Choosing the right manager

It could be argued that hedge funds are no longer considered an alternative investment, rather they are an alternate way of investing in traditional assets.

Many investors’ initial foray into the world of hedge funds has been driven by a desire to improve returns and increase portfolio diversification.

Certainly, the uptake of investment in hedge funds globally might suggest they are now well accepted in the investing community.

The recent annual State Street Hedge Fund Research Study (March 2007) demonstrates this trend by tracking the investment in these assets for the past three years.

The report looks at the role of alternative investments, including hedge funds and private equity, in the portfolios of institutional investors attending the 2006 Global ARC event in Boston.

The study, which covers institutions with more than $US1 trillion in combined assets, canvassed those investors’ views on these investment strategies and found that hedge fund investing is rapidly becoming mainstream.

Nearly two-thirds (or 64 per cent) of the respondents reported having more than 5 per cent of their portfolio allocated to hedge funds. This is a big increase on the previous year when only about half had allocations to hedge funds. Only 4 per cent did not have any exposure to hedge funds at all, while all of the funds this year had allocations to private equity.

With such a large sample of investors, it’s clear there is a growing allocation to hedge funds by the world’s institutional investors.

What is most likely driving these larger allocations is a rising comfort with hedging strategies as well as the positive views on the performance diversification that hedge fund allocations have already afforded institutional portfolios.

Not surprisingly, positive performance experiences go a long way toward explaining increased allocations, with hedge funds earning high marks from institutions for increasing absolute portfolio returns.

The greater uptake of hedge funds also has an effect on the wider financial services community, from which all participants are benefiting.

Greater hedge fund participation in financial markets has increased trade in global market instruments such as interest rate, equity index, commodity and foreign currency futures contracts and related derivatives, helping to improve overall liquidity and pricing efficiency.

The maturing of the sector has also prompted a convergence between alternative and traditional investment strategies and, in some cases, investment vehicles themselves.

This phenomenon is highlighted by the increasing use of hedging strategies and derivatives within traditional investment mandates. Examples include strategies such as 130/30 funds, which are 130 per cent long and 30 per cent short and are fast becoming the active equity strategy of choice among sophisticated Australian superannuation funds.

For planners and their clients, there are lessons to be learnt from the experiences of institutional investors who are pursuing a more fully-fledged understanding of the risk/reward opportunity of hedge funds and the role they play in a portfolio.

One of the key lessons is the greater assessment of the risk factors associated with hedge funds, which institutional investors are now demanding.

To this end, State Street has launched a comprehensive white paper on hedge funds as part of its Vision series of papers on topical investment issues.

The paper examines the impact of rising institutional allocations to alternative investment vehicles on institutions, as well as the hedge fund industry more widely.

The Vision paper reinforces the notion that along with the increasing flows to hedge funds comes a need for greater understanding of all aspects of hedge fund investing.

How institutional investors use hedge fund managers

While larger investors are driving up overall allocations to hedge funds, how they invest is changing. According to the 2007 study, the number of direct hedge fund managers hired a on a per institution basis has risen, with more than half of institutions investing with more than 10 direct hedge funds managers, and 44 per cent investing with more than 20.

This implies the portfolio construction of at least half of those investors is in line with current evidence that supports a properly diversified portfolio of hedge funds to mitigate systemic risk.

While direct investment has gained momentum so has investing in fund of funds, rising from 14 to 24 per cent in the year. This may in part be due to the influx of new investors into hedge funds.

But while new investors do prefer to go to fund of funds, they are hiring fewer of them, with 60 per cent of investors saying they invest with between one and three hedge fund managers.

However, overall, the use of fund of hedge funds among institutional investors is declining, with more than a third now not using fund of hedge fund managers at all, compared with only a quarter that didn’t the year before. This is probably because of two factors: the cost benefit analysis in favour of the do-it-yourself direct approach, and a growing sophistication and familiarity with hedge fund investing.

This second factor is particularly important. If institutions continue to allocate more to direct hedge funds rather than fund of hedge funds they are going to require additional knowledge about hedge funds in general, and guidance in selecting the managers and strategies to best suit their investment goals and portfolio diversification needs.

Evaluating a hedge fund manager

As a first step, when evaluating a hedge fund manager, investors should conduct a comprehensive due diligence review.

Several key areas are important to explore as part of this process, and investors, whether institutional or retail, should consider the following.

1. Ownership structure.

Review the ownership structure of the hedge fund management company to ensure the fund’s terms, including redemption policies and lock ups, are commensurate with expectations and that compensation of employees and principals is properly aligned to motivate performance.

2. Adherence to strategy.

Analyse current and historical account statements to confirm adherence to the specific hedge fund strategy for which the manager is being hired. Doing so could reveal managers who have become opportunistic investors, once their style comes under performance pressure.

3. Background check. Conduct a complete background check on the hedge fund and its principals, including education, work history, and both civil and criminal records. Complete confidence in your manager is essential to a successful strategy.

4. Trading. Thoroughly analyse the hedge fund’s securities dealing and clearing procedures. Whether these procedures are conducted internally or via the service of a third party provider, details can provide insight into a fund’s risk management philosophy and fee structure.

5. Documentation. Review the hedge fund or separate account documentation, including offering memorandum and disclosure statements.

6. Internal procedures. Review the hedge fund manager’s internal procedures. It is important to know what tasks the manager performs itself and what duties are undertaken by third party service providers. It is important to ensure the proper risk controls and procedures are in place.

It is essential for institutions to know everything from how investment decisions are made to how the fund’s net asset value is calculated. This is driving the call for transparency, and often must be sought where it is not offered.

The global drive to find and produce absolute returns is bringing heightened attention to the various risk factors associated with hedge fund products.

As investors move to put larger percentages of their assets into hedge funds, they are also demanding detailed reports on how their investment managers monitor and avoid both investment and non investment risk.

Some hedge fund managers control their operational risk by outsourcing administration to a third party provider — a trend State Street is definitely witnessing among the growing band of alternative fund managers in Australia.

According to the 2007 study, half of the institutional investors who now have a hedge fund product in their portfolio say they plan to call for a more robust risk management program.

Within this same group, 46 per cent said they will require additional analysis and reporting from their hedge fund managers, as well as an increase in the rigour of ongoing due diligence practices.

The way forward

The growing interest in hedge funds has been partly driven by the relatively modest returns of traditional equity markets since the tech bubble burst in the late 1990s.

Investors are looking for new ways of supplementing their returns, with alpha, which is the value added arising from the skill of the manager.

But the story doesn’t end here. The next step is the ongoing convergence of alpha and beta returns, and the emergence of ‘synthetic’ hedge funds; funds currently being developed that aim to replicate hedge fund spread or trading strategies, but without traditional hedge fund fees. Australian advisers will start to see more of that.

For now, institutional investors are citing the correlation of investment performance with traditional assets as the significant challenge relating to their alternative investment portfolios. While this challenge remains, demanding more information from their managers will enable investors to more accurately make the best portfolio construction decisions.

Gary Enos is executive vice-president and head of State Street’s alternative investment servicing business. For a copy of the State Street Vision paper on hedge funds or the 2007 Hedge Funds Research Study please e-mail Carrie Choo at cchoo@statestreet.com.