Don't settle for second best

Investors need to take extra care when crossing over to multi-strategy funds ' managers may not be all they're cracked up to be, lacking the relevant expertise

Investors turning to single manager multi-strategy funds over fund of hedge funds could be stuck with a manager who has only taken a multi-strategy approach to raise extra cash for his fund.

Speaking at the Global Alternative Investment Management conference in Geneva last month, Nicola Meaden, managing director of Blackstone Group International, which has $5bn in funds of hedge funds assets, says some fund managers have turned their single strategy funds into multi-strategy offerings to gain access to a wider pool of investors. They often did this, she says, without possessing broad expertise in different strategies and to the potential detriment of customers at a time when the difficult markets demand greater familiarity with the various strategies.

The safer option for investors to gain access to different strategies was to buy into a fund of funds structure, she says.

While funds of funds invest in portfolios run by a number of managers who individually concentrate on one specific strategy, multi-strategy hedge funds by contrast are run by one manager who invests directly in different strategies, such as merger or convertible arbitrage, or market neutral.

Many multi-strategy funds focus on arbitrage strategies, such as fixed income, merger and convertible arbitrage, and Meaden says it is often from a focus on just one of these strategies that managers diversify into multi-strategies.

Take heed

Meaden's warning may appear to be contradicted by past performance data from CSFB, hedge fund manager Tremont and index calculator Tass. Over the short term, the data show that multi-strategy funds have the edge over funds of funds.

According to Tass data, fund of funds performance before charges has risen by 2.23% over three months, against a rise of 13.24% from the category which includes single manager, multi-strategy funds. Both strategies beat the wider CSFB/ Tremont Hedge Fund Index, which returned 2.22% over the period.

However, Meaden says historical data fails to reflect the potential problem of lack of expertise among multi-strategy managers presently trying to focus on many different strategies at once.

While multi-strategy single manager funds' short term performance may lead investors to choose them over funds of funds, over the longer term funds of funds have proved superior. The Tass fund of funds average has returned 3.15% over 12 months against a 14% loss from multi-strategy and a 5.1% gain from the CSFB/Tremont hedge fund index. Another potential danger multi-strategy funds face stems from investor concerns about the arbitrage-based strategies many such funds focus on.

The merger arbitrage strategy is facing a sharp fall in the amount of global M&A activity as economic conditions have worsened, limiting the investment selection field for the strategy.

For convertible arbitrage investors, the fact that more than 60% of the global convertible bond market is owned by arbitrageurs causes concern among some investors that the strategy may have too few non-arbitraging participants from which to to make money.

Meaden says multi-strategy investors should also be aware that some of the multi-strategy funds' best analysts, 'have left the business 12 to 18 months ago to set up on their own. So in multi-strategy you may end up with the second best managers.'

Tord Stallvik, director of hedge fund business at Schroders, says there are, 'not that many teams who were great at everything.'

'If we were to invest in a multi-strategy, we would want to make sure that we would choose the team for each strategy separately. Paying a percentage less here or there for multi-strategy does not make a good investment decision if you are not getting a good team,' says Stallvik.

Gary Smith, head of ABN Amro's alternative investment division, says it was not a question of multi-strategy versus fund of funds. Rather, investors should consider having some exposure to both categories. ABN Amro's fund of hedge funds, with about $200m assets under management, has two multi-strategy funds among its 25 holdings. Smith says some multi-strategy funds have experts in each arbitrage strategy, and strategy shifts in multi-strategy funds' portfolios could provide pointers, even for fund of funds managers, about when a manager may consider moving allocations between various arbitrage strategies.

Joel Katzman, chief executive officer of JP Morgan Chase Partners, says multi-strategy funds can move more nimbly into and out of arbitrage areas than could fund of funds.

Robert Dawkins, head of alternative investments at Coutts, says it can take 'two to three months to redeem a holding in a fund of funds so asset allocation can be more difficult for funds of funds.'

Dawkins has multi-strategy portfolios in each of the Orbita funds of hedge funds run by Coutts, but multi-strategy funds make up only between less than 10% (Orbita European growth fund of funds) and 15% to 20% (Orbita Global opportunities fund of funds).

Dawkins says he may use multi-strategy managers' allocations between strategies as a yardstick against which to gauge his own views on the markets, although other managers' outlooks need not change his. 'They could be favouring one strategy as a short term opportunistic move, which will not change my views, but it's a little bit of information that can be useful,' he says.

