Hedge funds, funds of funds and portable alpha

New recognition by investors of role hedge funds can play in portfolios

The participants
Andrea Bollyky Andrea M. Bollyky, managing director for business development and client relations of absolute-return strategies, Aetos Capital Management   Daniel Celeghin Daniel Celeghin, director, Casey Quirk & Associates   Kent Clark 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
Peter Gilbert Peter M. Gilbert, chief investment officer of the Lehigh University endowment   Alan Kosan Alan Kosan, managing director and head of alpha research, Rogerscasey   Jim Vos Jim Vos, CEO and head of research, Aksia
Moderating was P&I Online Editor Gregory Crawford
Photos by Rohanna Mertens

Hedge fund investment has never been more difficult. Between the markets and the Bernard Madoff scandal, every manager now is suspect and the quality of investment and operational due diligence is critically important. Hedge funds-of-funds managers remain vitally important gatekeepers for many institutional investors in the asset class.

More sophisticated institutions that decided to invest directly in hedge funds are rethinking the decision and might go back to funds of funds. Many investing in funds of funds seek to replace incumbents that had Madoff exposure, experienced high-net-worth investor redemptions or had liquidity problems with other funds-of-funds managers.

Recently, Pensions & Investments brought together a distinguished panel of hedge funds-of-funds managers, investors and consultants to explore the dynamics that will reshape institutional investment in the next few years.

The participants were:

Andrea M. Bollyky, managing director for business development and client relations of absolute-return strategies, Aetos Capital Management LLCNew York;

Daniel Celeghin, director, Casey Quirk & Associates LLC, Darien, Conn.;

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;

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, CEO and head of research, Aksia LLC, New York.

Gregory Crawford, P&I's online editor, moderated the panel.

In this excerpt from the 90-minute discussion, panelists discuss the changing role of hedge funds of funds — and hedge funds themselves — in portable alpha programs.

Mr. Crawford: Peter, many institutional investors use hedge funds-of-funds managers to serve as the alpha engine in their portable alpha programs, and after disappointing performance in 2008, many are being dismantled or revamped. What do you think the loss of such big mandates will mean to hedge funds of funds?

Mr. Gilbert: I think there are two issues there. Let me try to take the first ... When I was at the Pennsylvania State Employees' Retirement System, we had probably one of the largest portable alpha programs. It made up almost 25% of the fund and most of our equity exposure.

But portable alpha is a complex program to manage. You have the alpha component. Equally important is the beta component. For this to work, you have at least three things that you really have to keep track of.

One is to realize that it is an economically leveraged program, so as well as it works on the upside, it can work equally badly on the downside. So it requires a great deal of monitoring, understanding the pieces that go into it.

The other important thing is that you have to be aware of what beta you have in the alpha engine and adjust for that.

And the third point is on the beta side: You need collateral in order to manage that program. When things are going up, it is not an issue. When things are going down, you have to be able to cover your losses.

And, generally, the hedge fund-of-funds program — if you're using that for your alpha — is not liquid enough to be able to cover that beta. So you have to have other funds set aside to do that.

Mr. Crawford: Kent?

Mr. Clark: I'd say there (are) probably two things that really happen. One is an under appreciation of how much a portfolio of hedge funds can lose. And so not only did traditional markets, or the beta, go down a ton — “a ton” is a technical term by the way; quant, very quant — but also, the hedge funds lost more than most investors anticipated. So that was one big disconnect.

Fundamentally, the way most of these programs were constructed, there was a liquidity mismatch. We talked about lots of asset-liability mismatches or liquidity problems in hedge funds, but this was one of them. And it was true probably for currency hedges as well and other kinds of financial engineering ... But there was a liquidity mismatch, and when you have a liquidity mismatch, then you're going to have surprises or you're going to have to scramble to cover the liquidity mismatches. ...

So there's a question of what's appropriate, what isn't appropriate, right? So finding a different pool of liquidity might be appropriate for your program.

Mr. Celeghin: I think maybe a positive outcome in the longer run for the fund-of-hedge-fund industry from the shortcomings of portable alpha is that it accelerated ... the recognition that hedge funds are not an asset class; that certain strategies actually do have some beta in them, and therefore, it makes sense to view hedge funds and use hedge fund strategies — first of all, categorizing them the right way. Recognizing what you have and recognizing that across your ... asset allocation there can be a role for hedge fund strategies.

What doesn't make sense, or makes less sense, is to segregate them and sort of bucket them as this strange thing called hedge funds that I don't understand and I'll put them all together; I'll create a diversified portfolio, a balanced, diversified portfolio and put it here.

Rather — and I think we're seeing some groups move down this line — it makes sense to say, for example, "I have 60% exposure to equities. I maybe don't want that to have a beta of one, since there is a lot of risk in this; therefore, a portion of my equity investment I will invest in a long/short fashion.

"Maybe if I have the staff and the governance, I can go direct. Maybe it's actually more efficient to hire a fund of fund or a fund of funds ....

"But I do recognize there is beta in this. And just as my long equity portion will go up and down, this thing, too, can go up and down. Hopefully, it'll be dampened.'

But I think that recognition of basically looking under the hood, recognizing hedge funds aren't all one and the same, and I can get parts of what's in there and apply it to different pieces of my portfolio in a different way, is where the buyers are slowly heading.

Mr. Kosan: To your point about hedge funds having a different strategic purpose in a portfolio — maybe more nested within an equity or fixed-income allocation as extensions of those strategies — is true. We're starting to look at common factors of risk and return, as opposed to isolating just purely on alternative as a distinct bucket.

Mr. Clark: The good thing about portable alpha programs is there's a recognition that alpha exists. So fundamentally that's good. The second thing that I often say is, "Listen, if you find alpha, just leave it where it is and grab it. Don't worry about moving it around. It's hard enough to find al-pha. Let's just take advantage of it.'

I think that, ultimately, the recognition that you can make money and maybe now is an opportune time to have some real alpha is what we hope investors are focusing on.

Mr. Kosan: And I think the key point that came out between Daniel (Celeghin) and Peter (Gilbert) is when the beta swap is unwound, it's not a repudiation of hedge funds that serve as the alpha engine.

So whether they go into an absolute-return strategy, they get nested within a broader equity/ fixed-income allocation, there wasn't a recoil from hedge funds as it was from the disappointment in that particular investment.

Ms. Bollyky: There are a significant number of institutions, particularly very large public plans, who are anticipating making investments in hedge funds. And they're doing so to diversify away from the portfolios that they're rebuilding or reallocating to.

So, as Daniel had suggested, the role that a hedge fund plays in a portfolio is really dramatically transitioned to being one of a diversifier and a beta reduction element to a portfolio than one of simply adding on return.

Mr. Crawford: So it's reimagining the idea. Peter?

Mr. Gilbert: I think it's a key point that hedge funds are tools that can be used in a portfolio in a variety of different ways. You know, they're not an asset class. I mean, they can be used as (a) so-called absolute-return vehicle. But you have to be clear on what purpose they're serving.

For instance, for us, we want a diversified pool that is going to give (us) a different stream of return and different risk than equities or fixed income.

At the same time, as Daniel said, we use long/short, long-biased equity funds in our equity area and then, again, in our inflation hedge we have a variety of different commodity long-biased hedge funds.

We have a commodity manager that actually is neutral, and that we have in our absolute-return bucket as opposed to the commodity bucket, because we're not getting the beta from him.

So I think going forward, you'll see much more emphasis on how hedge funds fit in to fill a certain purpose within the total portfolio structure.