Are Dangerous Because They Use Derivatives Because the use of derivatives is highly complex and depends on the underlying development, creation, and analysis of quantitative models, the use of derivatives is limited to sophisticated investors, including hedge funds that have specialized staff to analyze these positions.

When used as hedging vehicles, derivatives generally lower portfolio volatility and also offer a cost-effective methodology to reduce risk. If used to make big bets, derivatives may raise portfolio volatility to higher levels. Simply put, nobody really knows how to define the impact of derivatives on a portfolio, because to do so one needs to know the extent to which these contracts are being used.

In some instances, with levels of leverage, derivatives can cause massive problems for the fund and its investors. In other situations, the use of derivatives can add significant alpha. The reality is that not all uses of derivatives are bad; when used appropriately, derivatives are an important part of the capital markets. The Use of Leverage Is Bad Most hedge funds use no level or limited levels of leverage to extract opportunities from the marketplace.

Most individual investors regardless of size can borrow up to 50 percent of their holdings. This includes the amounts that individual investors can use in Hedge Fund Investing 35 their brokerage accounts as well. While some funds such as traditional fixed-income or mortgage-backed securities arbitrage funds use higher levels of leverage, the use of leverage peaked in when managers were able to borrow as much as 12 to 15 times the value of their underlying securities.


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Now, in light of the current credit crisis and decrease in leverage mandated by banking examiners, the numbers have been dialed down considerably; in , most fixed-income managers are able to get 3 to 10 times in leverage. Two things seem funny to us when the discussion turns to excessive leverage. First, leverage is nothing more then borrowing; most Americans use leverage every day when they buy a home or a car or use the plastic card in their wallets. Furthermore, it was the excessive use of leverage by the traditional banks and the investment banks—often more then 25 to 30 times their balance sheets—that many believe is to blame in part for the credit crisis and the economic havoc that taxpayers around the world were being forced to deal with in early Hedge Fund Strategies Are Niche or Quirky Hedge funds are often viewed as being the extension of the highly guarded proprietary trading desks of Wall Street firms of yesteryear.

That is where creative minds were able to exploit market inefficiencies and capitalize on the large capital base and distribution capability of the investment banks to earn massive profits for their shareholders. As hedge fund entrepreneurs develop their business models, the key is to be able to replicate the style and strategy of their former shops and then grow the new hedge fund business franchise.

Hedge funds of today have replaced many of the proprietary trading desks of yesterday, because hedge funds answer only to their investors and the regulators. Today, most investment banks have either merged into traditional banks or are themselves in the process of becoming traditional banks. As such, each is no longer able to put capital at risk, and the risk takers have been replaced. Hedge funds now fill this crucial area of the capital markets.

They pick up where Wall Street left off. Hedge Funds Are All-Day Traders Using Nonpublic Information As the hedge fund industry has become more globalized and trade less liquid positions in many strategies, the holding periods for securities have grown longer and longer. As investment returns have moderated, hedge funds are looking for less-trafficked ideas, many of which are longer term. Because of the growth in the number of hedge funds since , market liquidity has increased.

New financial products such as weather derivatives or investments in private equity and real estate have provided financing for many projects that have unique funding requirements, with financing coming from hedge funds. Many of these trades are not covered by traditional rules regarding disclosure.

However, most funds discuss transactions as they relate to the overall performance of their fund. Furthermore, in light of some of the insider trading cases that have been prosecuted in New York and other jurisdictions over the past few years, it is clear in the minds of many that there is a clear distinction between what is and what is not public information, including the ramifications for disclosing nonpublic information to those who can profit from it.

The Securities and Exchange Commission, regardless of the lapses manifested in the Madoff situation, takes quite an aggressive stance against trafficking in nonpublic information. Let us just say this: When investors demand a decrease in fees, the fees will decrease. As such, hedge fund managers are providing a greater flow of information surrounding their investment strategies, with most providing position-level transparency. If a manager is not receptive to providing an acceptable level of transparency, investors should simply take a pass. However, the argument for the additional fees is that fund of funds managers provide a level of service and expertise that some investors cannot accomplish on their own.

