By Niki Natarajan
As Sebastian Vettel sped across the finishing line to win the Monaco Grand Prix last week, I realised that the hedge fund industry had bifurcated into Fords and Ferraris. As with the high octane hedge funds of old, Formula 1 winners may sometimes scoop a win simply because another has crashed. AIMA’s Investor Steering Committee recent Guide To Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures, has offered a new manual on how to build a Ford and avoid crashes (page 26), but no mention of how to enhance performance – still, of course, the central issue for investors.
The assumption has always been that investors buy hedge funds for performance, but it seems more true to say that the majority of them are simply using hedge funds as a way to reduce the equity risk in their portfolios. For these investors, hedge funds are not really an alternative investment anymore; they are a business that manages money differently. As Kathryn Graham, a keynote at the upcoming InvestHedge Forum (page 20), said at the recent EuroHedge event in Paris: “The industry needs to look more like a proper business, with proper boards, good governance and directors that know what they are doing.”
This is exactly as it should be for those manufacturing Fords with their low volatility and ‘safe’ returns. There seems to be a problem in the industry right now, however, as some investors still believe they can have Ferrari performance with a Ford chassis. But in reality of course, unless one chips the engine (and adds leverage) there is going to be continued ‘‘disappointment’ in hedge fund performance.
Many investors are now buying these operationally sanitised funds to build constrained customised portfolios, but what the majority are doing is sacrificing performance. “Every time you constrain a manager you are making it more difficult for that manager to earn superior returns,” said Mark Eaker of Sire Management Corporation in our interview last month.
If performance is not the end game, then technically this should not be a problem; but right now the lacklustre performance of the indices is creating a sustainability issue. Dampened, institutionalised performance has created a Catch 22. With performance no longer the goal, the hedge fund indices are suffering. Most funds of funds do not report the performance of their customised accounts and even if they did the lower returns would only serve to dampen the FoHF industry’s returns still further.
This lower return environment in the FoHF space means investors are less likely buy funds of funds –which is in turn fuelling a stagnation in the allocations to single managers generally, but more importantly to the managers of tomorrow as well. Institutional seeding, such as APG’s IMQubator is one answer to this (page 37), but even many seeded managers often rely on savvy funds of funds as investors.
The $500 million expected to flow out of ABN Amro’s private bank is a small drop in the FoHF ocean (page 35); but it seems that the tide is turning. Looking at this month’s Mandate table shows that $580 million was allocated to FoHFs and there were a number of new mandates that also announced plans to invest in FoHFs (page 14).
According to Dariush Aryeh of Fundana (page 32) and Jean-Louis Juchault (page 34) experienced funds of funds are the only viable model to really access manager alpha – and discover the Ferraris of tomorrow. And it turns out that like in any cycle, one always ends up back to the beginning, which in this case sees the return of private banks, such as Julius Baer, who know how to drive fast, safely. The FoHFs, such as Fundana, on their highest conviction funds of funds lists, really know how to look inside the hood of the hedge fund engine to rev up performance.