Five Questions: K2’s David Saunders Weighs Changes in Fund-of-Funds Industry

K2 Advisors CEO David Saunders on finding returns in the hedge fund sector and why funds of hedge funds will continue to play an important role.

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The hedge fund industry has changed dramatically since David Saunders and his business partners founded K2 Advisors, the $9.4 billion Stamford, Connecticut–based fund-of-hedge-funds firm, in 1994.

Hedge fund assets have exploded from $167 billion in 1994 to over $2.37 trillion today; the investor base has become increasingly institutional; and the variety and number of hedge funds has increased. Outsize returns have become harder to come by, while manager transparency and the understanding of what creates non-market-driven performance, or so-called alpha, has increased.

Meanwhile, the fund-of-hedge-funds space has become increasingly competitive as these managers vie to prove they can add value for clients who otherwise might choose to invest directly in one or more hedge funds. In order to achieve critical mass, more fund-of-hedge-fund managers are choosing either to merge with or sell stakes to banks or asset management firms. Last year K2 sold a majority stake — between 50 and 75 percent — to San Francisco–based Franklin Templeton Investments. Templeton replaced Boston-based private equity firm TA Associates, which had owned a minority stake in K2.

Saunders, K2’s CEO, got his start as a hedge fund trader with WaterStreet Capital in 1992 before joining Julian Robertson Jr.’s famous Tiger Management Corp. as its head trader the following year. Recently, he sat down with Institutional Investor Senior Writer Imogen Rose-Smith to talk about challenges facing the fund-of-hedge-funds industry.

In the past few years, long-short equity — historically the most popular of hedge fund strategies — has underperformed the market. Is long-short equity over as an alpha provider?

We think there is a lot of opportunity in long-short equity, but returns will ebb and flow a little bit. There are many different strategies within long-short equity. If we take a high-level approach, we might say that fundamentals haven’t driven markets. The lynchpin lies in dispersion — that is, the spread between winners and losers — in equity pricings, and when we see dispersion drop back down, we expect to see an uptick in manager performance.

Over the past decade Apple has consistently been among the most popular stocks held by hedge funds. Given the rise in value of Apple over that time, wouldn’t institutional investors have been better off investing in the home-computer manufacturer instead of developing hedge fund allocations, particularly in the long-short space?

An Apple comes along once in a generation of investors. No one ever tells you at the time that this is the once-in-a-generation steal. It may be a testament to the hedge funds that Apple was the most widely held hedge fund stock. They all owned it, and then they all sold it. Interestingly enough, now they are starting to buy it again. That is the whole idea behind active management. They are constantly retesting their theses. The fact that many hedge fund managers owned Apple is a testament to the fact that active management works.

Institutional investors, particularly public pension plans, are increasingly bypassing funds of hedge funds to invest directly in hedge funds. Do you expect this to continue?

The market is definitely evolving, and there are certainly some large players that people feel comfortable with now. Our industry, like most mature industries, goes through periods of consolidation and repositioning, and I think we are seeing that. But we believe this current movement to go direct is a fad, not a trend.

Is that because such investors typically lack the resources necessary to manage a large hedge fund portfolio?

I look at it in terms of resources, and most of the resources lie with the asset management firms. The thing that you can’t lose sight of in the hedge fund space is that investing is a time-consuming, resource-intensive effort with the due diligence and monitoring that is required. Many investors, however, are allocating without these resources, and therein lies the risk.

The quest for deeper, more global resources is a significant driver behind the recent spate of fund-of-funds firms being sold to larger asset management firms and financial services providers. Was this a contributing factor in your decision last year to sell a stake in your business to Franklin Templeton?

We had a financial sponsorship arrangement with TA Associates and decided to transition to a more strategic partner with global resources to support our business. Finding the right cultural fit was important. The personalities were crucial; and when we met with Franklin Templeton, we had a good feeling about it. We’ve also been able to expand our geographic footprint from offices in five countries to over 30, which is the third piece for us. Information equals alpha, and we now have access to real-time information and people on the ground around the world. That was really important to us.

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