Decomposing FoHF returns
Where and when funds of hedge funds add and lose value
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25/03/2010
Comment: John Godden
The map of the hedge fund world is being redrawn. And following the near total re-charting of investment, away from high-net-worth individuals and towards institutional money, how much of this new investor landscape is likely to be capital originating from emerging markets?
At a macro level, it seems promising. There is already a global shift away from Western economies with their traditional wealth creation founded in industry and service sectors, towards new regions. Emerging economies and their 21st century resources, including energy, low-cost labour and manufacturing, are growing rapidly.
Fast-track growth has alerted hedge fund marketers to the potential in emerging regions, yet there are stumbling blocks. The money may be present, but most emerging market countries are making determined inward investment and, in many cases, are looking to raise external capital to assist with infrastructure development. So investing externally is contrary to such programmes. Additionally, the emerging economies are looking to buy assets that enable them to have ownership/control of upstream/downstream services. They want to control the means of production or ramp up the cost efficiencies of their own products, not flick through manager pitch books.
So why would these countries and their wealth managers be interested in investing in hedge funds and what would appeal to them? Despite a marked preference for internal investment, it does appear that there is a growing attraction of emerging market capital towards the very basic fundamentals of hedge funds. Diversification and non-correlated return streams.
If you have massive exposure to a narrow underlying resource such as oil or outsourcing services, no matter what level of relative value you place on the future value of your own ‘home market’ exposure, it will always be prudent to have a level of differential exposure to act as a hedge against these core exposures. Investing in geographically diversified baskets of equity, credit or real estate does not necessarily hit the right buttons, due to global factors often driving up correlation and thus dulling the diversification impact.
Rather, investing in strategies that are fundamentally differential to their core holdings can be the key. However, it still remains very difficult to execute pure alpha strategies in the Mena region, as the required tool kit, from short equity through to CFDs, is often not available. As such, accessing the returns of many arbitrage strategies requires the use of more mature markets, which can then provide the truly non-correlating return streams.
Of key significance to investors generally at this time is counterparty risk and infrastructure governance. This is perhaps more sensitive for emerging market capital where political and cultural requirements demand particular care. This is a key driver behind an upsurge in interest in pre-formed infrastructures such as Ucits or segregated managed account platforms.
The Ucits brand has travelled very well to investors from emerging markets, who see the Ucits III structure as an important quality mark. The dawn of absolute return ‘Newcits’ appears well supported among wealth managers representing emerging market capital, as they are seen as a safe access method to the alternative asset management skill set.
The massive uptick in the use of managed accounts is as a result of fund of hedge funds managers responding to the governance demands made by emerging market origin investors. The ability to gain proper levels of information and investment control are of extreme importance when mandate conditions include avoidance of exposure to certain commercial activities, let alone being able to control unwanted counterparty credit exposures.
So what should a hedge fund marketer put in their bag when heading off to engage with emerging market investors?
The current answer appears to be a range of strategies that are properly non-correlated to the economic interests of the target investor pool. Avoid beta – particularly commodities and equity
– and show evidence of differential return shapes (what used to be called alpha). Take the strategies neatly wrapped in a Ucits III or a segregated managed account structure and be just as
willing to be guided by their map, as your own route plan
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