Hedge funds: prevention or cure?

Mon Mar 5, 2012

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What is the right prescription for a potentially fatal lack of alpha?


By Niki Natarajan

"Trust me I am a doctor." This phrase once instilled trust and hope. These days less so. Why else are so many more patients turning to alternative therapies? Is the same true of those used to trusting their investment consultant without question?

As the land grab for advisory work accelerates some FoHFs are giving themselves away to retain the pension fund turf being eroded mandate by mandate by the very consultants that are supposed to be opening the trustee doors to them.

Among the top 10 largest FoHF there are now many offering a hybrid solutions with their FoHFs at the core and the ability to add a few direct names at the edges for little or no extra in terms of fees.

Meanwhile some (not all) of the brand name consultants continue to offer their cut and paste hedge fund solutions: one third to multi-strategy and global macro, one third to long/short equity and one third to credit. A little Caxton (even if Bruce Kovner is no longer running the ship); a dash of Brevan Howard and a sprinkling of Bridgewater (now part owned by Texas Teachers) and the portfolio is complete. Even a mere journalist can put a similar portfolio together.

But who is responsible for keeping track of the performance of these consultants' segregated accounts? Who is paying the legal fees? How is due diligence done (and paid for)? Are the consultants responsible for pulling the trigger on a manager who has strayed off course, or is the pension fund liable? Does anyone remember Rocaton and their penchant for Amaranth?

And at the same time, who is left to assist those thousands of pension funds that need FoHFs to trawl through the 2,280 funds run by 556 management firms housed in the InvestHedge FoHF database alone? Even filtering by assets so that only the 107 largest with $1 billion under management are considered, one would have missed 50% of 2011's FoHF winners (see pages 24-32). Even bFinance is now no-longer conflict free, having hired Chris Jones, ex-chief investment officer of Key Asset Management, to offer advisory solutions to clients.

I was recently lucky enough to be invited to sit in on my first UK pension fund investment committee meeting where the three year track record of their FoHF was quite rightly being questioned.

What I realised very quickly was that the plan cannot have been advised by their consultant as to why they should have hedge funds (performance or protection); what hedge funds are for (assets or tools) and hence where they should sit in the portfolio. Nor the nuance of the FoHF they hired: a US equity biased firm that was plonked in the alternative bucket at the start of the 2008 down turn; no wonder the plan was not pleased.

Now compared to its peers and correctly benchmarked, this FoHF had not done that badly, but was it the best pick for this UK pension fund? Was it in the right place in the portfolio?

The thing that galled me the most was the idea that the very consultant that put them into FoHFs in the first place has now changed its tune using the second layer of fees as the main argument against FoHFs (note that the FoHF in question had accepted a low flat fee in the first place).

The consultant's new 2012 version 2.0 policy is to offer a segregated portfolio of direct hedge funds at far lower fees than pre-existing FoHF. Fees are cheap, but is the investor getting value for money? As Patrick Fauchier, co-founder of $7 billion Fauchier Partners once said "It's like a doctor giving a patient a list of antibiotics. What if the patient picks one that does not work 'oops you picked a wrong one'. Then what?"

FoHFs are fighting back with their FoHF/advisory hybrids. The big ones believe that this is the right way to go. They believe pension funds get the benefit of institutional grade hedge fund reporting and infrastructure for what they see as a little margin erosion for services without revenues.

The smaller FoHFs, however, are struggling as they need their fees to pay for the ongoing due diligence costs that funds of funds incur because of the dynamic nature of manager and strategy selection. Assuming performance is one's goal, this group is where you will find it.

For now at least, with the hybrid solution pension funds do get the benefit of proper experienced manager selection and due diligence. But is this model ultimately sustainable? Is this the wrong prescription for a potentially fatal lack of alpha?