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Aug 1 2011 | 10:32am ET
Robert Covino is senior vice president of product development at SSARIS Advisors, the hedge fund and fund of funds platform for institutional clients of State Street Global Advisors. Working for a company that is both a fund of funds and a direct strategy provider gives Covino an interesting perspective on the hedge fund universe. FINalternatives spoke to him recently about the effects of institutional money on this universe, the importance of performance and the future of funds of funds.
What are institutions looking for that hedge funds, perhaps, in the past, weren’t used to delivering?
The main thrust is the continued reaction to 2008 and the global financial crisis and the difficulties that many hedge funds had within it. Many institutions have demanded additional liquidity, they’ve demanded additional transparency—in some cases they’ve gotten it and in some cases they have not. I think the industry as a whole has responded to that. We’ve seen an uptick in things like best practices, and generally speaking, the industry reaction has been a very healthy one.
Can you see a point where it won’t be possible for a hedge fund to refuse to provide transparency?
No, I don’t as there will always be some attraction to a superstar manager that might be limited in the information it shares. However, I believe that the number of hedge funds that can act in an overly guarded way will continue to shrink.
How can a hedge fund remain competitive in this new environment?
It starts with performance…It always is performance. I think people have reassessed their expectations [of hedge funds] from a risk/reward perspective. There has been a significant focus on what I would call tail risk—a very basic definition of that is that you had a lot of funds that portended to be very slow, steady and consistent that had very little volatility that had a shock [and went] down 20 or 25%. So we believe that investors have a greater understanding of that and are more engaged in the actual underlying diversification they have within their exposures.
What is attracting a buyer to a hedge fund? From an institutional perspective, it is our experience that ERISA continues be an important driver—an institution’s capability to a) take ERISA money and b) act in a fiduciary capacity on behalf of the underlying investor. We have not experienced much of a change regarding fees. There was some reaction to 2008 where there was a lot of drumbeating to get hedge funds to lower their fees, but I don’t believe that that’s happened consistently. Hedge funds have been more flexible on some other terms, such as their lockups, or their redemption requirements, but I don’t believe that there’s been a wholesale shift in fees. Certainly hedge funds that performed well through it didn’t lower their fees—in fact, some maybe even raised them.
Third, it’s transparency—not necessarily of position, but of process and of thought. I think [institutional investors] want to feel that they have access to their manager, that the manager has a culture of compliance, and that processes and procedures are important to them from a business-risk perspective. We’ve certainly noticed that the level of due diligence placed upon us has—increased would be almost too gentle a word, it would be almost safer to say ‘multiplied’— and there’s a significant focus on that on the institutional side.
What about the question of smaller vs. larger funds? I think institutional money is still tending to go to larger funds, can you see this changing?
I think it’s a mix to be honest. At SSARIS, we’re a hedge fund of funds and we’re also a provider of direct, futures-based programs, so my answer might be a little bit different in each.
Our experience has been—in the fund of funds space—smaller has been on many occasions attractive. There can be a perception that a smaller fund is more nimble…If there are arguably 9,000 hedge funds out there, one of the problems in 2008 was that the $10 billion fund of funds could really only put their money to a certain number of funds that were capable of accepting that kind of money, so you had a lot of concentration among the largest firms in the same underlying hedge funds. I think that people realized that and the fund of funds get a little bit more of a friendly pass in being smaller, in that a lot of your concentration risk is pass-through risk to the underlying hedge funds. So, being a $1 billion fund of funds, you’re not really taking on huge liquidity risk because it’s really the underlying hedge funds that will drive that.
Now, shifting to a provider of direct strategies, I think it’s harder for smaller firms than it was pre-2008. I think that one of the reactions people had was ‘I don’t necessarily need a fund of funds anymore, I’m big enough to go direct.’ And there is safety in numbers on the direct side, regardless of what people will tell you their process is. At the end of the day, they oftentimes need to start with a very comfortable name and it is often based on size.
I frequently read about the demise of the fund of funds, particularly in discussions of institutional investors, what’s your feeling about that, do funds of funds have a future?
I’m a little bit biased—I head business development for a fund of funds product suite that’s gone from approximately $320 million in assets in 2009 to just about $1 billion today, so I don’t think the garden that we are trying to grow is barren. But that being said, there have been some tectonic plates that have shifted, and my personal thesis (and this is more of a personal view than a firm view) is that pre-2008 you had such a beautiful world, things were low volatility, very consistent, barriers to entry in the hedge fund space were quite low and a lot of people just said, ‘I can do this myself, I don’t need a fund of funds to do this.’ Some got a little too close to the sun and got burnt and have now gone back to the comfort of asking a fund of funds provider to do the asset allocation, due diligence, manager selection and risk management for them.
Quite the opposite, you’ve had some who have said, ‘Well, the fund of funds got hurt anyway so I might as well save my fee and use some of the specialist consultants that have emerged. I can pay them a fraction of what I pay the fund of funds, I retain fiduciary responsibility, but at least I can retain a portion of the fee I can pay on top of just direct investing.’
In the end, I feel strongly that a well delivered fund of funds model adds considerable value and will continue to serve a valuable role within institutional investors portfolios.
What about managed accounts?
From an institutional perspective there was a huge immediate demand for managed accounts, post-2008. In other words, many believed managed accounts would have prevented some of the liquidity problems in 2008. They are part of the present and the future but with managed accounts comes operational and fiduciary issues. There are a couple of ways to think about that—you have platform providers who are, in effect, a commingled managed account, so, they’ll open a white-label fund and they’ll commingle the investors in it, but investors aren’t commingled with the investors of the underlying manager…They’ve definitely experienced some growth. There have been some larger institutions who have worked with hedge funds to do managed accounts, but I don’t think [they have] gained the traction that the groundswell in 2009 would have suggested.
Why would you say that is?
There is no question that managed accounts offer greater control, but the other side of it is greater operational responsibility and potentially some tracking error. …When people start writing ISDA agreements, when they start writing investment management agreements and they start realizing, ‘Well, it’s great to have all the positions but how do I monitor them?’ you take on some additional operational resources and costs there.