12/05/2010 Author: Erik Bernhardt

Comment: Erik Bernhardt

Much has been written about the impact 2008 has had on the investment management industry. While I am not about to pen yet another article about frauds, fragile banking systems and disappointing performance, the fact remains that the events of that year accelerated a number of trends that had already started to gain ground in the hedge fund world. A greater focus on due diligence, pressure on fees, a willingness to offer separate accounts and an openness to transparency being the most visible. This broad shift of power back to investors has led to another related trend – the increasing demand from institutional clients, both large and small, for customised fund of hedge funds (FoHF) portfolios.

One of the lessons of the recent past is that a nimble, flexible approach to investing allows for more effective downside risk management and tactical risk taking. For many institutional investors, this means allocating a larger proportion of their portfolios to hedge funds. A number of those institutions, however, are seeking alternatives to an ‘off-the-rack’ hedge fund product. Instead, they are trending towards the bespoke, with three main forms of customised requests being presented to FoHFs and consultants alike.

The first request is for tactical mandates, driven mainly by the macro-economic forces emerging over the last few years. The prospect of long-term inflation, driven by excessive government spending, clearly ranks near the top of perceived risks by institutions. The investor response is, ‘build me a hedge fund portfolio that provides both a beta and alpha component, that helps protect my portfolio should CPI start to accelerate’.  

In addition, from a risk-taking perspective, institutional investors are acutely aware of the massive activity taking place within the corporate world: re-organisations, spin-offs, distressed and stressed situations. Their response to this opportunity is similarly novel: ‘build me a dedicated event-driven portfolio that reaches across the entire corporate capital structure’. This trend of tactical mandates will continue, largely because institutions will find that well-designed multi-manager hedge fund portfolios are the best option for extracting value in a risk-focused manner.
The second theme in this ‘customised’ demand trend is actually not a new one – completion portfolios. But the interest level here appears to be accelerating as many institutional investors ramp up their direct hedge fund investment programmes, but find that resource or expertise constraints prevent them from effectively covering the broad spectrum of hedge fund opportunities. Instead, hiring a capable FoHF to customise a portfolio allows them to fill in the gaps.  

‘Replacement portfolios’ represent the third area where institutional demand is spiking, largely in the equity component but increasingly in corporate credit as well.  For equity, one only has to look at a few quick stats to see what is driving this growth. Over the last ten years, the CSFB Long/Short Equity Index has outperformed the S&P 500 by 8% on an annualised basis, with just half the risk. And frankly, most institutions simply cannot tolerate another 40% loss in their equity portfolio. While some have taken the extreme approach and completely substituted their long-only equity managers for long/short mandates, most are simply shifting a portion of their equity assets to a customised FoHF in a core/satellite manner.  

All of these trends are positive for both institutions and FoHFs, but it is harder to be enthusiastic about another emerging trend, the so-called managed account platform. Simply, a FoHF offers a platform that allows investor discretion over manager selection while the provider tackles operational due diligence, risk management and back-office operations. How much does this differ from the customised solutions discussed above? Significantly, in my opinion, due to the disintermediation of the experienced investor when it comes to constructing the portfolio.  

In fact, a strong case can be made that total integration in hedge fund investing – from manager identification all the way to final portfolio construction – is crucial for success. Risks in a hedge fund portfolio extend well beyond investment concerns; operational, legal and risk issues are significant factors. The fear is that decisions made in isolation may result in a sub-optimal portfolio for the institution. Better to have a close working relationship with the FoHF manager and allow its process to fulfil the institution’s hedge fund needs