Q&A: Mutualizing Funds Of Hedge Funds

Dec 5 2012 | 1:27pm ET

With two decades' experience in finance, including a dozen handling alternative investments for a family office in his native New Zealand, Matt Osborne is tackling a new challenge at Altegris Advisors: a mutual fund of hedge funds.

An executive vice president and managing director at Altegris, Osborne is also a co-manager of the firm's mutual funds. The latest addition to that lineup is the $70 million Altegris Equity Long Short Fund, a retail fund offering access to leading hedge fund managers.

Osborne, who in addition to his other duties also sits on Altegris' investment board, recently spoke to FINalternatives Senior Reporter Mary Campbell about the firm's newest offering.

Why launch the Altegris Equity Long Short Fund?

Equity long/short is the biggest alternative category and we felt like it was an opportunity to bring high-quality hedge fund managers into the mutual fund space in a multi-manager format. We think that this product is unique among equity long/short mutual funds available in the U.S.

How many managers does the fund currently invest with?

We’re currently using three sub-advisors but one of those sub-advisors is deploying two strategies for us, so we essentially have four underlying strategies.

Do you intend to invest in more managers eventually?

We’re constantly on the lookout for managers that fit our criteria. As the fund's assets grow, we look to increase the number of managers, although, don’t expect this to be a 20 manager or 40 manager portfolio in classic fund of funds style; it will always be a concentrated portfolio. I expect that the fund will  always have fewer than 10 managers in the portfolio.

What is your criteria for choosing managers?

We attempt to focus on managers that we regard as best of breed. We’ve established three U.S. mutual funds in the managed futures and macro spaces where we’re accessing well-established, well-known managers to express those strategies, so we sought to do the same thing with equity long/short.

Our process focuses on the qualitative aspects of a manager, on the people involved and their expertise in stock-selection, and the quality of their businesses from top to bottom, including their infrastructure. And, of course we look at track record and we form a view of the sustainability or robustness of their process. For this particular fund, we were very focused on stock-pickers who have shown a stark ability to pick stocks both on the long side and, particularly, on the short side, through bottom-up selection. These managers are not quantitative in nature, they’re qualitative, and focused on the fundamentals that drive stock performance. They have also demonstrated an ability to successfully adjust their net exposures.

Are there any special challenges in choosing long/short managers for a mutual fund? Is liquidity an issue?

We’re working with managers where, generally speaking, liquidity is not an issue. We’re avoiding managers who have a particular focus on very small, illiquid positions and where those positions have made a large contribution to their success over time. We’re looking for managers who have shown an ability to generate alpha in liquid stock selection so that we don’t have a material tracking error to their core strategy. The challenge is that some managers deploy strategies that can not be easily adapted to the liquidity constraints of the 1940 Act environment.

The primary constraint is that, in this portfolio of sub-advisors, none of the managers is earning an incentive fee. That’s a challenge, because what you end up with is a fund that, by mutual fund standards, has a relatively high expense ratio because we have higher flat management fee. That’s probably the biggest structural challenge.

Are you interested in any particular geographical areas or sectors?

Any managers that we will add in the future will need to be complementary to our existing manager lineup. We invest with Harvest Capital Strategies, out of San Francisco, in their flagship Opportunity strategy, which is very financials-focused. Harvest is also utilizing their Agricultural strategy, which is essentially a consumer-focused strategy. We’re also invested with OMT Capital Management’s Hawthorne strategy; they have a small- to mid-cap focus with a technology-biased portfolio. And we’re using one of Visium Asset Management’s strategies, Tax-alpha, which is a best-ideas approach across a diversified mix of large- and mid-caps.

We’ll be seeking to add managers who complement this mix. Another driver is that we want to deliver a fund that typically has a low net-long exposure. Of course, the managers have discretion to vary their exposures inside of the accounts that they manage for us, and our net will be the aggregate of that, but we like managers that have a genuinely hedged approach. We think that is the attraction to our core audience, the investment advisor.  The investment advisor is looking to diversify his clients out of pure long-equity exposure, and we want to have a product that provides a low-net equity exposure with stock-selection alpha.

Why the focus on qualitative rather than quantitative managers?

We want advisors and investors to be able to make informed product choices. Understanding what they are getting is a very important part of alternative investment education. This fund has a specific design based on fundamental stock-selection alpha, which is the basis for the original hedge fund strategies. We are not negative on quantitative strategies, but it may be that a separate investment vehicle is appropriate for that.

What is the fund’s capacity? Do you have a target for assets under management?

We have a good amount of capacity with each one of the underlying strategies such that the fund could, in its current construct, easily grow close to $1 billion without any constraint. It’s likely that we will have added more strategies prior to that.

What sort of returns do you expect and what is your minimum investment?

Stock-like returns over a full market cycle, but with moderate correlation to stock indices and less volatility.

Class A shares are available at $2,500. So it’s a mutual fund increasingly available on all the main platforms and brokerage firms countrywide.

Would you say the fund makes these hedge fund managers available to retail investors?

It really does. It’s part of the trend that we see in the industry towards what I would call the "democratization" of hedge funds via liquid alternatives. Equity long/short is clearly a strategy that can be delivered in a mutual fund. Our goal is to do that with quality first, because we think that there are products in the market that might be hedge fund replicators or have inferior managers that, over time, aren’t going to do the job as well as a genuine hedge fund strategy. Our goal is to bring genuine hedge fund managers into this format, subject, of course, to regulatory constraints

Do you have a preference for established versus emerging managers?

It’s something of a conundrum because an emerging manager is likely to be willing to work for lower fees and to provide more capacity, but that business opportunity is not necessarily consistent with our approach to find the best available talent. We would rather hold out for the likes of Visium or Harvest and work with them—and possibly pay them higher fees—because we believe that they have the proven track records to justify inclusion in our fund. The challenge of working with an emerging manager is potentially the short track record. Now, the Visium program we’re accessing has a short track record, but Visium as a firm is a first-class organization, in our opinion. So it’s a bit of a challenge, as you can see, balancing between length of track record, which helps to prove a manager’s ability to produce long and short side alpha, versus working with an emerging manager who probably could help us get a lower expense ratio.

Do you, as a mutual fund, have to be fully invested at all times?

We need to have 80% of the fund invested in equities, but with equities both long and short, we don’t have a problem meeting that criteria. We don’t need to be always invested 100% long.  In fact, our fund is currently about 80% gross long and about 50% gross short, and therefore about 30% net long, but essentially 130% invested. That’s consistent with our expectation of positioning through a lot of different market cycles. Now, the managers may increase their net-long exposures, if they saw the opportunity, or they may increase their net-short exposures, if they saw an opportunity, but on average we expect to be in this range of 30% net long positioning.

Because of the four managers, it’s a very diverse fund right now—we’ve got 125 positions long and we’ve got 155 positions short. We have very little overlap in positioning between managers, with the largest long at approximately 2% and the largest short at around 1%.

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