From Skeptic To Hedge Fund Investor
By: Myra R. Drucker & Edgar J. Sullivan
As the investment manager for the GM Pension Trusts, historically one of the largest corporate pension plans in the U.S., General Motors Asset Management (GMAM) regularly assesses new ideas to see if they merit consideration for inclusion in their portfolios. Four years ago, despite the then-recent failure of Long Term Capital Management, GMAM decided to take a look at a relatively new asset class – hedge funds. Myra R. Drucker, chief investment officer of GMAM’s General Motors Trust Company, and Edgar J. Sullivan, vice-president, of investment research, for GM’s General Motors Investment Management Corp., discuss how they came to invest $700 million in this asset class.
There is considerable and growing interest among institutional investors in hedge funds and in Absolute Return Strategies (ARS), an important subset of hedge funds. Proponents acclaim their strategic role in institutional portfolios and their defensive characteristics. Skeptics, on the other hand, caution that fashionable investments have a tendency to attract ‘hot money’ and investors in these loosely regulated funds are vulnerable to disappointment.
This paper chronicles the journey from ‘skeptic to investor’ for the members of the General Motors Asset Management (GMAM) task team that, in 1999, undertook a study of the investment case for hedge funds. In contrast with today, when stocks are down significantly from their bull market peaks, at that time the U.S. equity market was on its way to concluding a decade in which investors would realize an outsized 18 per cent annualized rate of return and the collapse of Long Term Capital Management was still very fresh in mind. This would not have appeared to be an ideal time to be investigating hedge funds.
However, GMAM – as the investment manager for the GM Pension Trusts, as well as for other GM and non-GM investors – had at that time approximately $100 billion under management in traditional long-only investments. As the manager of what has been historically one of the largest corporate pension plans in the U.S., we regularly assess new ideas to see if they merit consideration as a complement or alternative to existing portfolios.
GMAM’s initial interest in hedge funds was prompted by confluent factors that brought to the fore the need to make an informed decision about whether these investments merited a place in institutional portfolios. First, academics from leading universities were starting to turn their attention to hedge funds and publish some thought-provoking papers. At the same time, many of these funds were increasing transparency and implementing the risk controls that sophisticated institutional investors require. Finally, investments in hedge funds had risen sharply – from less than $100 billion in 1990 to an estimated $500 billion by the end of the decade. As a result of these factors, by the late 1990s, it was apparent to us that hedge funds merited a thorough review.
The universe of so-called hedge funds includes a wide range of strategies (see Exhibit I). A common element among hedge funds is that they are loosely regulated, privately offered pools of capital with investment limited to ‘sophisticated’ investors – high net worth individuals and institutional investors. Typically, these funds are not limited in the types of financial assets that they may hold nor are they restricted from short selling or the use of leverage.
Hedge funds are commonly referred to as skill-based investing designed to generate returns by exploiting market inefficiencies. In contrast, traditional market-based strategies expect to derive the bulk of their return from participating in economic or corporate profit growth and/or from returns for supplying capital.
Absolute Return Strategies are a subset of the estimated 5,000 hedge funds in existence today. As the name implies, an ARS fund aims to provide an absolute return; that is, an excess return – a return above the risk free rate – in all market environments. In their attempt to deliver absolute returns from period to period, these funds avoid significant directional bets on equity and bond markets and they tend to adhere to specific strategies rather than rotating opportunistically.
Selecting skill-based managers that attempt to generate returns largely through exploiting inefficiencies rather than directional market bets is only one component of a well-structured investment program designed to deliver an absolute return. Broad diversification across managers and strategies may be much more effective in reducing risk in skill-based investing than in traditional long-only market-based investing. In fact, the typical fund-of-funds hedge fund (a diversified portfolio of hedge funds or ARS funds) offered to investors attempts to provide attractive risk-adjusted returns, not just attractive returns, by careful due diligence in manager selection and broad diversification across managers and strategies.
From virtually the very beginning, our task team realized that the focus would have to be on a broadly diversified portfolio of skill-based managers. Our investment criteria focus on asset classes with attractive return characteristics that can increase diversification and reduce risk – strategies with low correlations to our existing manager base. This would exclude hedge fund managers who take directional bets, since they more often than not provide performance that tracks long-only stock and bond indices. In addition, the managers we would potentially hire would have to conform to appropriate levels of risk control, transparency, and process clarity, as well as our demanding due diligence standards and, most importantly, the managers would be expected to either reduce risk or enhance the return of our portfolio.
Team members were initially skeptical about uncovering an investment case for skill-based strategies. At the theoretical level, the members of the task team were well acquainted with the extensive literature on efficient market theory, which calls into question the case for successful skillbased investing. At a practical level, they were also well aware of the difficulty many active managers have encountered in attempting to generate consistent excess returns. Most U.S. large cap equity managers have produced razor-thin alphas at best and the literature on mutual funds generally shows little or no evidence of manager skill.
Our research, however, yielded impressive results. It showed that over the long run, portfolios of funds managed by skillbased managers – as depicted by the Hedge Fund Research, Inc. (HFRI) Fund of Funds Index – have provided comparable or superior returns to equities, generally lagging the broad market indices in bull markets and outperforming them in bear markets. As shown in Exhibit II, such funds had superior returns with much lower risk than stocks (S&P 500) and only slightly greater risk than bonds (SSB Broad Investment Grade (BIG) Bond Index) over the 123⁄4-year period ending September 30, 2002. Moreover, during this period, the fund-of-funds hedge fund index had fewer negative-return quarters than stocks.
