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Fond of funds

Pension managers are pouringmoney into hedge funds-of-funds. And funds are multiplying. But the talent to invest this windfall is in short supply.

Pension managers are pouringmoney into hedge funds-of-funds. And funds are multiplying. But the talent to invest this windfall is in short supply.

By Andrew Capon
June 2001
Institutional Investor Magazine

Pension managers are pouringmoney into hedge funds-of-funds. And funds are multiplying. But the talent to invest this windfall is in short supply.

Europe's biggest pension plan - the Netherlands' Algemeen Burgerlijk Pensioenfonds - announced last month that for its inaugural foray into hedge funds, it would seek board approval to hire a fund-of-funds manager. The E150 billion-in-assets ($130 billion) ABP's starting investment: up to E2 billion over the next three years. That's nearly twice the amount that the U.S.'s biggest pension fund - California Public Employees' Retirement System - said last summer that it intends to invest in hedge funds. Nicola Meaden, the chairman of funds-of-funds firm Tremont Tass, greeted ABP's move as "a tremendous vote of confidence" for both hedge funds and the funds-of-funds business.

But is that confidence warranted? Even as more European pension funds like ABP opt to invest in hedge funds through funds-of-funds, and hedge funds predictably proliferate, concerns are mounting that this sudden popularity is putting too much of a strain on a once-obscure industry that catered mainly to wealthy private investors. By exhaustively researching many hedge funds and then investing in a handful of them, the funds-of-funds are supposed to limit client risk. The worry is that a poorly managed effort may end up adding a layer of risk in an alternative investment that's already experienced a number of painful disasters.

Even some established players have begun waving a red flag. David Smith, chief investment director of Global Asset Management, which has been a funds-of-funds manager for many years (see box, page 54), observes: "This used to be a small business with a defined group of people in it. All of a sudden there is a rush of investment. There are systemic risks building up, and they are not just on the investment side. There is a lack of experience." The systemic risks range from a lack of proper due diligence to poorly constructed portfolios that are too concentrated in certain securities to providing insufficient information to clients. Smith's greatest worry is that a neophyte manager's mistake - whether in selecting a fund or administering the assets - will hurt the entire business.

A definite talent shortage has developed among funds-of-funds. The head of the European hedge fund team at pension consulting firm Watson Wyatt Worldwide, Stephen Oxley, confides: "We are very concerned that many firms seem to be heavily reliant on a few key individuals and that there is a limited pool of expertise beyond this top layer of management. There is certainly a skill shortage. There just aren't that many good hedge fund analysts."

The scramble for skills has produced a deadly serious game of musical chairs. Here are just a few rounds: When Mellon Financial Corp. launched Mellon Global Alternative Investments in London last December, it poached two 30-year-old hedge fund researchers, Derek Stewart and Scott MacDonald, from Liberty Ermitage Group, another funds-of-funds manager. In February Jupiter, a major U.K. fund management company catering to a largely retail audience, snagged a three-man fund-of-funds team, John Chatfield-Rogers, Peter Lawery and Algy Smith-Maxwell, from Lazard. And with two of the biggest names in traditional fund-of-funds management - SEI Investments and Frank Russell Co. - gearing up to enter the hedge funds-of-funds business later this year, the demand for talent is unlikely to abate soon.

It's little wonder that expertise is being stretched so thin. Fund-of-funds managers find themselves as gatekeepers to one of the world's fastest-growing, most dynamic marketplaces. London's Tass Research estimates that in roughly the past five years, hedge fund assets in Europe have grown more than sixfold, from $6 billion to $39 billion. Such companies as AstraZeneca, Unilever and J Sainsbury all plan to invest a portion of their pension assets in hedge funds. Swissair has already started to make commitments. The number of European hedge funds has almost doubled, from 151 to 277. Research firms say that there are at least 4,000 hedge funds globally and maybe as many as 6,000. Meanwhile, funds-of-funds in Europe alone have expanded about threefold, to more than 30, in just the past five years (at least twice that many now reside in the U.S.). Funds-of-funds now handle one of every five dollars invested in hedge funds, according to Hennessee Group, a New York consultant.

The appeal of hedge funds to pension funds is undeniable. The ABP's head of investments, Jelle Mensonides, explains his sophisticated public fund's rationale for so large an investment: "A common misconception is that hedge funds are risky. In fact, they have a low correlation with the overall portfolio of the fund and so are risk reducing." For funds like ABP that heed their total portfolio's risk profile or that balance index investments with active approaches, hedge funds offer the putative benefit of noncorrelation. Plus, they have usually done well as a group in down markets, mainly because they can short stocks or go long. Thus even as the Standard & Poor's 500 index plunged 10.1 percent and the MSCI Europe, Australasia and Far East index dove 20.5 percent in 2000, the average hedge fund gained 11 percent, according to Van Hedge Fund Advisors.

