Experts look under the hood of 3 large hedge funds of funds

NEW YORK — Morgan Stanley Alternative Investment Partners LP's mediocre hedge fund of funds performance last year proves bigger is not always better.

The $719 million Morgan Stanley Institutional Fund of Hedge Funds LP is the largest hedge fund of funds registered with the U.S. Securities and Exchange Commission. Still, it got caught by two of last year's hedge fund blowups, losing 70% of its combined $34.4 million investments in Beacon Hill Asset Management LLC's Safe Harbor Fund LP and Lancer Partners' Lancer Partners LP fund.

"Size is the enemy of performance, and so is overdiversification," said James R. Hedges, president of Naples, Fla.-based LJH Global Investments LLC, a hedge fund advisory firm.

Mr. Hedges thinks that Morgan Stanley, with 38 hedge fund investments in its fund of funds, made too many investments in too many large hedge funds.

"People believe they move away from single-manager risk by diversifying, but it can be the opposite. Morgan Stanley, with all their diversification, still managed to pick two (bad) managers," said Mr. Hedges.

Morgan Stanley officials disagree. Spokesman Bret Gallaway said managers of the fund believe having more managers is better than having fewer managers.

"We consider diversification as an asset to the risk management process," Mr. Gallaway said.

Mr. Hedges and Virginia Reynolds Parker, founder of the Stamford, Conn., hedge fund advisory firm Parker Global Strategies, reviewed the SEC filings from Morgan Stanley and two other registered funds of funds for Pensions & Investments.

Their findings offer insight into how hedge funds of funds differ in their composition and risk tolerances and how those differences can affect performance.

In addition to the Morgan Stanley fund, P&I also asked the pair to look under the hood of registered funds of funds offered by UBS PaineWebber Inc., New York, and Lazard Alternatives LLC, New York. They are the second- and third-largest registered hedge funds of funds that filed semiannual reports.

No two hedge funds of funds are exactly alike. Some take bigger bets on certain strategies; others seek to invest evenly across a broad array of different styles. Some charge higher fees than others. Performance benchmarks vary from fund to fund.

Most do not reveal anything about their composition to non-investors, making it impossible for outsiders to see which managers the funds select, how much they have with each manager, how those managers contributed to performance and how the composition of the funds changes over time.

The exceptions are those funds registered with the SEC. Hedge fund-of-fund managers choose to register for a variety of reasons, but mainly because doing so allows them to offer their funds to a wider audience of both retail and institutional investors. Unregistered funds are more restricted both in terms of who can invest and how much money they can accept from plan sponsors qualified under the Employee Retirement Income Security Act.

And just as the registered funds P&I reviewed differ from each other, so did some of Mr. Hedges' and Ms. Parker's views of the funds.

For example, Ms. Parker was a little easier on Morgan Stanley, calling the Safe Harbor and Lancer fund blowups "unusual and unfortunate" for Morgan Stanley.

"When hedge fund managers are doing tricky things, you can have very strong due diligence, but if people are not forthcoming with what's going on, sadly this kind of thing can happen," Ms. Parker said.

To a trained eye, the semiannual SEC reports show the kinds of bets each of the three funds of funds were taking last year, their risk exposures and where they generated their performance.

Morgan Stanley appeared to place its biggest bets with managers following event-driven or market-neutral trading strategies, Mr. Hedges said. Overall, the fund's biggest bet was on convertible arbitrage, with 25% of the fund's net asset value as of Dec. 31 invested with managers following that strategy, according to the SEC report.

"Convertible arbitrage, fixed income and mortgage arbitrage account for 50% of the (Morgan Stanley) portfolio," Mr. Hedges said. "These are quantitative driven, usually highly leveraged securities."

In its report, Morgan Stanley officials point to convertible arbitrage as a bright spot. That 25% bet generated a return of almost 9% between July 1 and Dec. 31, according to the report.

Another positive was the 41% allocation to nimble multistrategy funds, which could shift focus as market conditions changed. By Dec. 31, most of the multistrategy funds were tilted toward convertible arbitrage and distressed debt strategies, which rallied late in the year, according to the report.

One hedge fund manager employed by Morgan Stanley, The Clinton Group Inc., New York, ran 8% of the fund's capital as of Dec. 31. Ms. Parker said such a high allocation to one manager was unusual, but because it is a multistrategy manager, Morgan Stanley was perhaps comfortable with a higher allocation.

"Some fund-of-funds groups will limit the amount they allocate to any one manager," Ms. Parker said. "They do it for diversification, and also because if something goes wrong and the value goes to zero — which is a rare occurrence — then the view of the fund-of-funds group is they've limited exposure to 2.5% or 3%."

UBS PaineWebber's Event & Equity fund appeared poised to turn in good performance this year, based on the managers in which it was invested at the end of 2002, Mr. Hedges said. He said they tended to be newer, emerging managers that were biased toward distressed securities. Overall, he said, the UBS PaineWebber fund had a more concentrated portfolio than either Morgan Stanley's or Lazard's because the fund used the fewest managers and more of them followed the same kind of strategy.

"The only fund that stands for something is the UBS PaineWebber portfolio," Mr. Hedges said. "It is biased toward distressed and is more concentrated. UBS PaineWebber has the potential to outperform the others, which are much more diversified. This portfolio could be doing really well right now." (PaineWebber's Event & Equity fund is not available to institutional investors, but its size and composition offer a comparable proxy for tax-exempt investors.)

Ms. Parker also noted the UBS PaineWebber fund's concentration in distressed investments among fewer managers but observed that the report provides the least detail of the three.

Among the distressed managers listed in the report, Mr. Hedges said, are the Harbinger Distressed Investment Fund, which returned 4.2% for the year ended Dec. 31; Canyon Value Realization Fund, which returned 4.2%; Epsilon Global Active Value Fund II-B, which returned 3.9%; Och-Ziff (OZ) Domestic Partners, which returned -1.2%; and Satellite Credit Opportunity Fund, which returned 3.6%.

While Morgan Stanley's and Lazard's reports include narratives about how various strategies worked and contributed to or detracted from performance, the UBS PaineWebber report does not. Instead, it, like the others, lists the managers and the assets they had as of April 1 and what they ended with as of Sept. 30.

PaineWebber gives raw numbers on a manager-by-manager basis, Ms. Parker said, but not "percentages, which are much more helpful" when it comes to quickly determining asset allocations and performance attribution.

Ms. Parker said Lazard had the "broadest range of strategies" of the three funds. The fund had 29% of its capital dedicated to event-driven strategies, 24% to tactical trading, 23% to long-short equity and 21% to relative value. The remainder was in cash, according to the report.

Roughly 20% of the portfolio appeared to be dedicated to directional trading strategies, based on the managers used, Ms. Parker said.

Among the event-driven funds in which Lazard invested were Farallon Capital Partners, Marathon Special Opportunity Fund and The Canyon Value Realization Fund, according to the report. Other managers included West Side Partners (relative value), Framework Asset Partners (tactical trading) and Shaker Investments, (long-short equity).

Mr. Hedges called the Lazard fund a "highly diversified" multistrategy portfolio with "good funds."