Innovation at heart of funds of hedge funds survival techniques

Funds of hedge funds are finding innovative ways to produce alpha and justify their fess. Some are turning to bespoke solutions, unconventional hedge fund strategies or different structures.

The fund of hedge funds (FoHFs) industry is stepping up the pace of innovation in a push to improve performance and regain investor confidence. Business models have changed, fund structures have been overhauled and investment strategies have been tweaked, resulting in the launch of some innovative products.

There are good reasons for FoHFs to embrace change. The industry has come in for some harsh criticism of late. Frustrated investors complain that FoHFs diversify away hedge fund alpha, have too much beta and overcharge for their services.

Many have voted with their cheque books. Total assets managed by FoHFs have fallen 20% to less than $640 billion from a peak of $800 billion in 2007, according to data from Hedge Fund Research.

FoHFs have responded with a more flexible, client-focused approach to the business. “Our hedge fund solutions have many elements – manager selection, portfolio construction, risk management, insights on hedge fund strategies and their role in a broader investment portfolio. We’re offering these solutions as a complete package, or in separate pieces, providing them to clients in a variety of ways that are tailored to their circumstances,” says Chris Kojima, head of alternative investments and manager selection at Goldman Sachs Asset Management.

There is more of an emphasis on building customised portfolios for clients, rather than on selling off-the-shelf products.

At Investcorp customised portfolios now account for over 60% of total assets in its hedge fund business. Deepak Gurnani, Investcorp’s chief investment officer, says many institutional investors are showing a clear preference for customised portfolios over commingled FoHFs.

Goldman’s Kojima says his team is spending more time analysing clients’ existing portfolios and providing advice on how hedge funds can help improve overall performance. “We may have an existing hedge fund product that fits their needs but in other cases clients already have internal capabilities and they are looking for tailored services, either in the form of customised portfolios or an advisory solution that is then implemented internally by the client,” he says.

It is not unusual for investors to engage GSAM on a pure advisory basis to help their internal hedge fund teams with research and manager selection, particularly in niche strategies and international markets that are harder to access, according to Kojima.

FoHFs have also reassessed the building blocks they use to construct portfolios. There is a shift away from the multi-billion dollar, brand-name hedge fund managers that investors are most likely to access directly. Instead, FoHFs believe they can add value by identifying emerging managers and niche strategies that are off the beaten path.

In 2009 FRM made the conscious decision to shift allocations to smaller managers. “We think smaller managers perform better in challenging environments and have less downside risk than larger funds,” says Mike Weinberg, head of global long/short equity investments at FRM. Over 35% of FRM’s assets are now invested in managers with less than $1 billion compared with around 15% at the beginning of 2009.

Another way FoHFs are differentiating is by establishing ‘funds of one’ and managed accounts with underlying managers rather than investing in commingled funds. This gives FoHFs greater transparency and control over assets as well as the ability to create bespoke investment mandates with underlying managers.

FRM has converted “a substantial portion” of its hedge fund investments into funds of one and managed accounts where it is the only investor. “We rarely buy off-the-shelf hedge funds anymore,” says Weinberg. “We work with our underlying managers to tailor their mandates. This enables us to eliminate illiquid or less desirable assets classes and create products that are a better fit within our broader ­portfolios.”

Managed accounts
In some cases the traditional FoHFs product is being replaced by a fund of managed accounts model. Permal Group has established managed account relationships with nearly half its manager universe, according to president Omar Kodmani. Last year the company launched a dedicated fund of managed accounts, which has exposure to around 30 managers across a range of different strategies.

Investcorp is another major proponent of managed accounts. Over 60% of its hedge fund investments are in this form. Investcorp’s Gurnani says managed accounts can be “a source of alpha” for FoHFs.

Investcorp establishes tailored investment guidelines and risk controls for its managed accounts, including leverage and concentration thresholds, liquidity requirements and exposure limits. The accounts are monitored by the internal risk team to ensure managers do not stray from their mandates. The transparency of managed accounts also means Investcorp can be opportunistic on occasion. “If a manager has a great trade idea, and we don’t have a lot of exposure to it in our other accounts, we will allow them take a bigger position in it than they could in their commingled fund,” says Gurnani.

Investment strategies are also being tweaked and in some cases being rebuilt from the ground up. There are hard questions being asked across the industry about whether the traditional model of diversified, multi-strategy FoHFs still delivers value for investors.

