Funds-of-funds managers going long-only

(updated with correction)

Insistent institutional investor demand for alpha has been quietly fueling long-only strategies for two of the industry's biggest hedge funds-of-funds managers.

Among the industry's best-kept secrets is that hedge funds-of-funds heavyweight managers Black-stone Alternative Asset Management and The Rock Creek Group LP between them run nearly $7 billion in long-only strategies using hedge fund portfolio managers in manager-of-managers structures.

Industry sources contacted for this story were slightly aware of Blackstone's migration into long-only approaches, but none had heard of Rock Creek's endeavor.

By contrast, a number of respected hedge fund managers have been fairly open about the launch of long-only versions of their strategies just this year.

These firms include CQS (U.K.) LLP, Lansdowne Partners LP, Lone Pine Capital LLC, Maverick Capital Ltd., Tiger Global Management LLC, Viking Global Investors LP and Winton Capital Management Ltd.

Institutional investors, dissatisfied with the returns they are getting from their traditional active equity and fixed-income managers, have been the primary drivers behind the launch of long-only strategies by hedge fund and funds-of-funds firms, sources said.

A surprisingly high percentage — 44% — of institutional investors invest in long-only strategies run by hedge fund managers, according to data from Deutsche Bank Markets Global Prime Finance, the finance unit of the investment bank.

That compares to 40% of consultants, 36% of private wealth managers and 28% of hedge funds of funds, according to Deutsche's “From Alternatives to Mainstream” hedge fund survey report.

About 30% of the 60 hedge fund firms surveyed said they offered long-only strategies totaling $177 billion as of Oct. 31.

A majority of hedge fund companies — 67% — said demand from all client types was among the top three reasons for offering long-only strategies.

Only 28% of all 200 investors surveyed, on the other hand, said they asked a hedge fund manager to set up a long-only strategy, while 30% said they might in the future.

One asset owner that recently tapped a hedge fund-of-funds manager for a long-only approach is the $160.7 billion New York State Common Retirement Fund.

The Albany-based fund hired Rock Creek Group to manage $300 million in an active, long-only emerging markets equity strategy in October, Eric Sumberg, a spokesman for state Comptroller Thomas P. DiNapoli, sole trustee of the pension fund, said in an e-mailed response to questions.

The pension fund previously hired Rock Creek to manage $200 million in an emerging hedge fund manager fund of funds in 2010, Mr. Sumberg said.

Executives from both New York-based Blackstone Alternative Asset Management and Washington-based Rock Creek Group said they often manage multiple mandates for their institutional clients and — as with the New York state fund — a long-only strategy investment tends to follow an allocation to their hedge funds of funds.

Both firms also were early in quietly developing long-only portfolios for a subset of their largest institutional clients.

Blackstone launched a strategy for one of its clients in 2007 that employed hedge fund managers to trade the long-only components of a proprietary commodity index the firm developed. In 2011, BAAM also launched a long-only equity manager-of-managers approach in response to a client request. BAAM managed a total of $5 billion in long-only assets as of Sept. 30, within aggregate assets of $53 billion.

Gideon Berger, a Blackstone senior managing director and head of technology and risk management, said he could not identify the original or subsequent clients, but noted the construction of active investment strategies using hedge fund managers to run long-only money is typical of the firm's process.

“If we get client demand for a solution to a particular problem and if we see that the need is something a hedge fund manager can solve, we're ticking off two boxes. That triggers internal research on the problem, the solution and the structure. We talk to some of biggest, most sophisticated clients, collaborate with them and refine the strategy,” Mr. Berger said.

BAAM now is conducting similarly intensive research on other long-only strategies to be managed by hedge fund portfolio managers, but Mr. Berger said it was too soon to discuss them.

A large state pension fund asked Rock Creek Group to develop a long-only emerging markets equity multimanager strategy in 2009. That client, which Afsaneh M. Beschloss, the firm's CEO and president, said she could not identify, now has $1 billion invested in the strategy. Of Rock Creek Group's $9.5 billion in total assets managed as of Nov. 30, 18.9%, or about $1.8 billion, was in long-only emerging markets portfolios, with the balance managed in customized separate hedge funds of funds or commingled funds.

Word-of-mouth among institutional investors fueled the growth of Rock Creek Group's long-only strategy, which draws on the emerging markets equity management experience that many of its employees, including Ms. Beschloss, gained while working in the investment unit of The World Bank. Ms. Beschloss served as treasurer and chief investment officer there.

A very tough environment for shorting stocks and fixed-income instruments over the past few years led to hedge fund managers deciding to separate their skill on the long side of their investment approach into stand-alone strategies.

“It's a function of low alpha production on the short side since 2008 until about September this year. Short-selling as a stand-alone strategy or as part of a long/short equity portfolio was basically written off,” said Scott C. Schweighauser, partner and president, Aurora Investment Management LLC, Chicago.

Over the past two to three months, “shorts have come back” and “2014 is setting up to be very good for absolute positive returns and alpha generation,” said Mr. Schweighauser, but he said it's doubtful that institutional investors will abandon their hedge fund managers' long-only portfolios.

“Hedge fund managers, even if they are managing a long strategy, are oriented toward absolute returns. They are not guided by having to hew to an index benchmark as a traditional active manager and that tends to produce less correlated and idiosyncratic returns,” Mr. Schweighauser said.

“Most hedge fund managers are excellent stock pickers,” he added.

Aurora managed $9.3 billion in hedge funds of funds as of Nov. 30, but does not manage stand-alone long-only strategies.

Another factor in the profusion of long-only strategies is the lure of performance fees that will be paid on a lower bogey, said BAAM's Mr. Berger.

The 20% performance fee charged by many hedge fund managers is dependent on generating a positive absolute return above the fund's high-water mark. In bad years, hedge fund firms don't get paid, which means they can't pay bonuses and start getting nervous about losing staff, he said.

But performance fees for long-only managers are based on index-topping returns, even if returns are negative.

“Long-only funds switch hedge fund managers from an absolute-return model to a relative-return model, and that is attractive” on a cash flow basis, Mr. Berger said. n