Thursday, 23 March 2017
Last updated 15 hours ago
May 28 2010 | 1:00am ET
By Mary Campbell, Senior Reporter
Rory Hills is founding partner and principal portfolio manager of Hilltop Fund Management, a fund of hedge funds whose newly-launched All Weather Fund has assets of $11 million. He has strong opinions on the ills afflicting the fund of funds industry. He thinks the line between ‘hedged’ and ‘absolute’ return products has been blurred. And, sorry Simon Cowell, although he appreciates your talent-spotting abilities, he wouldn’t buy your album. FINalternatives' Mary Campbell recently spoke to the London-based Hills by phone.
You’ve said that the fund of funds industry ‘failed investors’ during the financial crisis—that hedge fund database figures show that between 30% and 40% of hedge fund managers were up during the crisis, but that 97% of diversified fund of hedge funds were down (and 87% of them down more than 10%). What went wrong in the fund of funds industry?
Back to hedge funds for a second—36% were up [Eurekahedge figures] and of those more than half of them—20% of the 100%, as it were—were up more than 10%. So, there was a sizeable winning pool out there and I would argue that a fair percentage of the losers were quite easy to spot; being either those with a permanent long bias or those who were running too much money and had lost their ability to be nimble. Yet fund of funds absolutely failed to pick from the winning pool, which is the whole raison d’être for a fund of funds.
So where has the industry gone wrong? I think that the industry changed a lot in and around 2003-2005. Asset growth in the fund of funds industry was exponential in the ‘00s (until obviously it stopped dead in 2007-2008). It rose 32-fold between 2000 and 2007 (at its peak) and the fastest bit of growth happened between ‘03, ‘04, ‘05.
This growth in assets created a lot of change in the industry, much of it, in my opinion, for the worse. The core problem arose as fund of funds started to adjust their models to look as pension funds wanted them to; if you wanted to win a big mandate, you had to look institutional, because that’s what pension funds were used to on the long-only side. One of the things that happened is that the funds of funds started to expand their staff, however they could not hire the same caliber of people that they had before, so they started to go down, largely, the graduate recruitment route, or hire people with only one or two years’ industry experience. So even by ’05 (it was a pretty quick change), I reckon the majority of meetings that I was having with a single manager in a fund of hedge funds, the fund of funds person was a junior analyst.
And the mainstream approach from this point of view, is that the senior people sit on the investment committee, they make top-down asset allocation calls, and then they come in at the end of the process and make the final fund selection—so the senior guys make sure nothing gets through that shouldn’t get through...But the middle bit, which to me is the most important stage, of actually getting out there and analyzing funds and meeting managers, is given to the analysts, and most of them are junior and inexperienced—and in many instances have no experience.
And experience is key for analysts evaluating potential investments?
I think you have to have experience, but experience alone is not enough and it is the talent-spotting role which is really important. My analogy is that I think the hedge fund industry is a talent-based industry like sport or movies or music ... and because the rewards in the hedge fund industry are so high if you get it right (and even if you get it wrong, in some instances, sadly) like actresses flooding into Hollywood, it attracts a lot of low-grade talent … particularly in a bull market. The role of the fund of funds is to spot talent. And my analogy, is that I wouldn’t pay to listen to Simon Cowell sing, but I recognize that he’s good at talent spotting.
Talent spotting is the core skill that is integral to fund of hedge funds business—people who can identify good managers. I wouldn’t have been a good trader but I’ve always been quite good at spotting good traders.
But you don’t think most ‘mainstream’ fund of funds are particularly good at talent-spotting?
I think far too many fund of funds place too much emphasis on making top-down asset allocation calls…So, at worst, they actually sit there and they say, ‘We think that the environment in the next few months is going to be good for this strategy and that strategy and not good for these ones.’ Well, that requires, absolutely at its heart, a macro call on what’s going to happen in the next six to nine months.
Now, leaving aside whether people are any good at making macro calls—and I don’t think many are—I don’t think fund of funds have the liquidity to make that call…if you’re running a long/short hedge fund where you might be 80% long and 20% short, the most important call you make is the macro call…but you have liquidity on your side: you can go to bed liking equities, wake up the next morning disliking them, and start to react to that immediately.
So, they’ve made their macro call and decided they like whatever strategy it is, equity long/short strategies say…So, then they say to the junior guy, ‘Here’s however many funds there are, go and shortlist that down to 20 that the senior team can come back and have a look at. But we’re going to box you in a bit, we’re going to tell you what we do and don’t like to begin with.’ And this creates this box-ticking mentality that is prevalent throughout the whole industry—ask any hedge fund, they’ll tell you about it—‘Don’t bother to look at anyone who’s assets are less than $200 million’ or whatever the number is. Location-wise, ‘Look, we’ve got offices here, our regular travel circuit is here, we’re not going to invest in anyone in Australia or Brazil’ or wherever it might be. Volatility. ‘We don’t like volatility.’
You’re also concerned with the concentration in the hedge fund and fund of funds industries – you’ve pointed out that somewhere between 70 and 75% of hedge fund assets are managed by less than 3% of hedge fund managers. Why does this worry you?
