A fresh look at funds of funds

Institutional investors seek better due diligence, risk management after rough year

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Continuous: Andrea M. Bollyky said hedge fund manager due diligence should be relentless and ongoing.

Institutional investors are examining every aspect of their hedge fund-of-funds portfolios and the managers in charge of them in the wake of the performance debacle of 2008, liquidity problems and the seismic shock of Bernard L. Madoff's massive Ponzi scheme.

That's according to a group of experts at a Pensions & Investments round table on the state of hedge fund of funds.

The Aug. 18 discussion focused on the quality of operational due diligence; the need for better portfolio construction and a related move back to more concentrated portfolios of underlying hedge funds robust risk management.

The discussion focused on institutional investors' changing expectations of their hedge funds of funds and covered the need for better operational due diligence, robust risk management and full transparency.

The panel also discussed the limitations and pitfalls of separate account hedge fund management.

“What do investors demand from their funds of funds?” asked Kent Clark, managing director and chief investment officer of hedge fund strategies and global manager strategies, alternative investments and manager selection, Goldman Sachs Asset Management LP, New York.

“One of the things that we never thought we'd actually have to say, but we (have to now), is (that the expectation is that) when (investors) call and ask for the money back, they actually get the money back,” said Mr. Clark.

Joining Mr. Clark were: Andrea M. Bollyky, managing director for business development and client relations of absolute return strategies, Aetos Capital Management LLC, New York; Daniel Celeghin, director, Casey Quirk & Associates LLC, Darien, Conn.; Peter M. Gilbert, chief investment officer of the Lehigh University endowment, Bethlehem, Pa.; Alan Kosan, managing director and head of alpha research, Rogerscasey, Darien, Conn.; and Jim Vos, chief executive officer and head of research, Aksia LLC, New York.

Panelists stressed that institutional investors likely will seek hedge fund-of-funds managers that are focused on both superior investment management and appropriate liquidity matching of the underlying hedge fund managers in the portfolio and of the fund-of-funds vehicle, rather than on asset gathering.

“I think it was pretty easy to raise a shingle and become a fund of funds in the early part of the decade. I think investors feel a little bit betrayed by all the packaging that went into the fund-of-funds business by new product launches, by liquidity mismatches, by aggressive (investment agreement) documents, statements about investment process that weren't necessarily fulfilled,” said Mr. Vos.

(To hear an audio excerpt from the round table, in which the panel discusses how beta and how much is right in a hedge fund or fund of funds portfolio, please click below.)

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'Real' organization

Mr. Vos said his consulting team looks for hedge fund-of-funds managers that are “running a real investment organization, so a separate CEO and CIO is must for us. We'd like to see a firm that has one or two investment (strategies) and lives and dies by those programs. And fairness between investors. I think that after 2008, people are very focused on (avoiding) any kind of product packaging that gives one class of investors any advantage over another,” Mr. Vos said.

Much of the deeper scrutiny of hedge fund-of-funds managers is focused on the quality of operational due diligence, driven to some extent by the Madoff fraud.

“Sophisticated investors are still going to look for a gatekeeper of sorts to ... provide oversight,” said Mr. Kosan. “I think the No. 1 demand is going to be in the area of transparency (and) in risk management. If anything, while Madoff wasn't a hedge fund per se, if anything, emotionally what it created was a huge response and as a result, I think hedge funds of funds many actually see an increase in business.”

Round table participants noted that successful funds of funds already have given operational due diligence a much more prominent role in manager selection and portfolio construction.

“I think one of the things that differentiates (fund of funds) now after Madoff is the focus on due diligence and the ability of funds of funds to have operational accounting, auditing (and) people involved with that due diligence. I think in the past there was (more of an) emphasis on performance and access to funds. (Now, processes are) much more driven by analysis — historical analysis — of prior performance of funds as opposed to operational and back office ... that's a major difference in terms of what institutional investors will be looking for going forward,” said Mr. Gilbert.

But to be effective, hedge fund manager due diligence must be relentlessly ongoing, Aetos' Ms. Bollyky stressed.

“Constant re-underwriting of the (manager selection) ... is crucial (because) these hedge funds are meant to take advantage of anomalies in the marketplace. So if the only time you've done your operational due diligence is prior to making that investment and you're not (performing) very systemic rigorous (due diligence on a regular basis) ... then you're missing possible changes or alterations that might occur at the firm,” Ms. Bollyky said.

Rogerscasey's Mr. Kosan predicted that hedge funds of funds will continue to evolve their investment models, to develop more customized funds, separate accounts and specialized single strategy hedge fund of funds in response to institutional investor demand.

As for hedge funds managed as separate accounts, Mr. Kosan said, “the growth of hedge fund separate accounts is putting pressure on fund-of-funds fees on some level.” Still, he acknowledged that there are some barriers to widespread institutional adoption of separate accounts, including the requirement for a large minimum investment typically of between $50 million and $100 million; the unsuitability of illiquid strategies to a separate account format; custodial and security issues.

More pessimistic

Mr. Kosan's fellow panelists were more pessimistic about the prospect of separate accounts becoming ubiquitous among institutional hedge fund or fund-of-funds investors.

“I think separate accounts (are) ... viewed as this silver bullet by a lot of groups ... but if you look at the attributes that ... they believe the separate account will give them ... a lot of those qualities (can be gotten) in other ways more efficiently ... and cheaper,” Casey Quirk's Mr. Celeghin said.

Mr. Vos said that even with the advantages of owning a separate account, in the end, the institutional investor will find that “their return is really not going to be much different than the commingled funds ... So the package is a great package, but it's not really a different investment choice.”

One big advantage offered by separate accounts in the past was transparency, but “I think that the whole industry is changing to a great degree and you're beginning to get the kind of transparency that that a separate account would have ... (that's a) tremendous change,” Lehigh University's Mr. Gilbert said.

“I think the industry as a whole now understands what institutional (investor) needs are and particularly after this last year, there's a much greater move toward more transparency ... (because) government will probably be requiring registration, more transparency, you see much more proactive change with a lot of underlying fund of funds that are willing to be more transparent now,” said Mr. Gilbert.

Separate accounts notwithstanding, the P&I panelists concurred with Goldman Sach's Mr. Clark that hedge fund-of-funds managers must navigate rampant change in the hedge fund industry.

“Frankly, what we see is an industry in tremendous change and it's still changing and ... I argue (it probably will continue to change) through the end of this year ... in the last couple of weeks (we've seen) very large, presumably still viable hedge funds just pack it in. ... And it's not even year end yet when things could get ... really interesting,” Mr. Clark predicted.