Direct investing through single-strategy managers requires a significant internal expertise and substantial investment in infrastructure. The fund of funds fee should more than offset the resources that the fund of funds provides, including research, due diligence, ongoing monitoring, appropriate portfolio diversification, and risk reduction for the investor.

Choosing a fund of funds is right for some and wrong for others. The key is making sure you are getting what you pay for. In reality, fund of funds spend considerable resources and time and are reluctant to make changes to their allocations unless the strategy currently being pursued is no longer viable or changes have taken place within the organization that merit redemption. However, many fund of funds that have deliberate, comprehensive due diligence processes that are developed over a long period of time to identify strategies are welcomed by many hedge fund managers as sticky investors.

Many investors, including a small number of fund of funds, are constantly searching to find the next hot strategy and will jump from manager to manager in search of perceived or untapped alpha. Hedge funds want stable assets! Many hedge funds compare these sticky assets to core deposits in the banking industry, where depositors are looking for a full-service relationship rather than a rate and term for the cash.

Many investors will state that it is easy to start a fund of funds because the start up costs that constitute the main barrier to entry are relatively low. The reality is that to be successful, the fund manager needs significant assets to manage to make the business viable. However, before those levels have been reached, some fund of funds have difficulty competing in the marketplace.

The manager must be able to fund the infrastructure and staff in order to source, review, allocate, and monitor the portfolio of hedge fund managers, not to mention handling the day-to-day tasks of running the business. Fund of Funds Investors In light of the poor hedge fund performance in and , capped by the Madoff scandal, many investors have soured on fund of funds. Zwirn, along with the fraud of Bayou. There is no level of due diligence or regulation that will totally wipe out fraud or blowups.

These are natural occurrences. However, managers who cut corners by not completing background checks or operational evaluations make the situation even worse. The reason fund of funds make sense, are important, and are worth the fees is that investors are buying services that are too hard, too costly, and too time consuming to perform on their own. FEES As of year end , by our unscientific albeit straight-to-the-point exercise, fund of funds averaged a 1 percent management fee and a 10 percent incentive fee. Fund of funds are often criticized for this so-called additional layer of fees, but unless the investor is prepared to build out an investment, due diligence, research, legal, accounting, and reporting team, the fees are actually low.

Fund of funds managers provide a unique and specialized service Hedge Fund Investing 39 as portfolio managers. However, because the business is scalable, the business proposition continues to improve as assets under management continue to increase. As long as fund of funds are able to achieve higher than average returns with lower volatility, there is, in our opinion, sufficient justification for the level of fees that are charged by the manager.

Many fund of funds managers offer various arguments to justify their fees—arguments that we do not subscribe to. Access managers generally below the radar screen. Achieve above-average performance results. Discover new and emerging managers as well as up and coming strategies. The fund of funds manager is supposed to access closed managers, access undiscovered managers, and uncover new strategies. Nothing stated here would make a fund unique.

But these statements must be met with skepticism. Many investors like to claim that they have been the first to discover and allocate to the newest, greatest manager that no one else knows about. Still, the question is really one of capacity. The new, emerging manager may have a great pedigree, but no track record.

He or she may have capacity constraints and may not be able to run a business. Since fund of funds are quick to point out the ability to source new up-and-coming managers, size may be the biggest challenge to performance. Most strategies such as small-cap or sector-specific strategies may have size constraints; most large fund of funds have size constraints before allocating initial capital, or requirements placing a maximum amount of capital that may be committed to one manager.

If this is an issue, fund of funds managers will look at larger managers that can accept unlimited amounts of capital. In the wake of the Amaranth blowup, many fund of funds investors quickly discovered that while they had invested with different fund of funds managers to achieve portfolio diversification, many of the fund of funds actually owned the same Amaranth position in each of their portfolios.

Amaranth was a widely respected hedge fund with great pedigree, and it would have been smart to include it in a diversified strategy. As a result, investors may not place a premium on the research ability of the fund of funds manager to find new undiscovered managers because the manager has a capacity issue and can allocate only to larger hedge funds that have the ability to accept larger inflows of capital.

