18/05/2011 Author: Shannon Hawthorne

Stamp of approval

As institutional mandates account for a growing proportion of hedge fund inflows, the role of investment consultants, frequently the key influence on pension funds’ allocation decisions, has gained increased significance. But what do hedge funds have to do to get their names on consultants’ ‘buy’ lists?

There’s no denying that the figures look good. Inflows are strong, recent performance has been solid, and while there remains some contention as to whether total assets have yet surpassed the all-important $2trn mark, it’s clear that the hedge fund industry is putting the dark days of the crisis firmly behind it.

What’s more, as is by now well-documented, the hedge fund investor pool has grown dramatically over the past few years, with a desire for better returns and portfolio diversification driving many institutions to examine the alternatives space for the first time.

So who is reaping the benefits of this trend? It seems that many big-ticket mandates are still going to big-name firms; according to a recent report by research firm Preqin, Bridgewater, K2 Advisors, Grosvenor, Paamco and Gam are the five most popular hedge fund and fund of hedge funds (FoHF) managers among public pension funds in the US, Europe and the UK.

Indeed, the recent hires of the $5.6bn Wyoming Retirement System, which is investing in the space for the first time, reads like a ‘who’s who’ of macro managers: BlueCrest, Brevan Howard, Caxton, Moore and Graham Capital Management.

And while this bodes well for said big-names, many less-prolific managers are finding it more difficult to gain the confidence of ever-cautious investors.

So who is it that they need to impress? Undoubtedly the board of trustees or directors, to whom the final decision on whether or not to hire a manager ultimately falls, are high on the list.

But this is only one side of the coin; usually, to even be considered by an investment board, managers need to first gain the approval of the institution’s investment consultant. “A consultant’s role is to pitch best practices and ideas.  A trustee’s role is to decide on those practices and ideas,” says Donald Kendig, a trustee at the $1.6bn Santa Barbara County Employees’ Retirement System (SBCERS).

Of course, the extent to which an institution relies on a consultant, or whether or not they use one at all, depends on the investor. “For example, in the UK, institutional investors, particularly the pension plans, are very reliant on their advisors because they tend not to have much in terms of in-house resourcing, whereas, in contrast, the big sovereign wealth funds (SWF) have historically used in-house teams,” says Robert Howie, a principal at global consulting firm Mercer.

Indeed, the newer entrants into the hedge fund space often rely heavily on the advice of their advisors, and on numerous occasions, HFMWeek has contacted staff at pension or endowment funds about future investment plans, only to be told: “Our consultant makes those decisions.”

The key, then, to winning mandates from such investors is surely to be endorsed by their investment consultant. “With the ever increasing allocation to alternatives, consultants play a vital role in providing unbiased guidance to investors who may not have the breadth of experience to navigate the large universe of managers and strategies that exist today,” says Tom Wiggin, a partner at alternative asset manager Cheyne Capital. “Being on a consultant’s approved list is a vital step for a hedge fund seeking to increase inflows from the pension fund community.”

Most consultants are keen to stress that they do not simply produce a list of ‘approved’ hedge funds for investors to choose from, but rather work with their clients on a case-by-case basis to find the best investment opportunities from them. “Investors should ask themselves for whose convenience a narrow ‘positive’ list is selected, for those consultants that operate on that basis,” says Guy Ingram, co-founder and head of research at alternative investment consultant Albourne Partners.

That said, the huge universe of hedge funds clearly needs to be narrowed down somehow, and many consultants use ratings systems in order to categorise managers, based on how positive an investment prospect they are deemed to be.
Towers Watson, for example, uses the FREX (Forward Return Expectation) rating, ranking managers from 1 to 4. Aon Hewitt designates managers as either ‘buy’, ‘hold’ or ‘sell’, while Mercer rates funds as either ‘A’, ‘B’ or ‘C’ [see box-out]. Such rankings are not specific to hedge funds, but rather are used across all asset classes, but it’s clear that being FREX 1 / Buy / A-rated will boost a fund’s chance of being awarded a mandate.  