“The classic notion of ‘all-weather’ FoHFs as a long-term diversification play is wearing a bit thin with investors,” says Francisco Arcilla, global head of the FoHFs group at Axa ­Investment Managers.

In his view FoHFs have to deliver products that serve “a functional purpose” in a portfolio. “We cannot think of FoHFs in isolation. Most investors have less than 10% allocated to hedge funds. For that 10% to make a difference, it has to help investors manage the other 90% of their portfolio,” says Arcilla. In this context the role of FoHFs is to “create unique exposures and outcomes that cannot be replicated with traditional instruments and to do it in a very controlled and predictable way”.

A new model?
Others argue the entire FoHFs investment model needs to be completely overhauled. “The problem is that while many FoHFs promise alpha, what they actually deliver is a lot of watered-down beta,” says Antoine Haddad, chief executive and founder of Bainbridge Partners, a FoHF manager in London.

He argues the average FoHF has too much exposure to strategies with a structural long bias to equity and credit markets. The pressure to deliver steady, low volatility returns on a monthly basis also drives FoHFs to overweight arbitrage strategies that profit from price convergence. These strategies have negative convexity, which is equivalent to being short volatility and long tail risk. The problems are compounded when FoHFs invest in illiquid strategies that “give the illusion of low volatility returns” but leave investors exposed to large losses in crisis periods”, according to Haddad.

“The FoHF industry has to refocus on alpha,” he says. “That means delivering positive returns with zero correlation or sensitivity to the broader markets. That is a very compelling proposition for investors because it allows them to add a FoHF to an existing portfolio of equities and fixed income without increasing their overall market ­exposure.”

Bainbridge takes a fairly radical approach to portfolio construction. Its flagship FoHF is beta neutral, liquid and has long volatility profile with a positive skew. Haddad avoids all arbitrage strategies, including long/short managers that seek to capture short-term statistical price deviations between securities. Illiquid strategies are also excluded.

“We stay away from anything that smells like convergence,” Haddad says. “What we want are managers that can profit from ­divergence ­scenarios.”

Bainbridge’s portfolio comprises largely of directional long/short equity and credit managers that trade across relatively short timeframes. Global macro and managed futures funds represent 20% of the overall portfolio. “What we want to capture is trading skill, not asset class exposure,” says Haddad. “When you build a portfolio of complementary trading skills, what you get is a return stream that, while lumpy, is uncorrelated to the broader markets and resilient during periods of crisis.”

Another way FoHFs can add value is by running concentrated portfolios of high conviction ideas. At SkyBridge Capital, the investment process is predicated on indentifying investment themes that offer rich opportunities for hedge funds. Its FoHF has meaningful exposure to the investment team’s favourite themes, which in recent times have included distressed credit, prepayment sensitive mortgage bonds and event driven equity. The top three themes typically represent between 60% and 80% of the portfolio, and a similar proportion of assets are in the fund’s top 10 underlying managers. 

The concentrated, thematic investment approach produces differentiated returns, says Troy Gayeski, a managing director and senior portfolio manager at SkyBridge. “You have to differentiate between opportunity sets for strategies. Otherwise, you end up looking a lot like the hedge fund indices. Even the best managers can’t get blood from a stone, but most managers will make money in a good environment for their strategy.”

SkyBridge’s analysis indicates its FoHF is, if anything, over-diversified. The top five managers have historically generated over 70% of the fund’s returns in positive years.

“The appropriate level of diversification for a FoHFs is always a difficult question,” says Gayeski. “We have around 35-40 names in the portfolio and a 15% limit on any individual position. But our view is that you have to take meaningful exposure to your best ideas and actively turn over the portfolio as the opportunity shifts to generate an attractive return.”

Although fresh approaches to portfolio construction are gaining traction, most FoHFs are focusing on incrementally improving their portfolios. One of the priorities after 2008 has been to address the liquidity mismatch in FoHF portfolios, whereby most FoHFs promise their investors better liquidity than the underlying funds in which they are invested.

FoHFs have removed illiquid and long-dated strategies from their diversified, multi-strategy portfolios. The shift to managed accounts has also helped improve the liquidity profile of FoHFs so they should be better placed to weather a liquidity crisis in the future.

Some FoHFs have created special products to capture the widening liquidity premium in financial markets, with appropriate liquidity terms. In late 2008 Permal launched a dedicated vehicle to acquire hedge fund shares being offloaded on the secondary market by forced sellers at steep discounts. The fund, which had a two-year lock-up, returned over 80% over the past three years. A second version of the product, launched in early 2009, has also generated strong returns.

