Navigating The Treacherous Waters Of Transition Management

Mar 26 2012 | 11:48am ET

By Adam Patti, CEO, IndexIQ -- The global hedge fund industry recently crossed the $2 trillion mark in assets under management, a symbolically important accomplishment given the turmoil inflicted on the industry by the financial crisis. 

But as investors have returned and performance has picked back up, the same growth in assets has not been shared equally across the hedge fund landscape. Whereas single-manager vehicles have long since surpassed their previous AUM highs, funds of funds continue to lag significantly behind their previous record asset total of approximately $800 billion. In fact, according to recent data from HFR, funds of hedge funds actually saw three straight quarters of outflows to end 2011, finishing the year with approximately $630 billion in assets still under management.

A challenging environment, yes, but hardly the death knell for the fund of hedge fund industry. There are still more than 2,000 such vehicles in operation and the benefits of the fund of fund approach remain much the same as they’ve ever been, namely in their ability to provide diversification and risk mitigation by investing across various managers, strategies and styles; the access they can offer to managers and teams that might not otherwise be available; and, in the case of especially skilled fund of funds managers, the opportunity to add alpha generation to an overall portfolio.

While the potential benefits remain, traditional challenges to overseeing a fund of funds structure remain as well, including the always tricky topic of transition management, something that fund of funds managers, perhaps more than any other type of manager in the alternatives space, face on a regular basis. Transition management can be fraught with pitfalls. Handled incorrectly, a transition management initiative can prove to be extremely expensive; it can miss significant market moves while assets sit in cash; and, perhaps of greatest concern, it can draw unwanted regulatory scrutiny should various rules not be followed to the letter.

After all, a change in a fund of funds’ portfolio is not as simple as shifting a position in a stock or moving from long to short. Instead, portfolio changes necessitate transition management approaches that can be costly from both a time management and dollars-spent perspective.  One potential solution is the use of products built around investable hedge fund indices.

Why investable indices? There are four key reasons:

1. Investable indices, and the ETFs and other products built using these tools as their underlying benchmark, help keep costs low. ETFs that fall under this heading, including our own QAI, have expenses that are far below 100 basis points.

2. Use of products of this type help managers avoid regulatory restrictions on transfers of securities between “affiliated persons” in fund of fund portfolios, a key consideration when examining a portfolio and portfolio turnover from a legal, regulatory and compliance vantage point.

3. ETFs and other products built off of these indices can prevent “cash drag” and other problems associated with being out of the market and in cash. Looking again at QAI as an example, investable products like these offer highly liquid exposure to broad fund of fund performance characteristics, keeping a fund of fund and its investors involved in market moves, instead of waiting on the sidelines. 

4. Investable indices can also avert performance slippage resulting from the costs of unnecessary sales and repurchases.

Like the hedge fund industry, many investable hedge fund indices are passing key milestones of their own, including our IQ Hedge index family, which now has a live fund track record stretching back more than three and a half years, a live index track record dating back four and a half years, and QAI, which celebrated its third anniversary on March 25. Fund of fund managers who may have been taking a “wait and see” approach before incorporating products and approaches of this kind into their transition management plans, now have significant live track records on which they can perform their own analysis and due diligence. In the case of our funds and our IQ Hedge family of indexes, we’re very pleased to report that all have performed as designed, during what has been one of the most challenging three-year periods in hedge fund, and broader market, history. 

The fund of funds industry is at a key point in its history, and successful managers are realizing the importance of seeking out and embracing innovative approaches that can assist on the performance front, on the regulatory front, and in terms of keeping their costs down. Through liquid, transparent solutions incorporating investable hedge fund indices, real opportunities exist for fund of fund managers to incorporate significant new efficiencies in the transition management process.

Adam Patti is the CEO of IndexIQ, the firm behind the first family of investable hedge fund replication indexes, the first no-load, open-end hedge fund replication mutual fund (IQHIX) and the first U.S.-listed hedge fund replication ETF (NYSE Arca: QAI).


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