As an example, small-cap equity managers that are always looking for new companies with a unique edge in the market by researching companies that are not widely covered or followed are hedge funds that large fund of funds may not be able to utilize. Fund of funds managers that research and access small-cap managers or other specialized strategies are able to charge higher fees than the larger funds, given that the cost of discovering and allocating to new, emerging managers is more challenging.

At the same time, many of the large multistrategy managers are starting to look like fund of funds, further clouding the waters. When looking for hedge fund managers, fund of funds are looking for managers with a competitive advantage. That is not done with Hedge Fund Investing 41 published material or shared by others. BOUTIQUE INVESTING As the institutionalization of the hedge fund industry continues, this former cottage community of small, secretive boutiques is now morphing into large asset management firms that perform investment banking transactions, engage in commercial lending, and finance real estate, all the while managing large portfolios of global securities.

As a result, these large hedge funds are becoming some of the largest investment banking clients of Wall Street. He notes that no independent fund of funds is among the top nine ranked by assets under management and only one in the top 16 is an independent firm. Each of the largest is a part of a large money management complex. Remember, nobody ever got fired for buying IBM computers.

The same can be said for fund of funds. Consultants also provide a key role in the education of clients and consequently provide a different level of distribution of fund of funds for their clients. As the hedge fund industry grows and well-publicized frauds and blowups escalate, the need for greater transparency increases. Larger, better-capitalized fund of funds are able to develop state-of-the-art risk management systems and greater in-depth research staffs to analyze and conduct due diligence for newly created strategies. These efforts require a higher level of financial, legal, and regulatory oversight and come at a cost.

While hedge fund and fund of funds investors are always looking for market correlations or low correlation to major strategies and indices, one fact is clear: Critical mass is the major ingredient for growing assets, and many fund of funds are primarily concerned with growing with the masses. Weber and his colleagues have helped buyers enter markets, helped entrepreneurs sell their businesses, and helped parent companies divest their fund of funds holdings.

The motivation for sellers has been the need for liquidity or succession planning; pressure from a parent company or outside shareholder; or, as is usually the case, the need for greater distribution, greater size, or increased branding. On the other hand, buyers of fund of funds have been motivated by a need to enter the marketplace quickly, rather than trying to build out an organization, track record, and brand.

Buyers also want to gain product expertise and immediate presence in the industry. Most buyers want to capitalize on the brand and distribution capabilities of the acquirer as opposed to building it themselves from the ground up. With banks gaining an advantage over other financial services firms, it adds firepower for banking institutions to continue along the growth path of acquiring or building out alternative investment platforms.

Madoff Some of the questions that arose in the wake of the Madoff scheme were: What happened to the fund of funds? How did the due diligence fail or become so fooled? Why did the fund of funds fail to uncover the fraud?

4. Portfolio Diversification and Supporting Financial Institutions

The answer to all of these questions is simple. In an industry that has a global head count of more than 7, fund of funds at year end ,9 this means that slightly more than 1 percent of all fund of funds allocated to Madoff. It seems to us that the fees that Madoff paid to his investors were the major issue that caused allocators to avoid the strategy. The final reckoning on the Madoff situation is still to come, but one thing is for sure: In the end, the question that investors must ask is whether the cost of returns is justified by the large fund operators, or can smaller, niche fund of funds provide greater alpha by not increasing risk to an uncomfortable level and offering different levels of portfolio diversification.

It really comes down to what one believes and where one thinks benefits will come from with the allocation of assets. CHAPTER 5 Understanding Alternative Investing Is Both Math and Science T o evaluate the performance results of individual hedge fund managers and the consequent aggregation of results of a portfolio of hedge funds, it is necessary to look at and understand the major influences on or drivers of hedge fund returns. These investors believed prior to the market collapse that they had invested in a new breed of outstanding money managers.

