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November 16, 2009 12:00 AM

Long-only or hedge? It no longer matters

Christine Williamson
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    Institutional investors are gearing up to integrate hedge funds into their equity and fixed-income portfolios, part of a growing trend toward allocating assets based on their sources of return — alpha and beta.

    After years of maintaining separate and usually quite small allocations to hedge funds, more investors are recasting the role of hedge funds in their portfolios, sources agreed.

    Consultants, hedge fund-of-funds managers and risk management system providers reported a dramatic spike in the number of pension executives who are seriously thinking about emulating their endowment and foundation brethren in being agnostic over whether managers run long-only or hedged strategies.

    The result, sources said, likely will be a boon for hedge fund managers as institutions abandon their low limits to hedge funds, now typically between 3% and 5% of assets.

    “I don't think there's a difference between hedge funds and regular managers when it comes to risk assessment and portfolio construction. More investors are thinking about how to include, rather than exclude, hedge funds from the asset class categories appropriate to the investment strategy, beyond the small group of very sophisticated institutional investors that adopted this approach some years ago,” said Maarten Nederlof, managing director and head of portfolio solutions at Pacific Alternative Asset Management Co. LLC, Irvine, Calif. PAAMCO manages $9 billion in hedge funds of funds.

    The driver behind the shift was last year's market crash. Sources said institutional investors were surprised by the revelation that the total market exposure — known as beta — of their separate equity, fixed income and hedge fund allocations was larger than thought. Combining hedge funds and long-only managers into a single portfolio allows the fund's investment staff to better understand and manage sources of both alpha and beta, consultants and money managers said.

    'Once in a lifetime'

    Institutional investors had a “once-in-a-lifetime chance to see how things really worked” in 2008 and are assessing “what worked and what didn't. Hedge fund and fund-of-funds returns were negative last year, but returns of long-only managers were much worse,” said Kelsey Biggers, managing director and head of risk and information technology, K2 Advisors LLC, Stamford, Conn. K2 manages about $8 billion in hedge funds of funds.

    “The realization that hedge funds were better performers in such an extreme crisis has resulted in many plan sponsors trying to find the right tools to measure and analyze hedge funds,” said Deepak Gurnani, managing director and chief investment officer of the approximately $4.5 billion hedge fund and fund-of-funds business of Investcorp International Inc., New York.

    “The right risk allocation to hedge funds is the No. 1 topic being discussed in the institutional investment industry now. I think this year will be looked back on as a period of a fundamental shift, the defining point in how institutional investors use hedge funds in their portfolios,” he added.

    Investcorp's research shows that the right tools will “analyze what you actually own, what you have in those hedge fund portfolios. What's really necessary is identifying sources of alpha and beta, deciding your risk tolerance, and managing the entire equity or fixed-income portfolio along those lines,” he said.

    Essential to analyzing alpha and beta sources is “true transparency” for all asset classes, down to exact positions in every portfolio, said Olivier Le Marois, chairman of risk manager RiskData SA, Paris.

    Andrew Lapkin agreed. “Investors got away from ... basic investment(s) — equity, fixed income and cash — and began investing in real estate, private equity and hedge funds, which are much more complicated,” said Mr. Lapkin, managing director and president of Measurisk LLC, a New York risk management and hedge fund data aggregator. “Investors had really detailed information on the basics (asset classes) and none on alternatives.”

    The infamous unwillingness of hedge fund managers to provide full transparency on their investments presented a huge obstacle to institutional investors' ability to analyze the true beta of a portfolio, sources said.

    The good news is that institutional investors have succeeded in pushing hedge fund managers to provide portfolio positions, generally on a monthly basis, to risk aggregators like Measurisk, RiskData and New York-based RiskMetrics Group. Bound by strict confidentiality agreements to protect trading positions, data aggregators provide investors with the aggregated risk exposures of individual hedge funds and across the total hedge fund portfolio. The risk providers also can assess risk, including that of hedge funds, across an investor's entire portfolio.

    Brian Schmid, head of RiskMetric's alternative investment business, said two years ago that about 45% of the hedge fund community was providing portfolio positions. Today, about 85% offer full transparency, and most of the remaining 15% are in some stage of preparing to provide the information, Mr. Schmid said. RiskMetrics has about 1,200 managers on its risk platform.

    Measurisk is adding about 30 hedge funds per month to its platform, and about 1,000 managers now provide monthly information. Mr. Lapkin noted that 65 of the 100 largest hedge funds are on the firm's platform, which shows that it's not just “the smaller, more desperate hedge funds that people always say are the only ones who will provide this kind of information.”

    Full advantage

    Specialist hedge fund consultants and hedge fund-of-funds managers are taking full advantage of better hedge fund transparency.

    Hedge fund consultant Aksia LLC, New York, just contracted with Measurisk to give Aksia clients access to hedge fund manager data. Jim Vos, Aksia CEO and head of research, said the firm is in midst of assisting many clients — none of which he would identify — to mainstream hedge funds into their regular portfolios. Essential to the process is an absolute understanding of beta and the ability to identify and manage it, Mr. Vos said.

    “We're passionate about beta. We don't think it's a dirty word. The rest of the industry tends to run away from it, but we're focused on beta measurement, based on positions, not return streams, and we track it over time. In the portfolio context, the beauty of beta is that sources can be added and subtracted across the portfolio,” Mr. Vos said.

    Beta isn't a bad word in Nigel Lewis' lexicon either. He is managing director of strategic research and risk management at the $88 billion Texas Teacher Retirement System, Austin.

    The fund has a dedicated hedge fund target allocation of 4% that has been incorporated into the fund's stable-value portfolio, which acts as protection against deflation, for the past couple of years. The stable-value portfolio accounts for 20% of total assets and includes cash and long Treasury investments in addition to hedge funds. The fund also has 20% invested in an inflation-protection portfolio and 60% in global equities.

    Mr. Lewis said hedge funds are not handled separately within the portfolio, which had led to more efficiency primarily because staff knows the degree of beta embedded in the hedge fund portfolio.

    “We know how our hedge funds will perform within different market cycles because we know what their risk and beta exposures are. We build an environment footprint for every manager in the fund, including hedge funds, so we understand what they will do,” he said.

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