‘Look the manager straight in the eye,’ say selectors

Date: Wednesday, July 11, 2012
Author: Lukas Sustala, Investment Europe

Despite staging a comeback in many portfolios, as low yields elsewhere fuel the need for returns, hedge funds still face demands for trust, transparency and track records.

“I expect the hedge fund and absolute return industry to raise another $500bn over the next ten years.” Even as Marcus Storr, head of hedge funds at Feri, warns of some pitfalls of hedge fund investing, he is sure that investment managers will have to turn to them to find diversification and returns.

“Pension funds and insurers have to earn 4%-4.5% to cover their liabilities, but they earn only a fraction investing in government bonds,” he says. “At the same time, boosting the equity allocation increases volatility, so they have to look to alternative investments, hedge funds and absolute return strategies.”

The recent growth in assets shows that hedge funds have regained some trust among investors. According to recent data, the industry has experienced inflows since 2010 (see chart, below).

The dire conditions in many bond markets have increased the interest of selectors in German family offices, insurers or pension funds in the hedge fund industry, Storr observed at the first Hedgefonds Investmenttag, organised by Feri which, besides its ratings business, has more than €20bn of assets under management: “Many clients, who never had anything to do with hedge fund strategies, have started to look into the market.”

Allocation rethink

Especially in Germany and Austria, where the investor base still is sceptical of unregulated offshore funds, there has been a rethink.

Dirk Rüttgers, director at asset manager Do Investment, emphasises that hedge fund investments still raise eyebrows at many family offices and advisory boards. During a discussion session, he complained that investment managers still have to do a lot of persuading. Given the complex matter of investing in hedge funds, from manager selection to tax issues, he recommends getting external advice to improve allocation towards hedge funds.

Stefan Löwenthal, investment manager at Macquarie Investment Management in Vienna, agreed that smaller firms cannot carry out the whole manager selection process on their own. “But what remains central is to understand the idea and strategy of a hedge fund manager each step of the way,” he said.

Many participants in the hedge fund conference invoked the issue of trust. Rüttgers said: “It is key to see the managers; to get to know them; to look them straight in the eye.”

He added a criterion widely shared among Germany and Austrian selectors: “I favour managers who have money invested in their own funds.” Ulrich Voss, investment manager at Black Horse Investments, went even further: “We choose products only in which managers themselves are invested.” For Storr, this was simply “a guarantee that the manager will do anything within his power to preserve the wealth that is invested in the fund”.

It was Gideon King, CIO and CEO of hedge fund Loeb Capital in New York, who warned investors at the conference in Bad Homburg not to be naïve about hedge fund investing. “We are overpaid. There is a compelling profit motive in the industry. But, at the same time, the average hedge fund lasts only for three to five years,” he said.

Too many funds have become obsessed with a single strategy and high leverage, thus becoming vulnerable to downturns in the economy and financial markets. “Hedge funds are supposed to be hedged. Yet, a ballooning level of beta has infected the hedge fund industry,” King added.

The hedge fund industry as a whole did a poor job on diversification in the past couple of years. A look at the HFR Indices proves hedge funds were not able to avoid the downturns in 2008 and 2011, losing clients money, just as other risky assets were beaten down by volatility.

Yet, that glance might be misleading, according to Storr. They might be interesting tools for benchmarking managers, but not for investment decisions. He said: “It is way more important to pick the right manager than the right strategy.”

Small managers with less than $600m assets under management might be able to offer more alpha than the big funds included in the index.

The issue of size again boils down to proper risk management on the side of the hedge fund managers, Gideon King believes. “As the inflows increase, it becomes increasingly difficult to run money safely and soundly,” he said.

Pros and cons of ucits

Ucits, the regulatory framework for onshore funds, has boosted the industry, according to Storr. “It has levelled up the education of investors, as more and more funds are distributed and advertised to investors that had no exposure to hedge funds before.”

Yet, Ucits funds themselves are laden with problems, ranging from higher fees to limits from the regulatory framework to the need for the manager to hold more cash to deal with redemptions. That has led to a reversal in Ucits growth lately, with more funds closing than launching.

Storr feels more comfortable in the offshore universe. One of the reasons might be the scope for diversification. Now, roughly 8,500 managers are available in the offshore universe, whereas the product range onshore amounts to 450 strategies (see chart, below).

However, Ucits – and the crisis of 2008 – changed the offshore universe too. Löwenthal said transparency and reporting standards have dramatically improved in the past couple of years, often “via the pressure of investors. Managers provide much more information today than before 2008. Investors feel more comfortable to invest.”

In addition, the financial crisis has served as “a washout for rogue funds” and so left investors more certain about the legality of existing funds.

Most of the investors at Feri’s conference were also sure about another aspect of hedge fund investing: diversification. Ewan Kirk agreed strongly. The CIO and CEO of Cantab Capital Partners, a systematic global macro hedge fund, is sure the growing segment of systematic hedge fund strategies offers value for investors: “CTAs are not a put option, they are not a hedge. The strategy is a diversifier,” he said.

The assets in this hedge fund segment have grown from $300m in 1980 to over $270bn in 2011, but Kirk insists that this is not “a crowded trade”. Indeed, as trend following has worked for 30 years, he believes it will in future.”

However, investors have been more alert than ever about the issue of herding in certain strategies. A selector at a German family office remarked that in some strategies “too many are doing too similar things”, so killing alpha opportunities.

The summer months of 2007 spring to mind. During one week in August, a couple of quantitative long-short hedge funds in the US experienced huge losses in tandem even as the stock market itself did not suffer that much. The reason for the moves, according to scholars and practitioners alike, was a liquidity issue that quickly affected hedge funds that were holding similar portfolios due to their akin strategies.

“Multi-strategy is the way to survive,” according to King. “One strategy alone leaves you imbalanced and prone to extreme beta.”

Paul Glazer, founding partner at Glazer Capital, a hedge fund running a merger arbitrage strategy, tries to make money on already announced mergers or acquisitions by evaluating whether a merger goes through or stumbles over regulatory hurdles. “Because of the Volcker rule, there are fewer merger arbitrage managers out there,” he said.

For Robert Rauch, a Partner at Gramercy, a fund focused on emerging markets and within that, mainly distressed debt investing, the opportunity set lies elsewhere. “European bank deleveraging creates more possible deals. Ten years ago distressed debt investing was about knowing the debtor’s willingness to pay; now it is about the ability to pay,” he said.

But why would investors seek these strategies? The reason is diversification.

“This was the prime reason for us to look into the industry,” Löwenthal said. He noted the importance that investors should not be over-ambitious about return targets, but to make sure that the hedge funds act their part in portfolios: “It is short-sighted to look at hedge funds on a standalone basis. Every asset class needs to be assessed in terms of their role within your portfolio.”

Fonds anzahl, geschätztes verwaltetes vermögen

Fonds anzahl (number of funds)