Unfortunately, as technology stock prices fell, so did the value of many of their investments. The reason investors use or invest with a fund of funds is because they believe that the manager knows how to evaluate and decide who is and who is not swimming naked. But what happens when the market heads south? Which manager really has the skill set to profit from short positions? Or which manager has the exceptional talents and the conviction to identify trends, such as subprime, before the herd comes thundering through and early on establishes short positions in anticipation of a meltdown while the conventional wisdom is to be long?

Yield Curve Hedge fund returns are also driven by the shape of the yield curve. An upward sloping curve is good for the economy and stock prices, but it is especially advantageous for arbitrage strategies including convertible arbitrage, fixed-income arbitrage, and capital-structure arbitrage. There are many ways to attack these markets when things are on the rise. A flat or inverted yield curve creates a nightmare for arbitrage investors; it creates few opportunities for investors, because the markets are not moving or are moving in the wrong direction.

While declining interest rates benefit corporate balance sheets and earnings, rising interest rate environments present a challenge. A flat-rate environment with an upward sloping curve is beneficial to many types of fixed-income arbitrage. Credit Spreads Credit spreads also play an important role in hedge fund returns. As credit spreads widen, bond prices come under pressure, as we witnessed in the corporate scandals of and with the subprime meltdown of — Interest Rates With the globalization of the capital markets, most markets are linked, and as we learned in —, most markets are positively correlated.

Simply put, a problem in the United States is a problem in Europe, and so on and so on. It is has been an unwritten rule of Wall Street and the world that when the United States sniffles, the rest of the world catches the flu. As we write this book, the world markets seem to be using a lot of Vicks NyQuil. Volatility Market volatility is another factor that comes into play with hedge fund returns. This index reflects an estimate of future market volatility. In a market environment of low volatility, conventional wisdom would suggest that profit opportunities are strong.

However, a spike in the VIX can lead to wide swings in return. Hedge fund results have been best in years when the equity markets were calm see Figures 5. The short sellers are making investments that profit from the market moving downward. Managed futures managers profit from the spike in commodities prices that occurs when equity markets go down and investors look to gold, silver, oil, and other commodities as a source of returns. Unfortunately, our data concludes that these two strategies represent just 5 percent of all assets invested in hedge funds at the close of As an example, a price increase of 2 percent on a 5 times levered portfolio results in 10 percent gain on that portfolio.

However, on the flip side, a 3 percent price decline on a 5 times levered portfolio results in a loss of 15 percent and possibly more if the manager is forced to sell positions to meet a margin call from the prime broker or Wall Street investment bank. However, a combination of capitalizing in the change in several of these factors along with the acumen of the manager should result in profit for the investor.

The bottom line is due diligence. When performing due diligence, investors must weigh the results of the manager in light of the factors previously listed. Asking a credit manager how he made money while credit spreads tightened is a good idea. Or how did the fixed-income manager make money while the curve was inverted or flat? Or with a flat and declining VIX, how did a convertible arbitrage manager have extraordinary results?

Were there factors to drive the returns other than those listed in the marketing material or offering documents? One lesson that everyone has learned in light of the events of is that if something is too good to be true, it probably is; therefore, investors must ask questions and demand answers. A Short but Sweet Case Study During a recent due diligence exercise, we met a convertible arbitrage manager with high teens performance results in a year when the convertible arbitrage index was slightly positive.

After extensive questioning, he revealed that he had several positions in PIPEs private investments in public equities. Generally, these are illiquid private placements, difficult to price, and initially priced at a substantial discount to the public market. We took a pass. To reiterate, look at the results of each manager and compare the results to what has happened in the real world to gain a greater understanding of the source and repeatability of returns.

There is no excuse for not doing the work—after all, it is your money. For the record, marketing and distribution are synonymous with raising money. The reason it is called low-hanging fruit is because this sort of fruit is the most ripe. It is ready to fall to the ground. Once this list has been gone through, the manager will market the fund to a wide range of high net worth investors and institutional investors who the manager knows has some interest in what he or she is doing. Most managers try to build relationship upon relationship on relationship to reach out to and access as many potential investors as possible.

