The most important initial decisions for an investor are whether a hedge fund allocation is suitable for their portfolio and, if so, what the size of the allocation should be. It would be prudent to obtain expert financial advice when making this decision. The next step is how to access the opportunity set of available hedge funds, and here investors can choose to invest directly in one or more single-manager hedge funds, or use the multi-manager approach and invest in a fund of hedge funds. A fund of hedge funds is a diversified portfolio of individual hedge funds.
Dedicated and specialised skills
Going the multi-manager route means outsourcing manager selection, portfolio management and risk monitoring to a dedicated team. These functions require active management, for which funds-of-funds managers charge a fee. The investor needs to weigh up whether the benefits are worth the additional cost. In our experience, the main benefit of investing through a fund of hedge funds is the specialised level of governance that mitigates significant hedge-fund-specific risks, given that certain areas in the hedge fund space are still relatively unregulated.
In the hedge fund arena, risk management is a key aspect encompassing a host of factors that need to be continuously verified and monitored as part of a dedicated process. Hedge fund failures are more often than not related to operational issues rather than market factors. A weak operational set-up will also exacerbate the impact of market-related issues like tough trading conditions, even leading to an incapacity to deal with changes in the regulatory environment.
Operational risk may include inadequate technology or processes (infrastructure risk), which may lead to mispricing risk or the risk of a fund trading outside of its mandate. Operational risk also includes the risk of misrepresentation of investments, which is especially high when the fund manager is also involved in the valuation of the portfolio, and the risk of misappropriation of investments or outright fraud. Funds of funds managers typically verify the solidity of processes before investing and continuously monitor fund management teams and their operational set-up for any changes that signal increased operational risk.
Diversification is often cited as a major benefit of the multi-management approach but this is true only when it leads to risk diversification, with the multi-manager tasked to ensure that the combination of underlying funds brings different skill sets and resultant portfolio exposures to the blend. For example, investing in two great long/short hedge funds that are often invested in the same trade will not reduce your risk exposure.
As part of the manager vetting process, or manager due diligence, manager-specific risk should be identified and assessed prior to investing. The multi-manager should be able to distinguish between underlying funds with a sustainable business and sound operational set-up, avoiding fund managers with questionable credibility, trading methods, business practices or general uncertainty around business sustainability.
With the minimum investment amounts that are needed for investing in hedge funds, direct investment could lead to more concentrated hedge fund exposure, manager concentration risk, or economic exposure risk, and often more volatile returns.
Compounding at a stable rate
With a multi-manager approach, the investor should benefit from a more stable return stream and lower volatility in returns compared with the direct investment route. Lower volatility is the result of uncorrelated or lower correlated constituents. Funds of funds are thus potentially the ultimate compounders, which over the long term should result in superior volatility-adjusted performance.
Cost-effective investment platform
It is more cost-effective for many investors to use the infrastructure already set up by a multi-manager to do proper manager research, portfolio construction and management, as well as the ongoing monitoring of portfolios. An experienced multi-manager with an established investment process can deliver on these and may also have capacity arrangements with some hedge funds that might already be closed for new investors, thus allowing investors access to certain otherwise closed funds.
Another advantage is that multi-managers, by virtue of their size, can often negotiate better investment terms with underlying funds, including lower fees or improved redemption liquidity. As a result, investors benefit from economies of scale compared with a direct investor in a hedge fund who often cannot negotiate based on investment size.
Related to this is that many hedge fund managers prefer to deal with a handful of larger investors rather than more time consuming and administratively costly individuals. This leads to efficiencies in investor reporting, dealing with queries, as well as setting minimum best-practice standards in an industry that has been reliant on a self-regulatory regime for some time.
A representative voice
Multi-managers such as funds of hedge funds play an important role in the industry, almost as ‘gate-keepers’ and as representatives in financial forums. They influence the adoption of improved business practices and better alignment of manager and investor interests. Funds of hedge funds have historically also played an important role in media and investor education, in incubating new strategies and advising new hedge fund start-ups on the do’s and don’ts in setting up a fund and attracting prospective investors.
