Alternatives

Hedge fund investors apply core-satellite

Strategy an answer to issue of higher fees for mediocre performance

Sarah Shores
Sarah Shores said the move is a new use of an old model.

Updated with correction

Institutional investors are beginning to dramatically restructure their hedge fund portfolios, pairing a core allocation of cheaper alternative beta investment strategies with a satellite portfolio of alpha-generating hedge funds.

The trend is nascent but gradually gaining converts, attracting interest from asset owners fed up with paying hedge fund managers high fees for promised alpha that turns out to be market beta, observers said.

Money managers and consultants report they've seen huge interest in alternative beta portfolios in the past year from institutional investors of all kinds, including corporate and public pension plans and sovereign wealth funds.

Alternative beta strategies assume that risk premiums — the return from holding assets that carry risk — can be identified by a wide range of factors beyond simple market risk. Managers capture risk premiums systematically through passive replication strategies or actively managed, long/short multiasset strategies that invest in securities that meet factor characteristics. The approach also is known as alternative risk-premium or alternative factor-based investing.

“There is a strong need for alternative investments to provide diversification by offering uncorrelated returns to investors, which hedge funds provide better than real estate or private equity,” said Lionel Erdely, chief investment officer and head of alternative solutions, Investcorp Investment Advisers LLC, New York.

“Alternative beta can provide the robust diversification advantages of hedge without the high cost. Investors have a strong focus on hedge fund fees now,” Mr. Erdely added. He declined to provide the size of Investcorp's alternative beta strategies but said the firm has seen “very strong interest and an acceleration of inflows.”

That said, sources agreed the pace of institutional investor movement from investigation of alternative beta strategies to investment still is slow.

Broader strategies

Broader risk-premium strategies such as smart beta, based on long-only strategies, have attracted between $100 billion and $150 billion to date, said Deepak Gurnani, founding partner of Alternative Risk Premia Investments LP, New York.

Using the narrower definition of alternative risk premiums, such as multirisk premium market-neutral strategies that are favored by institutional investors, Mr. Gurnani estimated current investment totals between $10 billion and $15 billion.

Although the adoption of core-satellite portfolios for hedge fund exposure still is in its early stages, the model itself is nothing new to institutional investors.

“We've seen this before, beginning years ago when institutional investors combined core portfolios of passive or low-risk equity and fixed-income investments with active strategies in which they had a lot of conviction,” said Sara Shores, managing director and head of investment strategy for the factor-based strategy group and global head of smart beta for BlackRock (BLK) Inc. (BLK) Ms. Shores is based in the firm's San Francisco office.

“Multiasset strategy core portfolios with a baseline of alternative beta investments with investments in hedge fund that produce alpha is an evolving model, but one that makes a lot of sense,” said James C. McKee, senior vice president and director of hedge fund research, Callan Associates Inc., San Francisco.

“The approach is getting a lot of interest for good reason, because it's a viable alternative to too-expensive hedge funds,” Mr. McKee said, noting the core-satellite structure is very familiar to institutional investors.

Fairfield pension funds

Cost, transparency and returns uncorrelated to major markets were among the reasons the Town of Fairfield (Conn.) Joint Retirement Investment Board took a look at multiasset-class alternative beta strategies as a possible replacement for Diversified Global Asset Management after it closed last year, said Robert Mayer, the town's chief fiscal officer.

DGAM managed about half of a $35 million hedge fund portfolio in a hedge fund-of-funds strategy for the Town of Fairfield Employees' Retirement System and the Town of Fairfield Police and Firemen's Retirement System. The pooled assets of the two funds total $350 million and are overseen by the investment board.

“Hedge funds are expensive and returns haven't met expectations, so the board looked for an alternative” and found it in alternative risk-premium strategies, Mr. Mayer said, with the assistance of Callan, the fund's investment consultant.

The investment board is to interview three finalists, the results of a search last year, at its next meeting on Feb. 9. The finalists are Invesco (IVZ) Advisers Inc., Newton Management and Standard Life Investments Ltd.

The portfolio managed by the successful candidate will form the core of the pension funds' hedge fund portfolio, with existing direct investments in Conatus Capital Management LP and Wellington Management Co. LLP hedge funds providing alpha-generation in the satellite ring, Mr. Mayer said.

The value proposition for alternative beta strategies vs. hedge funds is compelling: Flat management fees for these portfolios range between 10 basis points and 80 basis points, depending on the complexity of the strategy and the amount of leverage used, industry sources agreed.

By contrast, the mean management fee for single-manager hedge funds in 2016 was 1.57% and the mean performance fee is 19.29%, according to survey data from institutional investors collected by industry researcher Preqin.

“Institutional investors' eyes have opened to the fact that they don't have to invest in hedge funds to get hedge fund-like returns,” said Andrew Beer, managing partner and co-portfolio manager of the dynamic beta strategy at Beachhead Capital Management LLC, New York.

Beachhead Capital manages a total of $550 million, of which $140 million is invested in the firm's alternative beta strategy.

Investment executives at United Parcel Service Inc., Atlanta, had five years of experience in using factor-based strategies within the long-only global equity portfolio of the company's defined benefit plans, but it still took two years of research before the investment team was ready to substitute alternative beta for some managers in the $3 billion hedge fund portfolio.

“Our goal was not to have any beta — equity, credit or duration — in the hedge fund portfolio,” said Syed Haque, director of public markets for UPS' defined benefit plans, which total $32 billion.

Because UPS' hedge fund portfolio doesn't have any beta, Mr. Haque said it tends to have a bias toward global macro and trend-following strategies. UPS' investment team determined that these returns could be captured by specific risk factors for a much lower cost than standard hedge fund fees. Long/short equity was another hedge fund strategy Mr. Haque said the team determined also could be adequately captured by risk premiums.

Two managers, whom Mr. Haque declined to name, were selected in mid-2016 to run market-neutral portfolios on UPS' hedge fund managed account platform using risk factors selected by the pension fund's investment pros. Mr. Haque said that after just six months, it's too early to judge returns of the alternative beta portfolios, but did note “directionality has been going in the right direction.”

UPS' ultimate goal is to have the alternative risk portfolios account for about 25% of the risk of the hedge fund portfolio by the end of this year.

Rising flows

Among money managers reporting rising institutional investor inflows into alternative beta strategies are Capital Fund Management SA, which manages $2 billion in the area; BlackRock (BLK), $1 billion; and ARP Investments, which manages $300 million.

Thanks in part to “very big flows” in the past year or so, Towers Watson & Co., New York, now advises or manages a total of $12 billion in alternative risk premium strategies, said Douglas A. Smith, senior investment consultant, hedge fund research.

Mr. Smith and his team have built a model, which is a reverse of the core-satellite model, that he said is growing in popularity across the institutional market. About 65% of the portfolio is invested directly in alpha-seeking hedge fund managers and 35% invested in alternative beta strategies.

“Too many hedge fund investors are chasing the same thing and paying too much for it,” Mr. Smith said, noting “there still are pockets of investment strategies that are open to new investors that offer good alpha opportunities and we want to be able to grab those managers for our consulting and investment clients.”

This article originally appeared in the February 6, 2017 print issue as, "Hedge fund investors apply core-satellite".