Unless the fund of funds manager has a large marketing staff with strong global relations—or a niche fund with a specialized strategy such as emerging markets, emerging managers, or sector-specific strategy—raising capital is usually done internally and is often the biggest challenge to success. They sit around and tell themselves and their colleagues that as long as performance is good and risk is kept in check, investors will seek them out. They believe that word of mouth from other friends and colleagues or other investors in the fund will magically cause investors to line Understanding Alternative Investing Is Both Math and Science 49 up at their doorstep.

It is, without a doubt, the most ineffective way to raise assets—one that reaches the smallest audience of potential investors. Included in the methodology is the belief that data mining by prospective investors, those who hunt through databases looking for fund of funds that meet a specific investment criterion, will find a fund and invest. Third-party marketers are companies or individuals who act as hired guns to raise money for a fund or fund complex. Besides not being well-versed in strategy details, many third-party marketers do not like the lower fees associated with working with fund of funds.

They find the compensation schedule unacceptable and therefore put little effort into a capital-raising assignment. Fund of funds fees are typically a 1 percent management fee and a 10 percent incentive fee based on a hurdle rate. This fee structure is much lower than those employed by singlemanager funds, and it reduces the amount of money a third-party marketer can earn working with a fund of funds.

It is our experience that the fees, along with the fact that one needs to know the direct investor e. Remember that third-party marketers are only as good as their relationships or ability to create relationships. If they are marketing a single-manager fund, they can target individuals, institutions, and fund of funds. However, if they are marketing a fund of funds, they lose one-third of their potential investors. The list of primary dealers reporting to the Federal Reserve has shrunk from 46 in the s to 19 today. What does that do to the outlook for hedge funds when Wall Street senior management teams decide that hedge funds present too much risk or too little profit?

Has Wall Street learned from past mistakes? In , the landscape is changing. The success of each of the Street firms when raising capital for hedge funds shows how valuable the strategic partnership with hedge funds and fund of funds can be. The math of the joint venture makes sense for both parties, but is it in the best interest of the investors? Sharing or recapturing 2 and 20 percent from a hedge fund is a lot better than the 50 or 75 basis points these firms earn managing long-only money. Given the proliferation of new investors looking for new ideas and trying to identify outstanding managers, investors must rely on intermediaries to identify investments and to perform sophisticated analysis and due diligence.

At the same time, global financial institutions and private banks are getting increasingly more involved because they, too, see the writing on the wall, regardless of recent meltdowns. Investors understand the need for investments that can go both long and short the market and allow their portfolios to grow regardless of which way the market is moving. Is there a higher payout for the internal product? These questions are ones that baffle many who work on the Street as well as those who are constantly trying to raise money.

The second question asks whether the solicitor is a sales agent, an advisor, or just a marketing person tasked with raising money. While many changes have been made in the post-Madoff period, sales conflicts are still prevalent in the current Wall Street model. The model is currently still somewhat broken. Our concern is that investors believe that because a product is being marketed or sold by individuals employed by some Understanding Alternative Investing Is Both Math and Science 51 of the most powerful and respected investment firms in the world, they have a false sense of security.

We hope that if Madoff taught us anything, it is to question everything. We believe that firms need to be more up front and transparent about their financial arrangements with the funds that they market. Investors need to ask the questions and get the answers. In the wake of the market meltdown of , we believe that investors need to have a greater level of transparency regarding their holdings.

The problem, however, is not getting the information or data, but knowing what to do with it. It is all fine and good that Congress believes that the Hedge Fund Transparency Act will bring a new level of transparency to the industry. But what are investors supposed to do with this data, how are they to use it, and what is the value of having it?

Many people believe that hedge funds will not provide transparency and are afraid of giving out data. To that, we say hogwash.

Investment Management: Portfolio Diversification, Risk, and Timing--Fact and Fiction

The managers will provide the information; the question is, what does the investor gain by having it? Also, in light of Madoff, we now have to question the accuracy of the information. However, this last point will be covered later in the book. For now, assume the data is accurate and that one knows what to do with it. These are tough questions to get answers to, and many have a hard time asking the questions and demanding the answers before they invest. This is the reason people invest in fund of funds. Their job is to do the due diligence, pick the managers, and deliver returns.