When going direct is better
Besides an extra layer of fees, the downside of investing through a multi-manager is that performance may be diluted, as underperforming constituents of the fund-of-funds portfolio reduce the positive impact of the top performers. When analysing the performances of the universe of funds of funds versus the universe of single-manager hedge funds, there is a much wider dispersion of returns in the single-manager hedge fund space. After taking fees into account, funds of funds typically underperform the top quartile of single-manager hedge funds, but outperform the bottom quartile. Direct investors who are thus confident that they will consistently choose the top-performing hedge funds should experience performance that is superior to the funds of funds. However, with funds of funds being effective diversifiers, the multi-management approach remains more of a ‘risk tool’. For investors looking to ‘supersize’ returns and who are willing to take on that risk, going direct might be the more appropriate course of action.
Another potential downside to investing through a fund of funds is that the investor gives up control over the asset allocation process. For those investors who prefer to be involved in this, some funds of funds use a building block approach where investors can control the top-down strategic asset allocation process, with the funds of funds’ expertise in manager selection used in creating the building blocks from a bottom-up perspective. Another option for such investors is to use a managed account platform, which can help the investor retain the manager selection process whilst outsourcing many of the operational and portfolio risk management functions to the managed account platform provider. In South Africa, however, many funds of funds already make use of managed accounts to mitigate non-market risk.
The price of peace of mind
Multi-managers might on the surface look like the more expensive option, but this view may not adequately discount the risks inherent in hedge fund investing. With more manager-specific risks or risks that are not easily quantifiable (such as regulatory or reputational risk), or risks for which the probability of occurring is low but with a substantial negative monetary impact when it does, multi-managers are paid to take much of this uncertainty out of the equation.
Using a multi-manager can also take a lot of the (often short-term) emotional challenges out of the investment decision provided the multi-manager follows a scalable and consistent investment process with a view to creating long-term wealth.
An investor with the time, experience and infrastructure would probably prefer to invest directly with a single manager. However, most investors would be well advised to rather outsource the portfolio and risk management to an experienced, dedicated and professional team as provided by a fund of funds. Well-known hedge fund manager Barton Biggs, author of Hedgehogging, calls this that “important layer of fiduciary insulation”.
Questions to ask when choosing a fund of hedge funds provider
- Is your fund of hedge funds provider a licensed hedge fund Financial Services Provider as defined in the Code of Conduct for Administrative and Discretionary Financial Service Providers, 2003?
- What is the size and composition of the manager research, investment and operations support teams and do they have relevant experience?
- What investment philosophy and portfolio construction methodology is followed?
- How do they view and apply risk management of funds of hedge funds portfolios?
- Are non-investment functions, for example, fund valuation or ‘pricing’, outsourced to independent third parties?
- From a legal or investment vehicle perspective, how is the fund of hedge funds portfolio set up and what protection does this offer the investor in terms of liability limited to the investment amount?
- What is the scope of the provider’s research of the investable universe of hedge funds?
- Does your provider have a sound industry reputation, and to what extent is the team capable of securing capacity or better investment terms on your behalf?
What does Regulation 28 mean for your alternative investments allocation?
The amended Regulation 28 of the Pension Funds Act clarifies the extent to which local pension funds can invest in alternative investments.
Among the principles highlighted is that a pension fund and its board have a fiduciary duty to act in the best interest of their members, including adopting a responsible investment approach that will lead to adequate risk-adjusted returns to meet the fund’s specific needs and liabilities.
A long-term perspective should be taken on investments in funds of hedge funds, designed to be a core compounding part of the total portfolio, which can make these suitable for pension funds with long-term liabilities. The diversification obtained through funds of hedge funds often leads to more stable returns with lower volatility over time.
Another principle highlighted in Regulation 28 is the need for ‘reasonable due diligence’ prior to investing, and to have an understanding of the risk profile of assets. These functions are effectively outsourced to the fund of hedge funds manager when using the multi-manager approach.
The maximum exposure to a single hedge fund is limited to 2.5% of the pension fund’s total assets; the maximum investment allowed in a fund of hedge funds portfolio is 5%, acknowledging the additional diversification, oversight and risk mitigation obtained.
This article first appeared in HedgeNews Africa (Third Quarter 2011, Page 8 – 9). For more information, please visit www.hedgenewsafrica.com.