But the arcane investing approaches and short tenure of many of the newer funds raise troubling issues. A lot of popular strategies have not been tested under all market conditions - and may not perform as promised. Rick Sopher, an LCF Rothschild Asset Management managing director who runs the firm's Leveraged Capital Holdings hedge fund, says: "I see risk with the modern obsession of dependence on quantitative analysis. I think that excessive reliance on historical statistics seems to have drawn many investors into supposedly low-volatility strategies that look great on paper. But I am not convinced that these investors really understand how risky these strategies could be in bad markets." Adds Tremont's Meaden, "There is no black-box approach to fund-of-funds investing that can be credible."

A small but growng body of academic work is also beginning to question the credibility of certain fund-of-fund and hedge fund investment styles. In a paper delivered this April to Q-Group, a U.S.-based association of leading quantitative finance professionals and researchers (including Nobel prizewinners William Sharpe and Harry Markowitz), Nikko Securities Co. International's chief investment officer, Andrew Weisman, argued that certain hedge fund styles, including market neutral and merger and fixed-income arbitrage, can post surprisingly good risk-adjusted returns over relatively long time periods using naive investment strategies. Unfortunately, argues Weisman, the inexorable rules of the financial markets are such that these strategies "in most cases imply a catastrophic loss of capital at some point and offer no long-term benefits." Moreover, Weisman contends some of the standard optimization techniques being used by funds-of-funds to build portfolios "will systematically create all sorts of horrible outcomes." His paper, entitled "Dangerous Attractions: Informationless Investing and Hedge Fund Performance Measurement Bias," is available on the Web at qwafafew.org/boston/handouts/ weisman20010313/ABW.htm.

Weisman's research complements that of hedge fund manager Clifford Asness, who disputes the conventional wisdom that hedge funds almost automatically provide noncorrelated returns.

Their conclusions will be debated. But examples of hedge funds that have gotten into spectacular difficulty are not hard to find. Long-Term Capital Management is the best-publicized case. Its $1.6 billion in losses came on an esoteric short-volatility strategy that had seemed sound and even conservative to LTCM's banks. Mortgage bond specialist David Askin's Granite fund pursued a supposedly market-neutral strategy in his mortgage-backed-securities arbitrage fund. When the U.S. Federal Reserve Board hiked interest rates in 1994, the fund blew up, and its investors lost essentially all their money.

Risks are heightened today because so much money is chasing so few "hot hands," particularly in Europe. Several funds have had to stop taking money. AlphaGen Capella, managed by Roger Guy at Gartmore, is shut completely to new investors. London-based Eureka, run by Marshall Wace Asset Management, returned 20 percent of accumulated capital gains to its investors in January. Rothschild's Sopher says that the $600 million invested in his firm's European Capital Holdings fund is the limit of its capacity. He wonders how other managers can run larger European funds. Also shuttered is GAM's Multi-Europe fund. With so many long-standing funds unavailable, investors may feel pressure to participate in any way they can by putting their money into untested funds.

Fund-of-funds managers can be invaluable as experienced navigators of this daunting, unmapped terrain. Since hedge funds tend to be relatively small - usually less than $1 billion - large investments like ABP's must be spread over several hedge funds, each pursuing its own unique style. Fund-of-funds managers' extensive databases, personal contacts and analyses can be vitally important in appraising individual funds and combinations of funds. Says Watson Wyatt's Oxley: "We would not pretend to have the expertise to select the hedge fund managers or build a portfolio of them. For that reason we have focused our efforts on researching the fund-of-funds managers." Although ABP plans to bring hedge fund expertise in-house over the next few years, it will rely on a fund-of-funds in the interim. As investment chief Mensonides notes, this investment is "a departure for institutions in Holland."

Certainly, ABP won't lack for choices among hedge funds-of-funds managers. New ones are appearing from every financial quarter. In 1999 Credit Suisse Asset Management launched its Global Alternative Investment Business, which manages $2.5 billion in a Luxembourg-listed hedge fund-of-funds, Credit Suisse Prime Select Strategies Fund. From this and other sources, the firm has a total of $3.7 billion in hedge funds under management. Four-year-old Deutsche Asset Management's Absolute Return Group added $2 billion in hedge fund assets last year, bringing its total to $3 billion.

