“Smaller managers are better managers,” said Samuel “Q” Belk of Cambridge Associates, the investment consultancy advising on institutional assets worth about $3 trillion.
Speaking on a consultants panel during the recent FINforums Annual Hedge Fund Summit in New York, Belk said all consultants faced the concern that mega funds were merely asset gathering and that 'multi-strategy' was simply another way of saying 'style drift' while smaller managers were “in that sweet spot...giving you their best returns in the first two or three years.”
Cambridge, he said, is “always on the hunt for smaller managers,” a view echoed by his co-panelist Neil Sheth, director of hedge fund research at NEPC:
Neil Sheth“Of the funds that we recommend,” said Sheth, whose firm advises on about $700 billion ($60 billion in hedge funds and private equity), “40% of them are under $1 billion...and some of them, we start.”
But although Belk thinks it's “wonderful” to walk into newly established hedge fund office where “there are phone wires all over the floor and they're in a dirty office building and you know that one day they may be great,” some managers are simply too small.
“With $20 million or $30 million under management...they're not at break even yet, even if they're not paying themselves. They can barely pay for their phones and their Bloomberg [terminals],” he said.
Marne Gorman of Cliffwater, a $41 billion consultancy, agreed. Her firm, she said, while attracted to the same 'sweet spot' in terms of manager returns, “doesn't want to be too big a percentage of a manager's assets.”
So what's an emerging manager to do? How do you distinguish yourself in a universe of an estimated 7,000 to 9,000 hedge funds? How do you get on the radar of a large consultant? The answer seems to be, “Don't call them, they'll call you.”
“Don't call us if you're coming into town next week and say, 'I'm coming into town,'” advised Sheth. “We're pretty busy, just like you are.” Sheth prefers his hedge fund research team be pro-active in reaching out to managers that interest them—or managers that interest their clients who, he said, “have some pretty good ideas.”
Panel moderator Don Steinbrugge of third-party marketing firm Agecroft Partners also cautioned against calling consultants: “If you call on an endowment or pension fund and they say, 'My consultant is X, go call them,' that doesn't mean, 'I want you to call my consultant and he'll meet with you.' That means, 'Go away, I don't have time to meet with you.'”
Most firms maintain vast databases of hedge funds from which they cull the lucky few in which they invest. Cliffwater's database contains roughly 1,300 funds, said Gorman, 500 of which they actively monitor, 70 of which they allocate to.
“The hurdle to get to that list is very high,” she said. “I always encourage managers to reach out to keep in touch to keep us informed but recognize there is a level at which we are doing our own monitoring.”
Lou Kahl, an associate partner at Hewitt EnnisKnupp, which advises on a whopping $4 trillion ($28 billion in hedge funds) in assets, said that within the broader universe of hedge funds “the actual investable universe is really considerably smaller.” His firm ranks funds according to a number of factors of which performance, perhaps surprisingly, is not primary. Kahl says they usually get to performance “at the end” of the evaluation process and “back into that” from an evaluation of more qualitative factors, including “What have they done? How have they done it?” and “Is it consistent with the risk profile our clients are looking for?”
Cambridge, whose clientele is chiefly endowments and foundations—early adopters of alternatives who now allocate, on average, 25% of their portfolios to hedge funds and have a higher tolerance for risk—has the luxury of considering funds that “don't necessarily have every box ticked,” said Belk in response to a question from the audience. But there is one box that must always be ticked for Cambridge to seriously consider a manager:
“It ultimately comes down to a very soft thing, based on hundreds of data points: Is the manager aligned with the investors?...If they're just there for the fees and because they want to get rich...let them go back to a prop. desk or work for some other hedge fund first and throw away somebody else's money.”
Popular Versus Right
Asked what strategies his firm was currently interested in, Kahl pointed out that the strategies clients are looking for are not necessarily what he considered to be “the best opportunity set.”
That caveat aside, Kahl said he stills sees a lot of interest in trading-oriented and macro-oriented strategies, both of which he feels are under-represented in many institutional portfolios. And while “pure classic distressed opportunities” are ebbing rather than flowing right now, there are “pockets within the credit space that are very opportunistic, very appealing,” he said. Kahl also said clients facing a new risk to their fixed-income portfolios from rising interest rates are looking to offset it with credit alternatives.
Belk also agreed that “what's popular and what's right are often too different things.”
Consultants discuss hedge fund investing at FINforums Annual Hedge Fund Summit on Sept. 20, 2012 in New York
“Popular strategies are often just performance chasing,” he said. “Post-2008, one of the more popular strategies that didn't even exist pre-2008 is tail risk.” Now, he said, “Everybody's got a tail risk fund.”
Belk sees institutional investors as underexposed to global macro (especially discretionary global macro) and to arbitrage strategies—particularly fixed income arbitrage which he believes, given the volume of government securities to be issued and the potential volatility around the listing of interest rate swaps, could be an area of interest.
Gorman says many of her clients (some of whom are first-time hedge fund investors, some of whom are more sophisticated) are looking for yield and also for fixed-income alternatives structured as hedge funds. Macro strategies, much in vogue a year ago, are “a little less sought after,” she says, having underperformed.
Sheth characterized the past five years as a “very difficult active management environment,” one that he doesn't expect will change that much in the near future. NEPC was bullish last year on credit and non-investment grade credit, but thinks it may be less profitable now. “We're always looking for just talented teams in every area because we're constantly trying to put together attractive, risk-adjusted portfolios for new clients, for existing clients.”
To Hedge Or Not To Hedge
Steinbrugge asked the panel to make the case for hedge funds, given their rather lacklustre recent performance compared to stocks or bonds.
Kahl questioned the notion of a hedge fund asset class. Even if such a thing exists, he said, it's not the way to invest. “The dispersion of returns at individual strategy levels is so great within more skill-based active management strategies that to really focus too much on what is the best strategy in a particular market environment may be the wrong question.”
The right question, he said, might be “within areas of opportunity, who are the best managers and what is the best method of implementation within certain strategy areas?”
Belk said that hedge funds are a good proposition because net returns have been “really, quite good” and even risk-adjusted returns “for the longer-lived managers” have been good.
“The robustness of a well-built hedge fund portfolio has been borne out by 2008,” said Belk. “We all worried post-1998 when all these hedge funds blew up, like Long-Term Capital and Eagle and Convergence, that the hedge fund industry would blow up every time there was a downdraft. Well, the fact is most hedge funds outperformed in 2008 relative to their long-only counterparts.”
But while hedge funds are still a worthwhile investment, expectations need to be reset, said Sheth.
“The idea of a percent-a-month return with bond-like volatility that some have tended to expect, those days are over. The reason to enter the industry is...there's talent, and some people deserve a full bag of golf clubs and then there's others that think they deserve it and they should really stick with the driver...I think people have to go back to investing as opposed to trading. Trading is very difficult, not many people are good at it and I think everybody's trying to be a trader these days.”