It is what you pay for, and it is their job. And while that is all well and good, another interesting trend that has developed in the last few years in the funds of funds industry on the part of institutional investors is the use of fund of funds as a tool to find new, exciting, and emerging managers. The investment premium of the fund of funds is lessened as the investor starts to allocate away from the fund of funds. Selecting a fund of funds that is right for your assets is a process that takes place over a period of months—and in many cases, years.

It includes checking references; checking service providers; and hiring independent firms to perform background checks on the people who run the company, pick managers, and handle the money. It is not easy, it is not fun; it is work, and it is worth it because it is your money! Many believed prior to the Madoff revelation that institutional investors and their consultants applied a more rigid process of scrutiny and due diligence to asset allocation because of the nature of the source of funds. However, in light of the losses that pension plans, endowments, family offices, insurance companies, and their advisors experienced with their allocation to Madoff, it appears that due diligence has been lackadaisical and a smoke screen of sorts to a small percentage of hedge fund investors.

This cannot, should not, and hopefully will not continue. Managers, both single-strategy and fund of funds, must understand the decision-making process and the need for independent evaluation of the firm during the marketing process. While most fund of funds and hedge funds meet the expectations, many investors report negative experiences in dealing with the marketing individuals and teams at the firms. Attitudes, arrogance, and annoyance are often quite prevalent. It is not a good or bad thing, it is just a thing. There is little, if any, glory in sales, and many fund companies seem to have a revolving door when it comes to their marketing staffs.

There is clearly a shortage of experienced institutional marketing professionals relative to the size of the market. The marketing phase takes place over a long period of time, and personnel changes are common at both the investor and the consultant level. Equally important is the fact that investment strategy education is critical, because many investors may be first-time investors, and constituents of the investment process may be time constrained. Understanding Alternative Investing Is Both Math and Science 53 Asking Questions As basic as it may sound, the most effective marketing question that should be asked by a fund of funds professional to potential investors is: What are their investment needs and their expectations of the investment?

On the flip side, an investor should ask what the stimulus for firing or redeeming a manager is and when was it last triggered. Meeting with key investment and risk managers of the fund of funds organization should provide a high level of comfort in the decision-making process regarding the portfolio. However, you need to go deeper than a couple of meetings.

Interaction between the fund of funds and its investor provides many with a high level of satisfaction, but satisfaction is not enough. You need to get documents, meet the accountants, and perform background checks. There are many people who say that Madoff would never have passed their investment test; however, there are even more who are considered serious hedge fund and fund of funds people who got caught in the fraud.

Getting Answers Fund of funds must be able to plainly explain the difference between their strategy and that of other firms and to demonstrate where they can and do add value. It is more than a matter of a few basis points here or there. Many fund of funds are accustomed to bringing armies of analysts to hedge funds during the due diligence process. This can be a smoke screen. It is nothing more than an appearance that work is going to be done.

We believe that the manager should bring only senior representatives, including a decision maker, to the meetings—that is, the people who have a role in the funds management process and understand the investment process. Too many cooks spoil the soup. After screening various databases for fund of funds according to predetermined quantitative requirements, the investor or consultant will follow up with on-site due diligence to meet prospective managers. In addition to meeting key investment personnel, operational staff, and legal and compliance personnel, the prospective investor should feel comfortable that the investment philosophy and strategy had been well articulated by all the people involved.

When reviewing the investment portfolio of hedge fund managers and strategies, the investor should understand the flow of information and how the best ideas make their way into the fund of funds portfolio. The Due Diligence Process One of the most effective tools used as well as abused as part of the research and due diligence process in identifying managers is the Request for Proposal—RFP in the vernacular.

