OmniQuest Capital: Why Funds of Hedge Funds Work

Aug 11 2016 | 4:47pm ET

There have been few sectors of the alternative investment universe under as much fire in recent years as funds of hedge funds (FoFs). Although the broad hedge fund sector has been generally on the rebound since March, the vast majority of hedge funds have struggled since 2014, with HFR’s HFRI Fund Weighted Composite index returning a historically low 2.25% annualized. Granted, underperformance versus benchmark indices like the S&P 500 can be partly attributed to extraordinarily expensive equity and fixed-income markets over that time span, which led many risk-concious discretionary funds to adopt more conservative stances, but the fact remains hedge funds in general – and funds of hedge funds in particular - have come under significant pressure to justify their fees in the face of low relative performance.  

For FoFs, the question is even more fundamental. Can they can consistently produce the enhanced returns and risk reduction expected from fund selection and portfolio diversification? In other words, do funds-of-funds deliver enough value added to justify the additional layer of fees they charge – especially in this low return environment? 

The answer largely depends on which type of investor you are. For most large institutions, the extra fees associated with FoFs, depending on the allocation, may be far in excess of the costs actually needed develop and maintain an in-house infrastructure. Conversely, for smaller institutions and family offices, investing in fund-of-funds provides manager access, diversification and risk mitigation benefits that are very likely unobtainable otherwise. And for the individual investor, who often does not have the size, expertise, or resources to invest in hedge funds, access the markets and/or sophisticated strategies in which hedge funds invest, a FoF is the one of the few ways they can access investments that have traditionally produced high risk adjusted rates of return.

Nonetheless, last year was undeniably tough. The FoF segment lost $12 billion in AUM in 2015, according to industry data provider Preqin, bringing total assets under management in the space to $807 billion. Three times as many funds closed as launched. Pressure on fees remains unabated, while many large institutions are bringing manager selection in-house. The June 28 decision by the Alaska Permanent Fund to redeem $2 billion worth of funds of hedge funds is a case in point.

To get a better understanding of the current fund-of-hedge funds world, FINalternatives caught up with Eloise Yellen Clark, founder and CEO of OmniQuest Capital, for her insights on the space. Founded in 2002, Clark’s Los Angeles-based market neutral fund of funds manages approximately $100 million for a select group of individual investors including Liberty Media CEO Greg Maffei and TCV founder Jay Hoag.

The goal of most funds of funds is to produce equity-like returns with a fraction of the volatility. It is an aggressive investment objective, often only accomplished because the vast array of strategies and markets available to hedge fund managers allows for much more effective diversification than can be achieved in other asset classes.

Clark’s fund is a good example of how investing into a combination of largely uncorrelated styles, strategies and global asset classes can create attractive volatility-adjusted returns. Indeed, the cumulative return of Clark’s fund closely mirrored that of the S&P 500 from inception through the end of 2012, a net 77.9% versus the benchmark’s 77.6%, with around half the volatility. After that point, many hedge funds were positioned defensively in perpetual anticipation of Fed rate hikes. As a result,  hedge funds largely failed to participate in the massive, policy-driven rally that drove equity markets up 50.4% in 2013-2014. However, by February of this year, certain sectors of global fixed income and equity markets had declined enough to produce compelling opportunities, and the shift in sentiment produced strong performance for hedge funds and FoFs alike. As a case in point, Clark’s fund rose 7.8% over the five months through the end of July.

Concentration and Diversification

Clark believes concentration is the key to both outperformance and low correlation to broader market moves. “OmniQuest invests in a high-conviction, concentrated portfolio of 10-15 hedge funds diversified by strategy, style, and asset class,” she says. 

“The more managers you have, the less alpha you will have,” Clark explains. “It’s that simple. Plus, FoFs with 50+ managers are not necessarily as diversified as they believe.”  According to Clark, an investor can get more effective diversification through ten funds invested in ten highly differentiated strategies than via 50 funds in the four primary strategies. “Most portfolios of hedge funds are over-diversified by number, under-diversified by strategy, and inexplicably invested in low volatility hedge funds,” Clark adds. “It is nearly impossible to be profitable with this strategy.”

Illustrating her point, Clark revealed that approximately 89% of her fund’s assets are deployed in her top ten funds. That’s by design. “Almost anyone, even very large managers, can thank their top ten positions for 60-80% of their gains,” she says. “The best ten managers I can find are significantly better than the next ten managers. Moreover, even if every one of those managers were highly concentrated with 80% of their assets in their top ten positions, 80% of OmniQuest would still be invested in 100 securities, providing plenty of diversification.

“The actual concentration of our underlying managers depends on the strategy, but on average, about 60% is invested into their top ten ‘ideas’”, she explains. Although OmniQuest is very concentrated by industry standards, Clark believes her top ten hedge funds provide significant diversification. Choosing that top tier wisely thus becomes a key differentiator. 

