The last 12 months have been, to put it mildly, “disruptive” for the hedge fund investor. No more so than for endowments, foundations and pensions that may have only recently invested in alternative investments. This month we direct our “seven questions” to someone at the mine face who advises and educates these investors on their alternative allocations.
Greg Dowling is Managing Principal and Director of Hedged Strategies at Fund Evaluation Group, a 70-person investment consulting firm serving institutions such as pensions and foundations.
Greg, what about the recent 12 months surprised you the most, and how has it changed the advice you have given your clients?
It would be hard to pinpoint just one surprise. The whole sequence of events that occurred post-Lehman was not only surprising, but also all together shocking. For years, you would hear from analysts covering the financial sector who worried about the investment banks and large money center banks’ exposure to hedge funds. In the end, it was hedge fund’s exposure to the banks that almost brought them down. There is certainly some irony here. One of the most regulated industries, banking, nearly collapsed, yet those “evil” unregulated hedge funds held up fairly well in comparison.
What has changed? Well, you simply cannot make recommendations solely on a pure investment risk/return basis anymore. You now need to consider the health and liquidity of both the client and the manager.
What do you see as the areas requiring the most client education today?
A large part of the education process is now focused on overcoming a wall of misconceptions that is often exasperated by the mainstream media. It’s hard not to find a hedge fund article that doesn’t contain the words “secretive,” “highly-levered” and tools for the “rich and privileged.” Don’t get me wrong, there are a lot of great journalists writing fair and balanced pieces; and not all of the coverage should positive by any means since there are bad actors in every industry. However, many hedge fund actually do offer acceptable levels of transparency and use little or no leverage.
More practically, a lot of our time has recently been spent on educating clients on accounting and audit changes like the recent updates to the AICPA guidelines and FASB 157.
What are they key mistakes you see from alternative asset manager when approaching your clients?
Alternative managers just need to understand their targets better before undertaking an aggressive marketing campaign. For example, while start-up funds approach us all the time, FEG is not in the manager “seeding” business. There is merit to investing with smaller, more flexible managers, and there are a lot of great Fund of Funds that do this already, but our clients don’t. You would be shocked, how certain managers cannot understand this.
What is your view on the convergence of hedge funds and long-only traditional managers? Do you have a preference for or bias against a hedge fund moving into a 40-Act fund or a long-only manager establishing a hedge fund?
One could argue that “investing is investing” no matter the specific strategy. After all, hedge funds are really just unconstrained active management. However, I think running a hedge fund actually does require a unique mind-set. As a result, I believe it’s easier for a hedge fund manager to run a long-only fund than vice-versa. Traditional managers often get too wrapped-up in things like tracking error and information ratios to run a truly unconstrained portfolio. Sometimes, we see traditional managers allow a talented PM to run a hedge fund on the side with the belief that this will help retain talent. But when this happens, there is often no true commitment from either the firm or the PM.
While there are significant opportunities for private equity, venture and real estate, the end investor preference appears to be for liquid strategies. How is asset allocation changing right now?
Even for clients with ample liquidity, this is still a tough balancing act. A few months ago, there was little talk about new allocations to these alternatives. But we are now beginning to see clients re-open discussions about less liquid strategies. They know that when it comes to private equity, for example, vintage years with the lowest commitment levels have usually been some of the best performers.
Distressed investments (e.g. RMBS, CMBS etc.) are also attracting renewed interest. The key is to buy from distressed sellers and not to just buy distressed investments. Clients are now also very concerned about the longer term issues of inflation. The only implementation problem is that in the short-term there is deflation risk given global overcapacity.
The recent market dislocation has exposed some flaws in the tools of portfolio management. MPT, VAR, Standard Deviation etc are all under fire. What new tools do you use or does the market need to accurately evaluate risk and correlation?
We still use all of those tools, but it’s important to understand the difference between risk measurement and risk management. Investors can often grow over confident when they become very good at risk measurement – providing them with a false sense of security.
More than ever, it’s important to not overlook the use of qualitative information and non-return-based statistics. Many times, the marriage of these metrics with traditional returns-based ones can yield very helpful insights. For example, you now need to adjust performance for leverage or net exposure. Also, you need to recognize “alpha decay” and increased correlations as AUM grows. As assets increase, out-performance may fade or begin to match the index. Traditional beta or even hedge fund beta exposure is fine, but you shouldn’t pay 2 percent and 20 percent for it.
Fund Evaluation Group recently released an article on “Rebalancing Strategies in a Bear Market” that compares buy-and-hold, constant mix, and Constant Proportion Portfolio Insurance (CPPI) strategies in light of last year’s annus horribilis. How are your clients using these restructuring strategies after last year’s tough markets?
There are pros and cons to each approach. In the end, the important thing is to rebalance in response to today’s opportunity set regardless of your chosen method. In general, we have suggested that clients rebalance equity allocation back to their (pre-2008) target levels. Also, for those that don’t have liquidity concerns, replacing a portion of their long-only equity with long/short equity makes sense if you think that equity markets will be choppy for the foreseeable future.
This blog post is courtesy of AllAboutAlpha.com. The views and opinions expressed do not necessarily represent the views and opinions of Fund Evaluation Group, LLC (FEG), AllAboutAlpha.com, CAIA Association or Institutional Investor.