Dawkins says manager-specific risk is a key issue for investors in single manager, multi-strategy funds.

'If there's a problem with a manager in a multi-strategy fund, it may permeate its way throughout all the strategies they are focusing on, whereas with a fund of funds you can have 20 different managers. Asset allocation can be tough in funds of funds. In multi-strategy, you have the single manager risk.'

Dawkins says that for investors who feel they need to invest in multi-strategy funds, it may be preferable to select multi-strategy spread across different arbitrage based strategies rather than global macro managers who also have bond traders and index traders.

'I think you are safer in (arbitrage) areas because with global macro you could argue they're all in one strategy, taking positive or negative views on similar things. With arbitrage strategies (within one fund) looking at convertible arbitrage and statistical arbitrage and fixed income arbitrage, in different asset classes.'

Smith adds that the variations on arbitrage themes on which most multi-strategy funds focus have, 'returns that were fairly steady,' and less volatile than equity long/short.

'So if you feel you should reduce exposure to one arbitrage strategy there's usually time to get out without damaging performance,' he says.

Robert Howie, investment consultant at Mercer Investment Consulting, says Mercer's preference for specialist managers of hedge funds would lean the consultancy toward funds of funds structures, even if the extra layer of charging in funds of fund structures meant it cost a little more than multi-strategy.

'When we advise our clients we want them to select a specialist bond manager, a specialist US equity manager and so on,' he says.

He adds that a fund of funds structure also minimises the danger of 'key man risk', the fact the stability of the product could be affected if the manager left, or morale or organisational structure made it difficult for the key manager to function effectively.

'If an organisational structure is no longer supportive of the single manager or if morale of all the other managers in the organisation is low, it can have an impact on your key person,' says Howie.

But one key potential disadvantage for investors in funds of funds, he says, was the lack of transparency down to the level of individual holdings in portfolios within the fund of funds structures.

'With a single fund the monitoring role may be easier for an investor, but that is what you're paying a fund of funds manager to do on your behalf if you're in that type of portfolio,' says Howie.

potential pitfalls

One problem that might be faced by investors in funds of funds, but is less likely for those buying into a multi-strategy fund, is a potential investment straitjacket on the fund of funds manager imposed by investors in secondary products based off the back of the portfolio.

Those restricting the fund of funds manager's investment freedom, or leverage levels, may be providers of protected products or ratings agencies rating collateralised debt obligations (CDOs) backed by fund of funds manager. In such cases the managers of the underlying portfolios are often given guidelines they need to follow, such as a set track record on the lead manager and the need to keep the fund liquid, that restrict the lead manager's flexibility with the portfolio.

While this may not be a determinant impelling investors to take the multi-strategy route, Christian Frei, director at Lazard Asset Management, says it is worth bearing in mind when investing in funds of funds structures.

'Principal protected products around funds of funds create their own specific redemption and liquidity requirements. They create their own set of risks as you try to navigate a product through a narrow channel of volatility and keep both a client and a risk manager of a bank balance sheet happy.'

Frei adds that investors should be aware their chosen fund of funds manager may face difficulties exiting a falling investment rapidly if they are outside their redemption period for the falling underlying hedge fund.

'If you're a fund of funds investor with a manager on limited liquidity terms there's very little actionable active risk management you can do unless you are within your redemption notice period. You can monitor the underlying positions and new risk modules have come out to make that easier to do.

'But the degree to which that can be done over a whole portfolio is still somewhat limited and there are few fund of funds managers who fully employ that kind of process right now.'

Eun Choi, vice president of Moody's Investors Service's European structured finance group, says in the case of CFOs, investors in the debt could require a fund of funds manager whose portfolio breached pre-defined minimum net asset value (NAV) levels.

'Market value-based collateralisation tests and minimum net value are designed to protect noteholders by enforcing predefined minimum levels of structural protection for the notes ' something the fund of funds manager needs to be mindful of,' he says.

Choi says another restriction on fund of funds products whose debt is used or CFOs, which is less likely among single manager, multi-strategy funds, was investment guidelines imposed on the fund of funds manager by the CFO investors.

Key Points

Some multi-strategy hedge fund managers may lack expertise across range of convertible strategies they aim to exploit.

Multi-strategy funds in fund of funds portfolios can help fund of fund managers see where value lies among convertible strategies.

Multi-strategy funds can move more quickly between strategies than funds of funds

Funds of funds use focused expertise in each strategy, and the fund of funds structure lacks ~key manager risk' if one underlying manager leaves.