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The Case For Global Fund Of Hedge Funds

By: Paul Easterbrook & Katherine Hawkins

For pension funds which may be wary of investing in single hedge funds, a fund of hedge funds may be an attractive alternative. Paul Easterbrook and Katherine Hawkins, of Schroder Investment Management North America Ltd., look at some of the advantages of using this approach.

Over the past 50 years, the hedge fund industry has grown from a handful of managers in the U.S. into a global business at the forefront of investment innovation. This has been reflected by the continued inflows into hedge funds as seen in 2004, when they attracted $73.6 billion in net inflows and expanded by slightly more than 18 per cent to $972.6 billion in assets under management.

Powering this growth has been the maturing of the industry and the increased acceptance, and use, of hedge funds in the investment strategies of pension funds. Indeed, a research paper from Greenwich Associates noted that 32 per cent of European institutional investors now use hedge funds, an increase from 23 per cent in 2003 (these usage and growth rates have been broadly mirrored in the U.S. and Japan). There are several reasons for this upsurge of interest in hedge funds. One is that they have delivered superior risk-adjusted returns compared to traditional asset classes. Figure 1 shows that the All Hedge Funds Index outperformed equities and bonds, as well as cash, over a 10-year period with a lower risk profile, in the case of equities.

Fuelled Growth
Coupled with the historically strong performance, the need for portfolio diversification and protection when markets turn downward (characteristics that hedge funds possess) have also fuelled growth (See Chart 1). Hedge funds can potentially offer such benefits to a traditional portfolio of investments because they are structured to operate in a different way from the classic bond, cash, or equity fund.

Although no neat, universally accepted definition exists for hedge funds – the reason being that they are not created equal – there are some common features such as the objective to generate positive absolute returns and preserve capital across all market conditions, rather then returns relative to a given benchmark or index. In order to achieve this, a hedge fund manager is afforded the flexibility to use specialist investment techniques (such as short selling, leverage, and derivatives). This flexible approach is possible because many hedge fund vehicles, unlike their traditional fund cousins, are unregulated.

As a result of the growth of hedge funds and the increasing interest from institutions, regulators have started casting a keener eye on them. The U.S. Securities and Exchange Commission (SEC) recently proposed a new Rule 203(b)(3)-2 which would require hedge fund managers to register as investment advisers under the U.S. Investment Advisers Act of 1940. In many respects, this increased regulatory oversight can be seen as a positive move from an investor’s perspective as the new legislation would call for hedge fund managers to meet higher standards for reporting and compliance, as well as subject them to the possibility of regular inspections. Registration for non-U.S. based managers with more than 14 U.S. investors is still being mandated. However, under certain circumstances, some of the requirements may be waived.

Notably, this example of possible regulator intervention is being driven by a U.S. body. Historically, the industry has been dominated by North American hedge funds. However, this is rapidly changing as hedge funds sprout up around the world and more fund of hedge funds portfolios are including a global content in their portfolio as opposed to purely U.S. components. This development offers interesting diversification benefits to a traditional portfolio of hedge funds. (See Chart 2).

Hedge Fund Umbrella
As previously highlighted, it is difficult to develop an allencompassing definition to the term ‘hedge fund’ primarily because there is an array of different strategies that fall under the hedge fund umbrella. An investor often finds it more useful to firstly understand how a manager is trying to achieve their returns and what types of risk they are taking to do this, rather than pigeon-holing an individual manager into a particular category such as fixed income arbitrage manager or systematic trader.

The Case For Global Fund Of Hedge Funds By: Paul Easterbrook & Katherine Hawkins For pension funds which may be wary of investing in single hedge funds, a fund of hedge funds may be an attractive alternative. Paul Easterbrook and Katherine Hawkins, of Schroder Investment Management North America Ltd., look at some of the advantages of using this approach.