U.S. fund-of-funds specialists are also stepping up. Tremont Advisers, in Rye, New York, acquired U.K. hedge fund research firm Tass Research in 1998. Tremont Tass now has $7.5 billion under management or advice. Man Group, the London alternative-investment house, acquired its former U.S. joint venture partner, Glenwood Group, last year.

The cost of the fund-of-funds service is not cheap. Fees of the underlying hedge funds - perhaps 1 percent of assets plus 20 percent of any upside - must be paid on top of the fees of the fund-of-funds manager, typically between 1 and 2 percent. Nevertheless, consultants like Oxley are convinced that fund-of-funds fees are well worth it. "Yes, you add a layer of fees," he says, "but you also add a layer of skill."

Fund-of-funds managers can now enhance that skill through fuller data. Although still prone to secrecy, hedge funds have become more forthcoming about performance and strategy in recent years. Public funds like ABP and CalPERS, of course, must report to their boards on their risk positions and returns, so they demand a clear understanding of each fund's operating style and portfolio makeup. And firms like New York-based Measurisk.com now augment transparency by providing fund-of-funds managers with detailed reporting on funds' risk exposures.

"In the early days, managers were trading in any opportunities that they saw, and you needed to develop personal relationships before you got coherent activity reports," recalls Sopher. "Reporting has improved a great deal since then, due partly to online access to information. The analysis we can do is so much better." Pension funds had better hope so.

GAM basks in reflected glory

"We are parasites on the greatness of others," says David Smith, disarmingly. Seated in Global Asset Management's elegant town house in London's St. James district - home to British royalty, gentlemen's clubs and the city's premier wine merchants - GAM's chief investment director is explaining why his firm is one of Europe's most successful funds-of-funds operators. "People like Louis Bacon and Paul Tudor Jones are great thinkers about the investment world," Smith explains, "so when they tell me about what is happening in Japan and the consequences it will have, I listen."

Smith, 35, a former investment management consultant, is not being altogether ingenuous when he downplays GAM's role in the fund-of-funds investment process. As any investor knows, recognizing talent in a portfolio manager takes talent in its own right. GAM has prospered over the years in good part because it has shown a consistent knack for being able to pick stock pickers - which is, after all, what being a funds-of-funds manager is basically all about. Along with Bacon and Tudor Jones, GAM's stable of portfolio managers has included - most before they became famous - Mario Gabelli, Bruce Kovner, Fayez Sarofim and George Soros, among other notables.

GAM has, however, backed some clunkers as well. It signed up with bond arbitrage manager David de Jongh Weill, who had two spectacular years before sharply rising interest rates in 1994 wiped out 60 percent of his Vairocana fund's capital. GAM promptly dumped de Jongh Weill, an American devotee of Eastern religions, who retreated to an ashram. Bad apples tend not to last long: Turnover among the managers in GAM's funds-of-funds is between 30 and 35 percent annually.

GAM is, by fund-of-funds standards, among the more venerable firms around. It was founded in 1983 by Egypt-born financier Gilbert de Botton, who amassed a first-rate modern and contemporary art collection and an equally impressive client list that included members of Princess Diana's family, the Spencers; Formula One race car driver Ayrton Senna; and clients of legendary banker-to-the-rich Edmond Safra. De Botton sold GAM to UBS (see Investment Banking, page 36) for $630 million in 1999; at the time, he owned 60 percent, Lord Rothschild 40 percent. Last August de Botton died at 65.

GAM manages roughly $15 billion for private clients and institutions; $4.4 billion of that is in funds-of-funds and the remainder in conventional assets. The bulk of the funds-of-funds money is concentrated in three large multimanager hedge funds: GAM Diversity, the flagship, with $1.7 billion; GAM Trading, with $1 billion; and GAM Multi-Europe, with $700 million. The funds' solid performance, modest volatility and, above all, low correlation to major-stock-market returns would seem to affirm academic research that posits that hedge funds - and funds-of-funds managers, in particular - should be included in a portfolio for diversity's sake.

Since its inception in 1989, GAM Diversity, which invests in global bonds and stocks as well as currencies but holds at least half its assets in equity hedge funds, has delivered an average total return of 14.5 percent a year before fees, compared with 7.9 percent for the MSCI world index, its main benchmark. Over roughly this same span, the Standard & Poor's 500 index returned 17 percent a year on average and the MSCI Europe, Australasia and Far East index 4.3 percent. It's noteworthy, though, that GAM Diversity achieved its performance with lower volatility than its benchmark (8.1 percent to 14.6 percent) and a higher Sharpe ratio of reward relative to risk (1.1 percent to 0.16 percent). In its worst year - 1994 - GAM Diversity outperformed its benchmark but still tumbled nearly 20 percent. Reminder: No investment is foolproof.

