11/08/2010 Author: Shannon Hawthorne

Finding a niche

The rise in influence of institutional investors has seen hedge fund assets concentrated mainly the industry's larger funds. But as diversification becomes key and investors feel more comfortable with the hedge fund space, many, both institutional and retail, are considering smaller, unconventional investments in their search for alpha

Size, it seems, really does matter. If the shaky performance of the hedge fund industry over recent months showed us one thing, it’s that when the going gets tough, investors stick to what they know – larger, more established funds.

According to recent data released by Hedge Fund Research (HFR), in Q2 2010, just under 60% of industry assets were invested in funds with more than $5bn in assets under management (AuM), while firms between $1bn and $5bn accounted for a further 26%.

But while smaller hedge funds may, generally speaking, have to wait a little longer for their moment in the sun, all is far from lost. In fact, those smaller managers

that have opted to take a more specialist approach to investing, while still attracting a relatively modest
proportion of overall allocations to the sector, are today enjoying a marked increase in interest from investors seeking a greater diversification of opportunities.

“A number of institutional investors have sought further diversification in their hedge fund allocation by adding exposure to return drivers that are otherwise very difficult to access directly – principally either through specific investment expertise or the ability to time entry and exit of investment,” confirms Craig Stevenson, an investment consultant at Towers Watson.

Such strategies are usually referred to as ‘niche’, an admittedly problematic epithet due to the fact that it can be (and is) interpreted in a number of different ways. Dr Chris Jones, chief investment officer of London fund of hedge funds (FoHF) Key Asset Management, points out that, “while for some institutional investors, allocating into, say, a single strategy FoHF might be considered ‘niche’, a hedge fund specialist would probably reserve the term for more obscure strategies”.

Nevertheless, taking the term to simply refer to more unusual or uncommon hedge fund strategies, it’s clear that investing in niche strategies is becoming an increasingly popular diversification tool for a growing number of investors.

“These exposures allow diversification not only relative to the traditional ‘long only’ exposures, but also to the mainstream hedge fund strategy exposures – for example, long/short equity, macro and long/short credit,” says Towers Watson’s Stevenson.

And for those investors seeking greater diversification, the different drivers of alpha generation offered by these niche strategies are understandably appealing. “Niche hedge funds tend to be smaller, more nimble funds, and so usually, assuming they do their homework, investors can get very attractive returns on such funds,” says Eric Syz, founding partner and managing director of Syz & Co, and a director at Swiss FoHF Altin, which invests around 20% of its portfolio in niche funds.

Inevitably, allocating to such specialist strategies, in particular those that are so niche that expertise within that particular area is limited, can be problematic. “If there is only one broker providing a quote, it is very difficult to get a truly objective, proper third-party evaluation,” explains Key Asset Management’s Jones. “For us as a FoHF, if a manager invests in strategies that are so arcane that they themselves can’t properly manage the liquidity or the risk, that’s a sign for us to stay away.”

The short-term nature of some niche strategies also means that knowing when to enter and exit the relevant markets can be key if managers, and by extension investors, are to fully benefit from their investment. “If a manager invests in, say, long/short China, they know they’re going to have a long exposure to China – as long/short managers there tend to be fundamentally long – and so they’re probably going to be better off in an up-cycle than in a down cycle,” explains Altin’s Syz. “You’ve got to get your market timing right.”

It’s a view to which Alastair Crabbe of alternative asset manager Permal also subscribes. “A number [of such strategies] do have short-term shelf lives, and this has to be understood, but used correctly these strategies offer good value to investors,” he says.

Given the risk inherent in investing in less common hedge fund strategies, rather than investing directly, the vast majority of investors choosing this do so via “a well-constructed FoHF portfolio diversified across a number of these ‘niche’ return drivers”, as put by Towers Watson’s Stevenson.

“In any strategy, investing with just one hedge fund introduces additional business risk and concentration risk,” says Lisa Fridman, associate director at global FoHF Paamco, “so to the extent that investors can diversify that risk away, they are likely to do so through a FoHF or through constructing their own portfolio of hedge funds.”

Permal also includes such strategies within its wider fund of funds portfolios as well as allowing investors to access them through separately managed accounts, Crabbe reveals. “Some may be more volatile than the more traditional products, but within a wider context of a multi-manager portfolio, they tend to sit well,” he adds. “This is about adding value and being able to more effectively express top-down-view thinking.”

So where exactly is the increased demand for these niche strategies coming from? Institutional investors? Family offices? Both? It’s an issue still up for debate. Robert Howie, a principal at global consulting firm Mercer describes typical niche investors as either “larger more sophisticated pension funds”, while Key Asset Management’s Jones asserts that those investors who prefer more niche areas are likely to be high-net-worth individuals, who are attracted, in part at least, to the novelty aspect of the investment and have a certain proportion of capital that they are more willing to invest in an area that may mean higher risks, but also offers high returns.

“Obviously this rule has exceptions, but in our experience with institutional investors, namely pension plans, those who want to diversify their holdings would opt for, say, a distressed FoHF (which they would consider niche) as opposite to a more obscure area of investment,” says Jones.

For Altin's Syz, however, when it comes to investing in niche strategies, it’s experience, and not investor type, that is often the deciding factor. “I don’t think you can break down the demand by type of investors; it’s more about how long people have been looking at the hedge fund space and that investment style,” he stresses.  “If you talk to less experienced investors – and these can be larger institutions or individual investors – they will tend to opt for more established funds, even if that means the returns are likely to be less attractive.”

In contrast, those who have had more exposure to the hedge fund space are more likely to recognise the potential benefits of investing in an area that is perhaps often overlooked, and it is with allocations from these investors that small niche hedge funds can begin to rival their larger counterparts. Optimistic? Perhaps – but as investors returning to the hedge fund space begin to feel more at ease with investing in the market, it’s likely that it will be those funds that are nimble, have a low correlation to traditional markets and, importantly, can generate alpha, that will reap the benefits.