In the world of asset management, the RFP was originally intended to be an invitation for an asset manager to submit a proposal to a prospective investor who was conducting a search for a specific investment mandate. They would then patiently await a favorable response from the prospective investor. Many financial publications such as Pensions and Investments advertise classified notices of current investment requests for proposals. Each RFP has a unique set of questions in which the manager lists performance history, the background and experience of the firm and its principals, legal structure, fee structures, investment process, and risk management systems.

RFP questionnaires can range from 15 or 20 pages to 50 to 60 pages. Many of the large hedge funds and fund of funds have staffs charged with the sole purpose of completing RFPs. As the hedge fund industry has matured, the RFP has taken on a life of its own. It is now used as a primary marketing tool by hedge fund managers. In short, it consists of words instead of pictures. While managers are proud of the hours spent by a staff of designers and analysts who insert the graphs, performance charts with peer group comparative results always showing the manager in the top deciles or quartile , org charts, and all biographies, the RFP is nothing more than a long-winded document that looks about as interesting as any printed page.

The consulting industry, along with other direct investors, now ask or request an RFP to obtain all of the information relating to the manager and strategy as the first step in the due diligence process. It provides concise data in a format that will provide investors with the opportunity to fill in the blanks with a standardized format. Size, it seems, matters here as well. One of the issues that concerns managers is that the RFP is considered to be a marketing piece and must be reviewed and approved by legal counsel prior to dissemination to potential or existing investors.

Since hedge funds are prohibited from advertising, each manager and the legal staff must be prudent about the content of these documents and safeguard the information being provided to both qualified and unqualified investors. The lawyers are really sticky about this point. Ongoing Monitoring Once the decision to invest has been made, it is important to follow up. Ongoing monitoring should include spending time with the key investment professionals and being provided with interim reports that describe the prior reporting period.

Updated RFPs should be received and reviewed to determine what changes have been made since the last written report. The information should also detail any changes that occurred to the portfolio during the prior period as well information on expected changes to the portfolio. In addition, the fund of funds manager should notify investors of any personnel changes, including key hires or departures and commentary on performance results. If it appears too good to be true, it probably is. These rules apply not only to investing in hedge funds, fund of funds, or private equity funds but to all investments.

It is your money, you worked hard for it, and you deserve to have it managed properly, ethically, and as described. Ask questions and demand answers; if you do not like what you hear or receive, go someplace else. There are plenty of smart, sophisticated people who will do the right thing; you must do your work and find them. This is essentially the same investor base as hedge funds have, with the newest large entrants being public and corporate retirement pension funds globally.

Hedge fund investors are typically looking for an investment vehicle that meets one of the following requirements: Historically, this group has been more visible in hedge fund investing than most other institutional investors, given that there is a requirement to make distributions of a fixed percentage of assets annually— and higher—consistent returns were required to meet this stated mandate. Family offices with substantial assets were also early to invest in hedge funds and fund of funds.

While the global macrostrategy employed by famed hedge fund managers George Soros, Julian Robertson, and Michael Steinhardt was the dominant strategy pursued during the s, many family offices recognized the need to diversify into other asset classes and less frequently adopted investment strategies. Our research tells us that all but a few family offices had the capability of identifying new and established managers in the fragmented and unfamiliar hedge fund universe. Most of this was done through word of mouth or through connections through the country club and other social settings.

During the early s, several fund of funds were being launched and were struggling to raise capital and to form infrastructures for the early phase of building out their businesses. This resulted in an unlikely partnership between fund of funds building new firms and looking for capital and family offices with capital to invest, and searching for hedge fund managers. It was the beginning of the relationship for several different family offices that have since dominated the fund of funds of industry and have consequently built very strong investment companies that invest in hedge funds.

This enterprise of cooperation was a good fit, because the larger family offices resembled larger institutional investors in the early developmental stage. This was probably the beginning of the convergence of private wealth management with institutional assets; everybody everywhere, regardless of asset size, was looking to hedge funds for alpha.

These investors were happy to invest with a fund of funds to learn the skills and to determine who the new managers were and what they were doing to extract profits from the market. A second benefit that this partnership offered was the ability of the investors to acquire the tools necessary to find new managers and gain access to a community they otherwise did not know.