So what criteria do hedge funds need to meet in order to have such ratings bestowed upon them? “We’re looking for managers effectively that are institutional-grade platforms,” says Craig Stevenson, senior investment consultant, manager research at Towers Watson. “A manager can be ruled out if they don’t meet the criteria from an operational due diligence perspective, even if we like them from an investment standpoint.”

It may seem an obvious point, but such operational quality is not necessarily a given in the hedge fund sector. “In the traditional world, we take [having an institutional infrastructure] for granted, whereas with a hedge fund, you have to ask: ‘Do they have that necessary infrastructure to take on these clients?’”, says Mercer’s Howie.

Institutional quality doesn’t always necessarily mean big, however, and neither Towers Watson nor Mercer have set criteria with regard to managers’ minimum assets under management.  However, while size is not necessarily a deal-breaker, it can impact on a fund’s ability to meet institutional operational standards, says Guy Saintfiet, UK head of liquid alternatives at Aon Hewitt, and for that reason the firm generally looks for managers over $500m in assets under management.

“Smaller firms might really struggle to have both the infrastructure and the people on back-office, middle-office, compliance and risk monitoring sides, that we think is necessary,” he says. “A firm that has an asset base that is quite narrow might struggle when they lose a client. We don’t want our clients to become a big fish in a small pond.”

However, it’s certainly not a rule set in stone and the firm does have a number of ‘buy’-rated firms that fall below the $500m threshold. What is non-negotiable, however, is transparency. “Either the firm gives us full transparency, or they won’t be considered,” says Saintfiet.

Towers Watson is similarly cautious about non-transparent managers. “We’re very wary of our role as a fiduciary and so we tend to shy away from managers with less transparency,” says Stevenson.

Of course, it will come as a surprise to few that portfolio transparency and an institutional infrastructure will stand a manager in good stead when it comes to being highly rated, but what some may not be aware of is the extent to which these factors take precedent over one of the key selling-points of the hedge fund industry – returns. “Although performance remains one of the greatest differentiators of good managers from bad, it is no longer enough to merely perform,” says Cheyne Capital’s Wiggin.

In fact, Aon Hewitt’s Saintfiet attests that performance is the last thing that the firm focuses on. “That doesn’t mean we’re not looking for the best performing managers but when we get to the performance section, we need to understand how they have achieved their figures – was it skill or was it luck?,” he says. “Our focus has always been on three things – business, people, and the process, and without those, you don’t really have any value.”

Though none of the consultants HFMWeek spoke to expressed a preference for any particular strategy, portfolio management can still contribute to, or detract from, the attractiveness of a fund.

“While we remain very open minded to reviewing strategies and managers, we’re not necessarily looking to have a view on every single product in the market. So we are quite focused in terms of making a first cut of managers and products where either we just don’t think there’s sufficient skill there or the manager has a portfolio construct that we would struggle with a priori,” says Towers Watsons’ Stevenson.

“For us, these would be products that are highly reliant on leverage to generate returns, or are consistently highly net directional in their view, although that’s not to say that we’re looking specifically for market neutral products.”

For Aon Hewitt, the ability for a manager’s investment approach to complement those of other ‘buy’ rated managers, and give comprehensive strategy coverage is also crucial. “We’re not looking to have 15 managers that all do the same and look the same,” says Saintfiet.

Ultimately, however, it’s not about implementing measures solely for the purpose of being highly rated by a consultant. Rather, managers should already be using such processes and approaches as part of the day-to-day running of their firm, says Chris Jones, CIO of FoHF firm Key Asset Management.

“I think that what investment consultants are looking for is very much aligned with what any good investment manager would do if they were aiming to generate good risk-adjusted returns,” he says. “We at Key Asset Management are not trying to do anything other than show that we have a logical, and consistent, investment process, driven by skilled and experienced investment professionals.”

Investors may be more open to hedge fund investments, but for many, the step from considering hedge funds to actually allocating is a big one and not one they take lightly. “Trustee turnover, and lack of hedge-fund specific investment education, makes hedge fund investing a tough sell for investment consultants,” says Kendig at SBCERS. Any manager, then, that has the skill, the infrastructure and the necessary transparency to make this job easier for a consultant will surely be at a distinct advantage.