I think running too many assets is one of the main ills of the hedge fund industry—and this goes for hedge funds and funds of hedge funds…When a fund runs too much money…let’s say you’re running a strategy for which the optimal amount of assets was $300 million, if you then decide you’re going to run $600 [million] because people are throwing money at you…your return profile will be negatively impacted, for sure. Now, in a bull market, you might not see it in the return, the return might keep going up…but some other element might be affected. It might be that you’re slightly less nimble now and you find that you’re swings are getting higher, so you’re volatility goes up. That might [also] be reasonably marginal in a bull market. What’s probably really going to be affected is your correlation, because you’re less able to move around…And your liquidity may well start to get worse. Because you’re now running more assets than you should in a bull market, so when the bear market happens—and liquidity always gets squeezed in a bear market—you can’t get out of it. So, those are the components of the return profile and our preference is to invest in people who run the right amount of money so they can remain nimble.
You also suggest that running too much money leads to another fund of funds industry problem—over-diversification. What can you tell me about that?
The fund of funds industry has been very over-diversified in general. There’s been quite a lot of academic work done on this, in terms of diversification or diversified fund of hedge funds, and most of the evidence points to somewhere between 10 and 20 names being the right number. Intuitively, that makes absolute sense to me. I’ve always felt that was right and it’s nice to see some academic work that supports that. If you go into 35, 45, 55, 75, 85 names, you’re just so over-diversified you become an index. I think it’s Warren Buffet’s quote that all that over-diversification does is take capital away from your best ideas and allocate it to less good ideas and I fundamentally believe that.
Secondly, it creates an index, so now, instead of trying to pick really good managers…you just buy a basket of managers. So now you have a macro view (we don’t like macro views) you think emerging markets will do quite well—so let’s go buy 15 emerging market managers, so that, broadly speaking, if our macro call was right we’re going to get what we wanted. Because actually, if we went and only invested in two—what would happen if we picked the wrong two? You know, we don’t trust our skills at picking managers, so let’s buy 15, which, of course, helps you run more money, because you can’t run $5 billion in 15 positions…Over-diversification suits their requirements, because it allows them to run more money. And the industry got very greedy and took on more and more assets, it went into full-steam asset gathering mode without considering the impact on its return profile.
You feel the industry doesn’t make enough distinction between ‘hedged’ and ‘absolute’ return products. What’s the distinction and why does it matter?
This is really important because, over the last few years the hedge fund industry has become known as the absolute return industry, the two have become synonymous…when actually, [hedge funds] are not really targeting absolute returns, they’re targeting hedged returns. And what I mean by that is that a hedge fund strategy will try and capture some part of a bull market…and then will try and preserve capital as best it can in a bear market. A hedged return strategy which ends up having a bit of asymmetry in its returns i.e., it might capture 75% at the outside of a bull market and limit the damage to 35% of a down market. Now, if you produce asymmetric returns like that, that’s a value-added product, I think. But when you’re marketing that to somebody, you’ve got to tell them, ‘This is a hedged return product and this is the return profile you should get…and the correlation may be high.’
An absolute return fund seeks to deliver positive returns in all environments, it won’t achieve it, everyone has a down year, that’s for sure, but when it has a down year, it should be for idiosyncratic fund reasons—our process wasn’t working that year. It won’t be just because markets were down; in fact, it should have very little to do with markets…These guys don’t chase bull markets…Now, I think that’s a really important distinction that has become blurred.
So, I’m guessing your approach is different?
Our approach is really the very opposite of all that. Number one, very bottom-up, so we are about trying to find really talented people running really interesting strategies. I like the words idiosyncratic and heterogeneous. So, bottom-up, not top down. For me, I want to be out there meeting managers all the time, not sending a junior analyst… Size-optimal strategy rather than larger. Correctly diversified—I met someone yesterday who said, ‘Oh, quite a concentrated position,’ which is a sort of a natural reaction for people because, frankly, they got so used to people being in 40, 50, 60, 70 [positions] that 15-18 sounds concentrated. But it isn’t, it’s the correct number. Correlation: a specific target to have low correlation at all times…Now, I’m not saying that mainstream fund of funds wanted high correlation, but what I’m saying is that low correlation was not a specific target for them—I think a lot of people think their role in life is to catch some element of a bull market and preserve capital in a bear market. That’s a hedge product, and that’s fine if that’s your game. But if you don’t have the liquidity…and you chase a bull market, it is inevitable you’re going to suffer in a down market, in my opinion.
We want to run the right amount of money—it’s a key element of what we invest in so it would be very hypocritical of us not to do it for ourselves—we think that the maximum optimum is $500 or $600 million, it may even be as low as $400 million. We think we’re optimal already—we’re only running $11 million, but we can deploy our strategy just fine at the moment (probably couldn’t do it with much less than $10 [million] to start with).
We have a very progressive fee structure…we've put in place a 36-month high water mark instead of a 12-month high water mark and the reason we've done that is because we think that the current, mainstream fee structure for hedge funds as well as fund of funds, of charging a performance fee on an annual basis, is inequitable for two reasons: first of all, it's far too short a period to judge anybody on, thus creating optionality in favor of the hedge fund or the fund of funds. So that they take a big fee in a good year, but don't hand it back in a subsequent bad year. Secondly, it creates a very sort of short-termist approach within a fund, not so much for the principals of the business who clearly should be focused and probably are on the medium to longer term, but on the staffers, who can be very important within the team (very similar complaint to what's going on, by the way, with the investment banking industry) if everything's geared toward what's going to be my bonus this year, then you may have a different mindset to how you trade (or whatever your role is) versus if you thought, 'I'm only going to get paid in three or five years' time.' And therefore, it's not all about making it this year, I've actually got to eke out some sensible returns here.