Understanding that historical returns are only part of the story, we also researched sources of return. We asked what, if any, edge do skill-based managers have over traditional long-only managers. We learned that higher fees may, to some extent, attract more talented managers to skill-based strategies, but their principal advantages appear to encompass the following factors:
- opportunity set
- arbitrage strategies
For example, we found that skill-based managers’ ability to short stocks and bonds may offer an additional opportunity to enhance returns and/or reduce market risk. One recent study (Finn, Fuller and Kling, Financial Analysts Journal, November/December 1999) indicated that stocks that are short-sell candidates tend to be overpriced as much as four times the amount that long-purchase candidates are underpriced.
Unlike traditional long-only managers that are required to track benchmarks which typically include hundreds of stocks or bonds, skill-based managers can be more specialized, concentrating positions in their ‘best ideas.’ Strategies that utilize arbitrage permit skill-based managers to hedge unwanted risks. Some convertible arbitrage managers, for example, hedge credit risk, while others who have expertise in credit analysis selectively assume certain credit risks to enhance returns.
As indicated by the IMF paper (Eichengreen and Mathieson, International Monetary Fund, 1998), the number of funds using leverage is estimated to be in the 50 per cent to 70 per cent range. Significantly (for us, in any event), the overwhelming majority of funds that use leverage have ratios of two or less. In our view, while always meriting oversight, leverage is used judiciously for the most part within the skill-based group of managers. As a recent example, there is no evidence that managers increased leverage to enhance returns in the challenging market environment of 2002. In fact, based on our experience, most skill-based managers increased cash and reduced leverage in response to the current diminished opportunities in strategies such as merger arbitrage rather than increasing risk to maintain returns.
Despite these reassuring findings, the GMAM task team also wanted to examine an issue that is frequently brought up by the naysayers: ‘Might hedge funds and ARS become victims of their own success?’ Large inflows into hedge funds and ARS strategies could erode future opportunities for successful investing or perhaps even create a bubble. After looking at this issue carefully, we believed then, and continue to believe now, that it is difficult to make a substantive case that the inefficiencies skill-based managers seek to exploit have eroded. After all, the estimated $500 billion currently dedicated to these strategies is still miniscule relative to the size of the global capital markets – a $16 trillion global equity market, a more than $30 trillion global bond market, and a currency market in which daily transactions are reputed to be in excess of $1 trillion.
From Skeptic To Investor
In the end, the task team concluded there is a compelling investment case for including some ARS investments in institutional portfolios managed by sophisticated professionals. This conclusion was reached after much internal discussion, a thorough examination of empirical analyses, and a comprehensive review of the qualitative and quantitative arguments for skill-based investments advanced by proponents, as well as the counter arguments of naysayers.
The work of GMAM’s task team underscored three points:
- the risk-return attributes of well-diversified ARS portfolios may offer attractive opportunities as a substitute for traditional long-only stock/bond investments or as pure return enhancer – a ‘portable alpha’ strategy
- the low correlation of ARS with traditional asset classes make them a potentially attractive addition to an institutional portfolio. Their inclusion shifts the efficient frontier to the left
- successful investing in ARS or skillbased strategies requires adhering to new and demanding standards for manager selection, monitoring managers, and portfolio construction
As suggested by this last point, successful ARS investing requires going beyond studies of historical performance and an examination of the arguments set forth by practitioners and academics. Manager selection and due diligence standards take on added importance. The spread between top-tier managers for skill-based strategies is much wider than for traditional longonly strategies. More often than not, skillbased funds are private limited partnerships managed by investment boutiques. Investors in these private partnership funds must rely more heavily on independent due diligence rather than regulatory oversight to be assured that prospective ARS managers are adhering to sound investment, business, and risk management practices. Finally, we believe that as a general rule, it is preferable for there to be an alignment of interests between the fund manager and the investor – managers should usually be expected to invest a significant portion of their net worth in their funds.
Implementing The Decision
In October 2000, based upon the Task Team’s recommendation, GM’s fiduciaries approved a one per cent allocation to ARS. This brought on new challenges – and a new focus of our research: How do you invest approximately $700 million in relatively immature, illiquid, and small funds?
To develop our investment program, we devoted considerable resources to building a skilled, internal team dedicated to serving the unique requirements of ERISA investors in this asset class. We made our initial investment in a well known fund-offunds with a proven track record. This strategy provided a well-diversified platform upon which to add attractive direct investments and also provided our team with an instant network of knowledgeable ARS investment professionals. The fund-offunds was the training wheels on the bike, so-to-speak, that helped the internal team get up to speed on the unique requirements of ARS investing.
With a well-diversified portfolio in place, we soon began adding individual managers to the mix. Initially, our internal team, all seasoned investment professionals who had worked in other investment strategies, worked closely with the fund-of-fund portfolio managers who were well versed in the unique aspects of successful ARS investing. Over time, they became increasingly knowledgeable in the nuances of investing in the asset class and developed a broad range of market contacts of their own. The fund-of-funds manager continues to serve as an ancillary source of information about potential investments among the thousands of funds in the hedge fund universe.
Today, fund-of-funds investments are a much smaller portion of our overall $700 million invested in ARS (as of December 31, 2002), as some 20 individual managers have been incorporated into our program. In the future, we expect to add additional managers judiciously to round out our strategies and to continue taking advantage of this unique and challenging asset class.
Myra R. Drucker is chief investment officer of GMAM’s General Motors Trust Company, and Edgar J. Sullivan is vice-president, investment research, for GMAM’s General Motors Investment Management Corp.
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