Permal expanded on the liquidity premium theme with a third product launched earlier this year. The Permal Select Opportunities Fund allocates to longer-term event driven strategies and also co-invests in deals sourced by Permal’s managers. It can also purchase hedge fund shares on the secondary market when they trade at attractive discounts. “We are not only investing in hedge funds, we also have pure play exposure to some of their underlying positions. It is a groundbreaking concept for a FoHF,” says Kodmani.

Tail risk hedging
FoHFs have incorporated more sophisticated tail risk hedging strategies within their portfolios. In the past the industry relied heavily on short-sellers and long volatility options strategies to provide protection in crisis periods. In 2008 short-sellers failed to perform as expected after regulators imposed a series of short-selling bans at the height of the crisis.

“After 2008 we had to think of better ways of hedging out the residual beta in the portfolio with non-linear, negatively correlated strategies,” says Scott Schweighauser, chief investment officer for Aurora ­Investment ­Management.

Aurora has since moved a portion of the portfolio it previously allocated to short-sellers into tail risk funds, which aim to provide a cheaper and more reliable hedge against extreme market moves mainly through derivatives that pay off when prices fall and volatility rises. Its flagship FoHF portfolio is also hedged with an overlay of short S&P futures and long put options.

Schweighauser and his team encouraged various managers to offer their internal hedging programmes as standalone funds with Aurora as an investor. “Hedge fund managers responded very quickly to the need among investors for better portfolio hedges. The ability to allocate to tail risk strategies on a diversified basis means we can create a more robust and reliable portfolio hedge within a diversified FoHF,” he says.

Generally the FoHFs left standing after the 2008 clearout are taking the ‘innovate or die’ message to heart. As FoHFs continue to evolve, more inventive uses and combinations of strategies will emerge as the sector strives to convince investors it can add alpha and justify its fees.

Case studies: innovation in practice 

Dynamic distribution

FoHFs were once the exclusive province of sophisticated institutions and ultra high net worth investors. SkyBridge Capital sees no reason why this should be the case.

Its flagship FoHF, SkyBridge Series G, has a minimum investment threshold of only $50,000. Merrill Lynch and Morgan Stanley Smith Barney distribute the fund to accredited investors, defined as individuals with an annual income of $200,000 to a net worth of $1 million, as well as to smaller institutions.

“We have an institutional-quality process and track record and we are offering that to both institutional and accredited investors through the broker dealer network. That is a pretty unique offering in this marketplace,” says Max Osborne, head of distribution for SkyBridge Capital.

This has been a successful strategy from an asset-­gathering perspective. SkyBridge has raised around $1 ­billion for the fund since July 2010. The fund’s total asset base is nearly $2 billion, up from less than $200 million in 2006, when it was structured in its current form.

The Series G fund has all the characteristics of an institutional FoHF product. It has exposure to 35-40 underlying hedge funds. The only notable drawback of the regulated fund structure is a restriction on commodity and commodity futures income, which excludes managed futures programs from the portfolio. This has done little to impede the fund’s performance, which has consistently outperformed the hedge fund indexes.

What makes the fund unique is its investor base, which spans the range from lawyers, doctors and small business owners to pension funds and endowments. The fund has around 13,000 investors and ticket sizes range from $25,000 to $25 million.

SkyBridge’s fundraising success is testament to the strength of its distribution platform. “The start-up and ongoing operational costs of running a registered investment vehicle are fairly substantial, so it doesn’t make sense to do this unless you are connected to distribution networks with access to a large base of accredited investors,” says Osborne.

Permal’s managed account solution

The desire for enhanced transparency, liquidity and control has led many investors to restructure their hedge fund investments as managed accounts. Permal has taken this concept one step further: it has created an internal managed accounts platform exclusively for its FoHFs business.

There are currently 85 funds on the platform, almost half of Permal’s manager universe, running $7 billion in combined assets for its FoHFs.

The platform is structured as a series of special purpose funds (SPFs). Permal determines the legal structure and terms of the SPFs and selects the board of directors and service providers, including the administrator and auditor.

“The obvious benefits of investing through SPFs are enhanced transparency, governance and control,” says Omar Kodmani, president of Permal Group. “But there are also less obvious benefits, such as lower fees and enhanced flexibility on the ­investment side.”