GAM Multi-Europe, which invests in hedge funds pursuing various European equity strategies, and GAM Trading, whose hedge fund cohort tilts heavily toward funds specializing in currencies, commodities and fixed income, have posted slightly higher returns than GAM Diversity with similarly low volatility and favorable reward-risk readings. For instance, Multi-Europe's average annual return since inception is 15.2 percent, compared with the MSCI Europe index's 11.9 percent, and its volatility is 10.2 percent, versus the index's 15.6 percent.

The current bear market has put the funds' claim of a low correlation to the major exchanges to a stern test - which, so far, they've passed with flying colors. In 2000 GAM Diversity was up 7 percent even as the MSCI world index declined 13 percent. Meanwhile, GAM Multi-Europe rose almost 20 percent, compared with a nearly 10 percent fall in the MSCI Europe index. (Smith chose to emphasize managers that were in a defensive mode and had a reputation for rotating their portfolios quickly as market conditions change.) GAM Trading, which makes a marketing virtue of its negative correlation to the MSCI world index, rose nearly 21 percent.

Smith likes to compare GAM's funds-of-funds role to that of a "gallery owner" displaying works of genius by others. But being a patron of portfolio managers is certainly not for dilettantes. At the core of a formidable funds-of-funds research effort is Smith's team of 26 analysts split between London and New York. They're dedicated to identifying, researching, meeting with and recording information about nothing but hedge fund managers. The goal, says Smith, who was once head of Buck Consultants' European research practice, is "to build the best database system on hedge fund managers in the world - we want a digital record that guides us through this unregulated and somewhat mystical market."

The fundamental researchers concentrate on different fund styles. For example, one might follow only convertible-bond-arbitrage managers. Based on the researchers' work, a monthly list of buy and sell recommendations is drawn up for Smith and his senior investment managers to use as the basis for allocating assets among funds. A team of nine quantitative researchers backs up this work by testing the GAM portfolios that would result from the managers' preliminary selections to gauge how they would be likely to perform in different markets. The aim is to ensure that each portfolio provides the highest possible return relative to its permissible risk.

But even with all the formal analysis and data-crunching, Smith concedes that, like a gallery owner with a good eye for art, he sometimes trusts his instinct above all else. "Do we do optimization studies?" Smith asks. "Yes, we do it every time. Do I follow it every time? I can't say that I honestly do."

Judgment still counts at GAM, and the firm has sought to attract the most experienced people it can. The manager of GAM Trading, for instance, is Nancy Skiest Andrews, who had been Paul Tudor Jones's execution trader.

But the fund-vetting process isn't over even after judgment is brought to bear. A specialist due-diligence team must have its say. Composed of a lawyer, a forensic accountant and a former custody banker, this steely eyed group probes each recommended manager for accounting anomalies, legal loopholes and operational deficiencies. "Some people think we are excessively detailed," concedes Smith, "but while there are many investment reasons for losing money, it would be unacceptable to lose money for noninvestment reasons."

A manager that survives this selection process can expect to be monitored constantly. GAM doesn't try to outwit the markets by over- or underweighting particular stock sectors or shifting to bonds in hopes of an interest rate cut. "Tactical asset allocation of that kind has never been shown to add any value," contends Smith. Rather, he and his team try to discern which hedge fund strategies will work best under prevailing market conditions and shift the portfolio accordingly - say, move more assets into a merger-arbitrage fund if M&A activity picks up. Again, experience and judgment come into play here.

The portfolios that result are often concentrated. The top three current positions in Multi-Europe - AlphaGen Capella, run by Roger Guy at Gartmore; Marshall Wace Asset Management's Eureka fund; and Egerton Capital, headed by John Armitage - currently make up 55 percent of the fund. All three are bottom-up stock pickers. GAM Diversity, whose broader investment mandate encompasses a wider universe of managers, has approximately 50 percent invested in its top ten holdings, including such established names as Tudor Jones, Bacon and Monroe Trout.

GAM doesn't, however, just stick with familiar brands. Its research is meant to discover rising stars. AlphaGen Capella, with $1.2 billion in assets, is today one of Europe's hottest funds, having risen 92 percent since inception 17 months ago. But on its opening day of trading, it had just $77 million: $7 million from the principals and a handful of other investors - and $70 million from GAM. "We didn't think of the investment as a risk," says Smith. "I have known Roger Guy [the founder of the fund] for ten years. We knew the way he traded, we knew the way his model traded." And, what's more, Guy must have passed muster with Smith's due-diligence brigade.