And it is precisely in the process of choosing which managers will go into – and remain in – a portfolio that a manager like Clark can be worth every penny of those extra fees. Clark’s three decades in finance, which include stints as an FX trader for Citi and roles in interest rate swaps and corporate capital markets with Merrill Lynch and Bankers Trust, has provided a thorough understanding across asset classes and armed her with an extraordinary penchant for very granular due diligence (for a ringside seat to Clark’s diligence process, see Trade Secrets in the May issue of Modern Trader) and the ability to see the proverbial forest for the trees. 

“Our managers often invest in concentrated portfolios, may carry illiquid securities, operate in inefficient markets, and/or employ complicated, niche strategies,” Clark explains. “Our funds tend to have high levels of volatility, so we have to combine the overall group very carefully if we are to maintain a low-to-moderate level of volatility for the portfolio.”

“The correlation among the managers in the portfolio is close to zero, and we work hard to keep it there,” Clark explains, “You don't want a high negative correlation – you won’t make any money – and you don’t want a strong positive correlation, because then you will have too much volatility.” 

Making the Cut

With such a concentrated portfolio, the fund selection process is understandably rigorous. Clark starts with managers that have asymmetric risk profiles and where managers have the majority of their own money at risk in their own funds, as she does. “I don’t want them running a business, I want them running a fund,” she says. “I want specialists with a defined area of expertise that are flexible and experienced enough to find opportunity in most market environments.”

Among Clark’s other criteria are strategies that hedge market or portfolio exposure for little or no cost, and managers with exceptional backgrounds and specialized expertise. Operations are important as well, Clark points out, stressing that she looks favorably on managers that work with blue-chip service providers – prime brokers, administrators and auditors – which lend credibility as well as act as independent sources of information.

Structure also has to match substance. “A fund’s redemption policies have to match the liquidity of the positions it is likely to carry, and it must be transparent enough for us to understand and monitor,” Clark notes. “Fees must also make sense in light of the market niche and the opportunity set. We’re happy to pay for skill, but the whole picture has to mesh together coherently.”

One of Clark’s most important tools? Time. “Time is one of the few valuable factors that can help distinguish luck from skill,” she says. “I value a long track record because it reduces my risk. I have much more information to evaluate. Luck might drive returns in one market cycle, but it won’t hold over multiple ones, and not through varied market environments.”  

And although it sounds counter-intuitive, Clark looks intently for periods of losses to determine how well a manager can adjust. “Just because you’re down doesn’t mean you’re wrong,” she says in a statement sure to comfort the managers that found themselves on the wrong side of the Brexit vote. “One of the things that makes a great investor is humility, the ability to acknowledge when you need to re-evaluate. If you can’t, you won’t be great manager for long.”

“The correct question to ask around a loss is why,” Clark emphasizes. “Just like a stock market is not necessarily cheap just because it has gone down, a hedge fund manager is not good based on one year's return. You have to dig deeper.” 

It’s All About Access

Another key, but often overlooked, advantage to funds of hedge funds is access. In some cases, the same fund managers who can consistently generate market-beating returns year after year are exactly the ones closed to new investment. Longstanding funds of hedge funds have the advantage of pre-existing relationships with managers that allow them to get around asset caps and other limitations. OmniQuest, for instance, offers unique access to a number of highly desirable, but currently closed, high profile managers like Third Point and Elliott Associates. 

In contrast to popular perception, manager selection is not a fire-and-forget activity. At least in OmniQuest’s case, allocations are constantly being assessed and, when necessary, tweaked to fit Clark’s ever-shifting worldview. In a broad sense, she makes some of the same judgments as the portfolio managers to whom she is entrusting capital. 

For instance, Clark was one of the early investors to short subprime mortgages in 2005 through Mike Burry’s hedge fund Scion. After a profitable exit at the end of 2007, she invested in a fund that purchased distressed subprime, an investment that profited through 2010 when she again changed her exposure to mortgages by investing with a specialist in agency mortgages and IOs. Clark was also an early investor in emerging market distressed debt and commodities, together a 35% allocation for the fund at inception. Clark’s instincts on commodities caused her to exit the sector at the end of 2012, and she eliminated energy exposure in her fund ahead of oil’s accelerated decline last year. 

As for the current situation, Clark believes markets have been over-priced since 2013 “Our managers have been relatively risk-off until recently, and as a result, our returns have been lower than our target. But, in some markets the only position to take is one of patience. If we had been making high returns over the past two and a half years, I wouldn’t have been able to sleep because I would have known we were buying things that were too expensive. Our performance through the end of July suggests this patience is beginning to pay off – the opportunity set has improved, and is the best since the beginning of 2013.”

In its 2016 outlook for funds of hedge funds, Preqin noted that significant volatility at the start of the year and the tricky macro environment that continues to confront managers could spur further consolidation in the fund of hedge funds sector. Perhaps - although volatility can be a double-edged sword. Investors may find that funds of hedge funds able to select managers consistently adept at generating attractive risk-adjusted returns through various market environments are worth many times their added cost.

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