July-August 2012

INSIDE VIEW: The perils of DIY

DIYFollowing the pounding of funds of hedge funds, investors were advised to go the do-it-yourself route. But this is an accident waiting to happen, says Robert Marquardt, of Signet Group. Bar a handful of sophisticated institutional investors worldwide, quality funds of hedge funds (FoHFs) are still the best way to access skill-based investing, bringing added value net of fees to investors. This may seem contrarian, given recent coverage of the sector. In the past few years, FoHFs have come in for a drubbing, in the industry and the press – particularly the press. Critics say FoHFs – as a category usually represented by an index – performed poorly. Assuming the indices showing the relative underperformance are properly constructed, the question remains: is the period under consideration long enough? Even a year is not. More so, which human being aims at the average anything in life? Therefore, why do it with FoHFs, rather than looking at the ones that clearly outperformed? Then there is the idea that FoHFs let us down on operational due diligence, hence the frauds. The truth is, most FoHFs have steered clear of frauds, a testament to their strong operational due diligence capabilities. On a similar note, some critics slate FoHFs’ skills when it comes to investment due diligence, saying they proved to be highly correlated when markets tanked. However, the number of managers that make up part of a FoHF’s portfolio, no doubt, contribute diversification. Ultimately, there is liquidity. Apart from the fact that investors should finally get to terms with the return/liquidity trade-off, things have much improved on this issue and liquidity is a priority for most investment solutions. The evidence frequently quoted by the singers of FoHFs’ requiem is they are hemorrhaging money. The reason for this, according to the press, is that investors are increasingly going solo – they are learning to DIY, or do-it-yourself, in other words. But what exactly is DIY? If it means going solo, it is an accident waiting to happen, apart from the case of a handful of sophisticated institutions globally. But if, as seems to be the case, DIY-ers still necessitate external expertise, the whole mantra of exodus from FoHFs is mostly a misleading chimera. Investors are still buying FoHF expertise, just under a different wrapper. Worse, they are buying, arguably, lesser-quality expertise from consultants-turned-FoHF-managers. These have their own conflicts of interest, and it is instructive how many talk their own book in their view of FoHFs. Equally, there is no alignment of interest between these consultants-turned-FoHF-managers and their investors, since consultants are unlikely to invest alongside their clients like FoHF managers do. Proof of the contrary to the hemorrhage argument, is that during the agony of the years 2007 to 2008, when several FoHFs, particularly in the US, significantly expanded their business. Due diligence
Furthermore, these alleged DIY-ers are frequently advised to put their money into the supposed safety of household hedge fund names which, however, are unlikely to deliver the best risk-adjusted performance. In addition, an ever more elusive alpha is going to push hedge fund managers to remote boundaries of their mandates – and perhaps beyond. This, coupled with the increased regulatory and compliance burdens on institutional investors, is going to increase significantly the need for expert and experienced due diligence – beyond DIY-ers’ capabilities. Another impression wrongly conveyed by the current raft of criticism is that a FoHF is a monolithic, stale and immutable entity. Nothing could be further from the truth. The old FoHF model is a stale idea but while the name has not changed, the new business model is radically different, particularly for the FoHFs that sailed through the last three to four years. As an example, our FoHFs offer three layers of returns: top-down macro allocation; bottom-up manager selection; and portfolio construction. All this, achieved by combining fundamental analysis and quantitative expertise, requires analytical work and allocation skills as well as portfolio construction and monitoring expertise. The risk management of such portfolios necessitates skills, experience and systems which are, again, beyond the reach of most DIY hedge fund investors. Additionally, emerging managers, which can be the source of increased returns, require a distinctive analytical approach. Diversification, even more important for nascent companies, is also a challenge for DIY-ers. There is also the question of the negotiation of favourable terms: FoHFs, by virtue of their bargaining power, are in the position to negotiate favourable conditions with the underlying hedge fund managers, in terms of lower fees, assured future capacity and increased transparency on the underlying investments and strategies.    Two additional common complaints from investors have been the lack of transparency and the drawbacks of having their money commingled in a fund. The industry has answered with various forms of segregated accounts, which address both complaints. Many large investors now prefer funds-of-one, where investor’s assets are not commingled, allowing the client and FoHF portfolio manager to focus on a specific strategy (for instance, Asian debt, European recovery, event-driven mandates) for the client.   This is the case as investors move out the liquidity curve and down the credit curve in search of additional liquidity and credit premia. Funds-of-one allow for concentrated or thematic portfolios and structure fees in a manner that benefits both. Cost-effective
Finally, superior and persistent returns necessitate an experienced and dedicated group of analysts and portfolio managers to select the best opportunities from a vast range of assets and to combine them into an efficient portfolio. Markets’ variability shortens considerably the shelf life of most trades, making the structure and expertise required to cover their full range prohibitively expensive to DIY-ers. The cost of building such an infrastructure in-house is beyond the reach of most investors, hence a FoHF, contrary to the current mantra, is a cost-effective way to access the necessary expertise. Hedge funds and FoHFs have been flat in the past 12 months. A zero interest rate and sub-par growth environment due to deleveraging and austerity has meant that less return was to be had and classic strategies such as fundamental equity and macro rates/currencies in the largest developed economies - the US, the UK, the eurozone and Japan - struggled. Further, hedge funds kept exposures low to protect investor capital, as is their mandate. A DIY investor would be mistaken to assume that what we witnessed in the last twelve months is what we should experience going forward and funds be selected accordingly.   The economic and inflation risks might be to the upside in twelve month’s time – 180 degrees opposite of today’s expectations. The problem for DIY-ers is how to adjust their portfolios to adapt to the risks and maximise risk-adjusted returns should this sea change materialise. This is when the investment skills of FoHFs come in to their own, and the perils of going solo become apparent. Robert Marquardt is founder, chairman and co-head of investment management at Signet Group ©2012 funds europe 

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