The SPFs allows Permal’s FoHFs to make subscriptions and redemptions on an intra-month basis. This flexibility in asset allocation is changing the way Permal’s FoHFs are managed, says Kodmani. “We see the benefits not only on the redemption side, but also in the ability to subscribe at short notice,” he says. For instance when the Nikkei dropped 20% after the earthquake in Japan in March, Permal was able to capture a significant portion of the rebound by quickly adding capital to its Japanese SPFs.

Another advantage of SPFs is the ability to engineer a manager’s strategy to meet specific investment goals. For example Permal may ask a SPF manager to run a concentrated portfolio of their best ideas with higher gross exposure than in their commingled fund. “As we are using these strategies within diversified multi-manager portfolios, we can sometimes take more risk in pursuit of higher alpha,” Kodmani explains.

The SPF model also allows Permal to carve out portions of an underlying manager’s portfolio. If Permal spots a unique opportunity in mortgage bonds, it can instruct one if its credit managers to provide exposure to only that segment of their portfolio through an SPF. In another example, a quantitative manager may be asked to exclude trades based on certain models from ­Permal’s ­portfolio.

The flexibility of SPFs enables Permal to generate “differentiated alpha,” says Kodmani. “What that means is, even if we have exposure to the same managers as our peers, the results may be very different because the way we access our managers is unique.”

Taming tail risk

Tail risk has been a hot topic in investment circles since the financial crisis. Having been caught out by the market meltdown in 2008, investors have been clamouring for strategies that perform well in times of crisis. Hedge fund managers have been keen to oblige, with dozens of tail risk funds hitting the market in the past three years.

FoHFs have been at the leading edge of these developments, often working closely with managers to develop tail hedge programmes that can be offered to external clients on a standalone basis. As the universe of tail risk funds has grown, some FoHFs have launched dedicated tail risk products.

In November 2010 Axa launched a multi-manager tail hedge strategy known as Axa Alternative Tail Hedge. The strategy has exposure to a diversified basket of equity, credit, macro and volatility strategies that are expected to generate outsize positive returns during tail events, characterised by steep declines across markets and heightened correlation between asset classes.

Francisco Arcilla, global head of fund of hedge funds at Axa Investment Managers, says a multi-manager portfolio of tail risk strategies can provide a more reliable hedge against calamitous events with less downside than investing in any single manager.

“By investing in a variety of tail risk strategies, we can be confident to perform in a tail event, so the focus shifts to optimising performance in normal market conditions,” he says.

“The managers in the portfolio all have a function in different points in the cycle. They don’t all deliver at the same time, so you don’t have three or five years of losses and then a big return in a tail event.

“We have designed a tail risk approach that has the ability to deliver alpha over market cycles with outsize, hedge fund-type returns when market conditions deteriorate,” Arcilla says.

The strategy’s performance in 2011 bears this out. Returns were flat through the end of July “when there was no tail in sight” before picking up in August and culminating in a double-digit return in September. “The alpha comes from containing losses and exploiting ranges in sideways markets,” says Arcilla.

Axa is not the only one to think of this. Earlier this year FRM started offering an investable tail risk FoHF. The fund grew out of an initiative in 2010 to implement more sophisticated tail risk hedges across FRM’s range of multi-manager portfolios.

“As new and high-quality strategies have become available and managers are more willing to create bespoke portfolios, we saw an opportunity to build more effective tail risk hedges,” says Michael Weinberg, head of global long/short equity investments at FRM.

FRM’s tail risk FoHF combines traditional tail hedges with more complex relative value strategies that generate negatively correlated returns in crisis periods at a lower incremental cost than plain vanilla options plays. “The tail hedge space has become more sophisticated with the advent of equity, credit and volatility based strategies which provide a very interesting, asymmetric return profile when combined in a multi-manager portfolio,” says Weinberg.

Pioneering research

Investment decisions should be based on sound research and analysis. This is easier said than done when it comes to hedge funds. The scarcity of reliable data and quality academic research on hedge fund returns is a source of frustration for many investors.

“If I look back 10 years ago, we really did not have the tools we needed to make medium-term calls on the expected returns and alpha of hedge funds,” says Deepak Gurnani, chief investment officer at Investcorp.

To address the problem, Investcorp initiated a proprietary research project in 2003 to unravel and quantify the risk and return drivers of hedge funds. The results of the research, known as the Alpha Project, have revolutionised Investcorp’s approach to strategy and manager selection.