Since many family offices were started by successful entrepreneurs, these investors were and still are willing to invest with new managers that lack a long and seasoned track record if the family could thereby gain an additional advantage in the marketplace. The investment objective for his portfolios was to diversify away from the risk of the public markets and several large concentrated equity positions that were held by several members of his families. As Trip started to look at hedge funds, he met two financial services veterans who were both starting their own new fund of funds.

Both needed capital, and both also wanted to expand the relationships that they had. Trip had capital, and he wanted to get his feet wet in hedge funds and Why Fund of Funds Work 59 thought that this relationship would be beneficial to both parties. The results turned out to be worth it. At the time, fund of funds returns, like those of hedge funds, were quite strong during the early years of his organization.


  • Fund of Funds Investing: A Roadmap to Portfolio Diversification (Wiley Finance).
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    • The gamble paid off. Capitalizing on the benefit of the relationship with the start-up managers, Trip has since expanded into direct hedge fund investing. The results have achieved the investment objective of each client, and they also preserved wealth during the technology meltdown of — He found that the fund of funds became overdiversified during this same period, and he now does all hedge fund investing direct with managers.

    In short, his enterprise has become a specialized fund of funds. As a result of interaction with many family offices, fund of funds have come to the forefront with many first-time investors like Trip Samson or those looking to gain a toehold in hedge funds without hiring a team of seasoned professionals. Since family offices are often very knowledgeable and not hesitant about paying for outstanding investment talent, many have also moved into direct investing while still maintaining relationships with fund of funds as an extended research resource.

    In general, family offices are concerned more with customization of the portfolio rather than the low volatility that other, more traditional institutional investors seek through hedge fund investments. They also like the greater tax efficiency of long-term holdings that may be realized through the customized portfolio rather than the greater diversification of an investment into a fund of funds directly. When investing in fund of funds, many family offices prefer niche strategies such as emerging markets, distressed investing, or specialized areas e.

    High net worth and family office assets are growing globally; regardless of market turmoil and fraud, assets from this group of investors will continue to flow into hedge funds and fund of funds see Figures 6. One of the unique aspects of family office investment mandates is that they are not as institutionalized as other institutional investors; they usually report directly to the senior family members, who are quicker to complete the due diligence process and make investment decisions. This is good for both the investors and the investment managers who receive the allocation.

    That being said, one group of investors that has been pushing industry growth forward in the past few years has been large-state pension plans. Large-state pension plans are massive pools of capital; clearly the biggest boys on the street. They know it, they use their size, and people respect them. Hedge funds are similar to private equity funds in that both are considered lightly regulated as compared with mutual funds and have limited periods of liquidity; most importantly, both structures permit investors to invest alongside of those who are actually managing the money.

    Similarly, investors should ask this question of the fund of funds managers if they are looking to allocate to their fund. As hedge funds and particularly fund of funds have grown, many of the largest funds are now starting to resemble mutual fund organizations, and the question arises, is this just a marketing organization, or is it an investment management organization?

    Most mutual fund managers are in the asset-gathering business, not the asset management business. They get paid for assets under management, not performance. Request permission to reuse content from this site. Product not available for purchase. Description A new look at the important issue of investment management in the 21st century Written for professional and private investors-as well as fiduciaries who rely on investment professionals-this book presents the content of an advanced investment-management course in an easy-to-read, question-and-answer format.

    He is a former academic UCLA and the Wharton School , a thirty-year veteran of the investment management industry, and the author of three books about portfolio management. He currently designs innovative hedging strategies, publishes his monthly Investing Insights, and consults with public and private pension funds and endowments in the United States and Europe. He is especially well known for his ability to cull academic research for insights that are useful to investment professionals, fiduciaries, and consultants, and to translate these insights into practical action-orientedadvice. Permissions Request permission to reuse content from this site.

    Getting Started—Your Tool Kit. What You Need to Know. Law of Small Numbers. Can Analysts Forecast Earnings Changes? Earnings Forecasts and Torpedo Stocks.