Q&A: Making Hedge Funds Work In A Multi-Manager Mutual Fund

Dec 20 2011 | 6:05pm ET

Mutual funds employing hedge fund strategies are growing both in popularity and number. When the Hatteras Funds, a $2.1 billion alternative investments firm founded in 2003, decided to go into that business, it bought a mutual fund of hedge fund strategies that's actually a year older than the firm itself.

Hatteras' mutual fund invests exclusively in separate accounts managed by hedge fund managers, giving it hedge fund-like returns while offering daily liquidity. FINalternatives' Mary Campbell spoke recently with Hatteras President Bob Worthington about their decision to get into the alternative mutual funds space, the nuts and bolts of fund manager selection and the benefits to the investor of a liquid fund of hedge fund strategies.

I’d like to focus on Alpha Hedged Strategies, your mutual fund. How do you choose strategies to invest in?

We have broken the fund into five major categories: long/short equity, market-neutral, relative value long/short debt, event-driven and managed futures. Those five broad categories, we think, represent about 80% to 90% of hedge fund strategies and are also strategies where we can invest in experienced hedge fund managers that can operate within a daily value, daily liquidity format.

How do you select the sub-advisors for this fund and your other funds? What criteria do you use?

It’s very similar to a normal fund of funds process. The team we have in place has anywhere from 10 to 20 years each of hedge fund and fund of hedge funds experience. That’s the benchmark of experience that we use to conduct due diligence, select managers and construct the portfolio.

In addition to the necessary portfolio management and risk management skills needed to manage a “hedged” portfolio, managers must meet acceptable standards of compliance and risk control functions in order to be seriously considered. We also want managers that have some form of focused expertise. For example, in long/short equities we have a couple of managers, one’s a healthcare-focused manager, and the other one is technology-focused. While it’s not exclusively what they do, it comprises a high majority of what they do.

Potential managers also must have enough in the way of the investment wherewithal—it can’t just be a one-person shop that doesn’t have any support; we need to see a build-out of an institutional quality type of manager together with the appropriate finance and operational support that’s necessary to grow a business.

You mention the manager who is focused on healthcare; would you go out actively seeking a manager focused on one or another sector?

In this case, we were introduced to a high-quality manager who happened to have a healthcare specialty. Next, we had to determine if a dedicated healthcare manager was appropriate for the portfolio. When we met with him, we thought, on a risk-adjusted basis, this will be a great addition to our portfolio. There’s a lower degree of correlation with some of our other managers, so it made sense in a diversified portfolio.

Is it difficult for your underlying managers to provide daily liquidity?

No. We believe that 75% of the securities hedge fund managers invest in are liquid, and thus our managers are able to effectuate their strategy similar to the way they manage their less-liquid products. Five years ago it was more of a challenge than it is today, though there are still some people that are initially resistant to managing a separate account for us.

We don’t exclusively focus on managers in the $25 million to $500 million range, but that’s where most of our managers come from. Once we’re introduced to them and talk to them about the benefits of our structure, what Hatteras is all about and the experience we bring, three-quarters of those managers are willing to manage a separate account.

Was the initial decision for Hatteras to launch a mutual fund employing hedge fund strategies the result of demand from clients or was it a top-down decision?

It was a combination of both. The Hatteras Alpha Hedged Strategies Fund has been around since 2002. We were approached by the original investment team, who ran into some difficulty in 2008, and they felt it was important to find a larger partner to help manage and distribute their funds as the environment became more competitive.

As we conducted more due diligence—not only on that fund, but speaking with other advisory firms—we became convinced that advisors want a place in their client portfolios for alternatives as well as liquid alternatives. So most of the clients we have now in the Alpha Hedged Strategies Fund already use the traditional, either hedge fund or fund of funds approach. They’re using this as a supplement and also as a way to increase their allocation to alternatives without compromising the liquidity.

As the financial crisis further unfolded in late 2008, we began hearing more from advisors that they had become concerned about what could happen with gates, which led us to say, "Look, we believe this is going to be the beginning of a really long-term trend." That’s why we made the decision to buy the fund and really make some changes to it. We brought in some new people to run it, and we formally started managing the fund in July of 2009.

Fast forward two-and-a-half years and I believe the results of our acquisition and efforts prove that our original thesis was correct: A liquid fund of hedge fund strategies has a place in an investor’s portfolio. We recently hired a very experienced institutional professional to focus exclusively on the consulting community here in the U.S., and he’s convinced that this is the beginning of a three-to-five year trend at least. In fact, it’s going to be a building case, where institutions will even start to look at these liquid alternatives as long as they meet these standards set forth.

Do you limit the number of sub-advisors in the fund?

Formally we do not. However, while we want to provide an appropriate level of diversification, we feel many products in the industry have become overly diversified. Currently, we have 23 managers in a fund complex of $550 million. We believe that, collectively, we can manage up to $5 billion in assets with a portfolio of approximately 35 managers.

Do you play with the weightings of the strategies within the fund? What strategies do you feel are best-positioned to do well in the current market?

We certainly look at and strategically make changes to our allocations. Due to the daily liquidity features of our fund, we do not have to wait to the end of each quarter to make a change to our allocations. This allows us a greater degree of flexibility. We typically do not make changes on a daily basis or weekly basis, but if market conditions change dramatically during the quarter we can make adjustments at any time, which gives us more portfolio management flexibility than the traditional model.

Currently our largest weightings are to long/short equity, at about 31% of the fund, and relative value at about 24%. While our overall view on the broad equity markets is not bullish, there are certain segments that have appealing valuations, and we believe experienced long/short equity managers can navigate the difficult and volatile equity markets we forecast over the next three to five years.

In relative value, we want managers who can take advantage of the opportunities in lower-grade securities when they are being rewarded for the risk, and hedge certain positions to reduce volatility in this segment. We like the flexibility of long/short equity and we think there’s a portion of the U.S. market that is actually pretty attractively valued. But again, we don’t think we’re going to see 12% annualized returns.

How has the increasing regulation of the hedge fund industry affected your business? Do you think people are looking to mutual funds as a safer bet?

At Hatteras Funds, we manage $2.1 billion in assets, with a product mix that is a combination of traditional structures, which offer quarterly liquidity and private equity which have five-to-10 year lockups, as well as the daily liquid mutual funds, including the Hatteras Alpha Hedged Strategies Fund.

As a fund of funds manager in a mutual fund we provide full transparency. Within this format, all of our advisors have to be Securities and Exchange Commission-registered. We have complete position level transparency, which allows us to evaluate where risk exposures lie much better than other fund of funds.

We believe people are looking at hedged mutual funds because of better liquidity and transparency that may help mitigate certain risks associated with investing in hedge fund partnerships. However, by doing so, they may give up some return potential as some of the more illiquid hedged strategies could provide higher returns. We believe a balanced portfolio of both liquid and illiquid structures makes the most sense, providing investors the benefits associated with both—increasing liquidity yet still having exposure to unique strategies or securities where the return potential is higher.

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