Investcorp’s research team set out to deconstruct scientifically the trades that drive hedge fund returns. Rather than taking a factor-based replication approach, they looked at real hedge fund portfolios and identified the standard trades hedge funds employ to capture the principal return components of various strategies.

This enabled them to model the generic returns, or beta, of various hedge fund strategies by implementing the standard trades against historical market data. For instance, the research team modelled the returns of merger arbitrage by going long the target and short the acquirer in every M&A deal over a 10-year period. The results were subjected to econometric analysis, which provided valuable into the performance of hedge fund strategies in different market conditions.

“The Alpha Project research allows us to make informed decisions about which strategies will outperform or underperform in the short to medium-term and identify managers within those strategies that truly add alpha,” says Gurnani.

The research helps Investcorp substantiate tactical asset allocation decisions. The results confirmed, for instance, that the best time to invest in distressed debt is once default rates have peaked. With convertible arbitrage the leading indicator of return is the steepness of the discount to theoretical value.

“We have a set of indicators for every strategy and we use these to make tactical allocation decisions,” says Gurnani. “This type of research is quite rare. We have been able to add significant alpha through tactical asset allocation since we started the project.”

The Alpha Project will culminate in the launch of a series of funds that will provide exposure to the generic returns of hedge fund strategies through systematic implementation of representative trades. Investcorp’s research indicates this “strategy beta” captures a large portion, typically over 70%, of returns in most hedge fund strategies.

The systematically implemented funds will provide liquid, transparent and low-cost exposure to hedge fund strategy beta. The idea is that they can be used within institutional or FoHF portfolios to capture the generic return of a strategy, which can then be supplemented with managers that add alpha. “We think it will ultimately change the way investors think about hedge fund returns,” says Gurnani.

Unconventional benchmarking

Hedge funds sell alpha but the returns of most managers are attributable to passive exposure to common risk factors, says Scott Franzblau, a principal at Benchmark Plus, a FoHF with $1.8 billion in assets under management. He can say this with confidence because Benchmark Plus has developed a quantitative system for calculating the market risk (beta) and skill (alpha) components of an individual hedge fund manager’s performance.

Benchmark Plus performs regression analysis on hedge fund portfolios to identify their exposure to over 700 common risk factors. The results are used to construct manager-specific benchmarks representing the risks embedded in hedge fund portfolios. The alpha component of a hedge fund’s returns is defined as the excess return over the benchmark, less the risk-free rate and fees.

Funds that generate at least 500 basis points of alpha a year and have a repeatable investment process for doing so are eligible for inclusion in Benchmark Plus’ FoHFs. Less than 10% of hedge funds meet this standard, according to Franzblau.

“All too often hedge funds promise uncorrelated excess returns only to deliver beta masquerading as alpha. The benchmarking process is an objective way of identifying the relatively small number of hedge funds that truly deliver alpha,” he says.

Benchmarking hedge funds in this way provides some unique insights into their performance. Franzblau says smaller hedge funds running niche strategies typically have the greatest alpha potential. However, these funds are largely ignored by FoHFs that allocate into traditional strategy buckets.

Benchmark Plus’s portfolio has exposure to some fairly unconventional strategies, such as closed end fund arbitrage, corporate activism and volatility trading. The average fund in the portfolio has less than $500 million in assets and the best performers are often under $250 million AUM, says Franzblau.

The ability to separate alpha from beta opens a number of possibilities in terms of product design. For its flagship Real Alpha Fund, Benchmark Plus constructs a portfolio of complementary alpha sources and then neutralises the beta component of the underlying fund’s returns by hedging the respective benchmarks.

“In the Real Alpha Fund we are trying to isolate and capture only the alpha generated by our managers with near zero exposure to market risks,” Franzblau explains.

This creates an interesting return dynamic. If a manager has a 0.5 correlation to equities, this will be hedged with stock futures. If equities rise 10% and the manager returns 4%, Benchmark Plus will realise a 2% loss on the position. If stocks drop 10% and the fund is down only 4%, Benchmark has a net 1% gain.

The Real Alpha Fund’s return stream can also be combined with measured amounts of hedge fund or market betas to deliver portable alpha solutions for investors. “Once we identify and isolate the alpha and beta components of hedge fund returns, we can repackage them in different ways to address the specific needs of investors,” says Franzblau.