A manager that deploys volatility/spread driven strategies is usually accomplishing performance by the volatility and/or spreads between the values of related financial instruments. The performance of liquidity/credit driven strategies is mainly driven by compensation for providing liquidity or credit, often in connection with expected corporate events and market driven strategies’performance which is mainly driven by market direction.

Broadly speaking, hedge fund strategies can be placed into one of those three riskreturn buckets as illustrated in Figure 2. However, as some managers deploy complex strategies they can straddle more than one of the risk categories at certain periods in time. Once an institutional investor becomes convinced of the potential benefits of adding a hedge fund element to its portfolio, the next issue is how to gain effective access to it.

Investing directly into a hedge fund through an individual manager can potentially pose some problems to those investors who may initially prefer to take a ‘toe in the water’approach. Some individual hedge funds have restrictive minimum investment requirements which may put off a first time investor, especially if it prevents them from gaining diversification across other managers. Also, access can pose a problem as top performing hedge funds may be closed to new monies. In order to overcome some of these barriers to entry, many institutions have been entering the hedge fund arena via the fund of hedge funds route.

Over the course of 2004, the $358.6 billion fund of funds sector expanded by 22 per cent in assets under management. This means fund of funds now control about 36 per cent2 of hedge fund assets. Fund of hedge funds tend to be investment vehicles whose holdings consist of shares in hedge funds. Some of these multi-manager vehicles limit their holdings to specific managers or investment strategies, while others are more diversified. In order to build a portfolio of hedge funds and to fully understand the sometimes complex nature of the underlying funds, a thorough due diligence is required at a number of levels.

Relevant Track Records
From an investment perspective, it is important when looking at a hedge fund to see if the investment managers have relevant track records and the right experience to be running their strategies. For example, a manager with long only stock picking experience may not necessarily have the skills to migrate to the long/short equity world. In recent years, the traditional fund management industry has seen many of its ‘star managers’ leave to start up hedge funds. Some have achieved success, although the pressures of running a business as well as running money have proven too much for some of these managers to sustain successful returns.

The operational aspects of the hedge fund world should not take second place in a due diligence to understand the investment process. A 2003 survey by Capco (a global research consultant) found that the “majority of hedge fund failures occur for non-investment reasons with 50 per cent happening as a result of operational events.” An operations analyst will want to ensure that a hedge fund manager is functioning within a compliant and legally minded culture. It is important to ensure that administrative and audit functions are set up independently from the investment management duties to avoid any opportunities for fraud.

Due Diligence
In order to perform due diligence and ongoing monitoring on an individual hedge fund, specialist skills (including portfolio construction and risk management) are required and the process can be time-consuming. This is one of the reasons why an institutional investor may find it more costefficient to outsource this function to a team of fund of hedge fund managers who have the required skills and are employed solely to analyze and select hedge funds. By employing experts, the fiduciary responsibilities are being outsourced in order to gain diversified exposure (by manager, strategy, industry, and market). As well, this gives access to those funds that have restrictive minimum investment levels and are closed to new investors.

As with all interesting propositions, there is no such thing as a ‘free lunch’and investors in funds of hedge funds are willing to pay two sets of fees, one to the fund of hedge funds manager and another set of (usually higher) fees to the managers of the underlying funds. This ‘double fee structure’has sometimes been regarded as a negative, but selecting hedge funds is a costly business and an investor is paying for expertise and access – that is, access to capacity within funds as well as to information, as hedge funds do not always have the same disclosure obligations as mutual funds so knowledge can be difficult to assimilate. Hedge fund investing via a fund of funds approach is a viable consideration for an institution and a global fund of hedge funds solution could be most appropriate for the foreign part of an investor’s portfolio.

Indeed, the proposed elimination of the foreign content limit should garner a higher level of consideration for a global hedge fund of fund product from institutional investors and their consultants. Potential for downside protection, diversification benefits through low correlations with traditional markets, and superior returns can be achieved with the use of global hedge fund of funds and should find a welcome home in a fully diversified Canadian institutional portfolio.

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