Before Arrowstreet Capital LP started a hedge fund, the firm took great pains to assure its traditional asset management clients that the new long-short equity fund would not drain talent or ideas from Arrowstreet's other funds, nor would it cause intra-office conflict with respect to compensation for the hedge fund managers vs. the traditional managers.
Peter Rathjens, chief investment officer of Boston-based Arrowstreet, said executives at the firm understood both matters were potential concerns for traditional asset management clients.
"They are both huge issues," Mr. Rathjens said. "Before we launched the hedge fund, we had to explain to our clients why this would not be deleterious to them."
As the hedge fund industry grows and more pension funds consider allocations to the strategy, an increasing number of traditional asset management firms are opening in-house hedge funds. Their goal is twofold: to capture some of the new assets and to keep talented managers from leaving to start their own hedge funds.
Keeping a balance
Starting a hedge fund, however, can bring with it a new set of problems. Hedge fund managers tend to be paid more than traditional managers, said Caroline B. Ballantine, a partner-in-charge at executive search firm Heidrick & Struggles International Inc., Chicago. Firms have to pay their hedge fund managers enough to keep them from leaving, but at the same time balance the two-tiered pay scale against the possible resentment it could engender among the traditional managers.
At the same time, the firm has to reassure its traditional asset management clients that the strategies in which they are invested - which have lower fees than hedge funds - have not suddenly become a secondary priority.
Brian Bruce, director of global investments for PanAgora Asset Management Inc., Boston, said the firm's managers run both the hedge fund and traditional portfolios. PanAgora manages $13 billion, including about $100 million spread among a structured market-neutral hedge fund, a leveraged core fixed-income hedge fund and a leveraged cap-rotation strategy hedge fund. All three funds are leveraged versions of traditional strategies run by PanAgora, Mr. Bruce said.
The structured market-neutral fund is the only one of the three hedge funds with institutional investors, including money from the $75 billion Teacher Retirement System of Texas, Austin. The investment decisions are made with the long-only portfolios in mind, and then the managers determine corresponding short positions for the hedge funds.
"If you're doing it fairly, which I believe every firm would need to do, the longs that you have are both the longs in your long-short and the longs in your long-only portfolio," Mr. Bruce said. "We make the long decision once. When we make buys, it's across the entire group of portfolios."
Arrowstreet manages $2.2 billion in assets, of which $70 million is in the firm's 4-month-old hedge fund, Mr. Rathjens said. To assure its long-only clients that Arrowstreet's traditional portfolios would receive the same attention as the hedge fund, the firm explains its overall trading strategy to clients in detail. Decisions about stocks are made without consideration for whether they benefit the hedge fund or the traditional portfolios. The protocol for choosing stocks is written into a computer program. Criteria get entered and the computer spits out long return forecasts, which rank about 1,500 stocks from "most attractive" to "least attractive." Then the Arrowstreet partners examine the list to find potential overweight and underweight candidates on the long-only side. Those weights correspond to long and short positions on the hedge fund side, Mr. Rathjens said.
Say, for example, the computer recommends an underweight position in one telecommunications stock and an overweight position in another. The traditional strategies would follow through with those recommendations, while the hedge fund would short the recommended underweight stock and buy a long position in the recommended overweight stock.
All of those trades would happen at the same time, so as not to use trades in the traditional funds to benefit the hedge fund, Mr. Rathjens said.
"At the stock-picking level, you shouldn't be focused on whether you like a certain stock in the context of the hedge fund," Mr. Rathjens said. "All the decisions are based on the same fundamental insights. That's how any responsible firm should operate."
Mr. Rathjens said the compensation differential between long-only and hedge fund managers is "a huge issue" at many firms that offer both products. At Arrowstreet, however, all of the portfolio managers are partners at the firm, and all work on both the hedge fund and traditional strategies.
While Arrowstreet's hedge fund might generate higher fees - the firm charges 1% of assets under management and 20% of returns, fairly standard in the industry - Arrowstreet's traditional international and emerging markets strategies still generate more income because they have more assets in them. The managers have no incentive to favor the hedge fund over the traditional portfolios, Mr. Rathjens said.
And making the managers partners eliminates one lure of leaving to join a small hedge fund shop, or opening a new shop.
"Every portfolio manager is a partner in the firm. That tends to be a very hard thing for competing firms to overcome," he said.
With respect to compensation, PanAgora's Mr. Bruce said managers share in the good times when the hedge fund strategies perform well, but aren't paid at the same rate as managers at small hedge fund shops. That stands to reason, Mr. Bruce said, because the people in those small shops have taken significant investment and career risk to start that business, they and deserve to be compensated for it.
"Because of that increased risk, there should always be increased return for those who do that," Mr. Bruce said. "Managers at a bigger shop don't have to be compensated as highly because the firm is taking on part of that risk."
Smaller shops, the so-called "three guys and a dog in the garage" shops, also have less overhead, meaning they can keep more of whatever profits are generated, Mr. Bruce said.
Typically, asset management firms that offer hedge funds tie the hedge fund managers' compensation to the performance of the hedge fund. The bonus can be linked to the profitability of the hedge fund group, or how well a particular fund performs. That bonus is usually paid on top of a salary and the offer of some equity stake in the firm itself, Mr. Bruce said.
In Mr. Bruce's opinion, the size of the compensation package has less to do with keeping good managers than the managers' fear of going solo.
"Can you pay enough to keep good managers? Hedge funds aren't the only reason to ask that question," Mr. Bruce said. "That's the same general question that you'd get if you've got a hot (long-only) team with a great track record at a big firm. What stops you from going across the street, renting space and setting up shop? Will they not be better compensated by doing that? The answer is `of course.' But you're incurring tremendous risk. There's no guarantee you'll succeed."