Hedge funds have had a rough year, dealing with rapidly deteriorating credit, housing and equities markets. Their performance, or lack thereof, has led to concern among investors, particularly funds of funds, which experienced net withdrawals of investor assets in the second quarter for the just second time on record, according to figures from HedgeFund.net.
FINalternatives recently spoke with Brad Balter, founder of fund of hedge funds shop Balter Capital Management and former managing director of the institutional investor group at Citigroup, about his views on hedge fund underperformance and its effect on his own portfolio.
FINalternatives: What’s your take on the sub-par year turned in by hedge funds thus far?
Balter: It’s the worst performance I’ve seen in six years for hedge funds, and everyone can have a theory why. Right now, it is about risk controls, because there are some funds of funds going out of business. I’ve found that when hedge funds correlate and go through a year of underperformance, things usually change within the next year.
Truth be told, as a group, they haven’t done that bad, but investors generally want hedge funds to perform in any environment. But there are environments where all you can do is relative performance because you cannot always produce absolute performance. So this is one of those periods when you’re limiting drawdowns and not trying to be a hero and generate positive performance every month.
FINalternatives: Market conditions have been pretty out of whack for hedge funds in the past year. Are market fundamentals still intact for hedge funds?
Balter: The fundamentals have gone out the window and eventually we’ll return to a fundamental-based environment. But during these periods, fundamentals don’t matter. You can decide that Lehman is a short and you can be right but you can also be wrong by 60% when the Fed suddenly says, “We don’t want you borrowing financial stocks to short.” These are 100-year storms, so things are happening that don’t ever happen.
FINalternatives: How has the industry’s performance affected the way you manage your portfolio?
Balter: This year we had our highest turnover. Since we launched two years ago, we’ve had five turnovers. One was forced because the manager was up 10% but was frustrated in raising money, and four of them happened this year. As we’ve lifted up the lid this year, we’ve seen some things we wanted to change. It’s not because people have fallen out of our mandate; rather, it’s because we’ve placed complete focus on operations, infrastructure and viability.
We don’t use levered fixed-income strategies because they are still not working. Debt has stunk and spreads keep blowing out. Guys who have had overseas exposure have also taken some pain. Sector-based global long/short has been very good and we have a consumer player and a technology, media and telecom player. We don’t use energy sector-based managers because they’re great on the way up but there is zero protection on the way down. Multi-strats have worked best because I’ve found their ability to play in any part of the capital structure has been a benefit.
FINalternatives: What types of strategies do you typically invest in?
Balter: We invest in very simple strategies: unlevered credit and multi-strategy where they’re either looking at the credit or debt structure of the portfolio with no credit default swaps or three-letter words all over the place. They’re sector-focused, which comes with more volatility but can give you more upside, or just global long/short.
If I can’t explain the strategy in three sentences, I’m not investing in it. It doesn’t mean there is no merit to more esoteric strategies, but at a time when prime brokers are stressed and are not offering much leverage, and the cost of borrowing has gone up, why get complicated?
FINalternatives: Are you looking to add more managers to your portfolio?
Balter: There are 16 managers in the fund of funds right now and I’ll probably bring it up to 18. I’m looking at an equity long/short and one multi-strat manager. The problem I have right now is that one of them is a healthcare player, and when I look at my generalist players there is a lot of healthcare in their books right now. As much as I want to add this person, I want the other managers to just move on so I can add him because we all know that there are certain stocks that just about every hedge fund owns.
I also would like to add another fixed-income manager who doesn’t correlate with our current managers. Sooner or later, I do feel that fixed-income will experience a massive snapback, whether it is this year or next year, and I would like to increase my exposure but not through one manager.
We will invest on day one because I spent 12 years on the sell-side and was day one with John Paulson and Larry Robins of Glenview. I’m not afraid of a day one manager as long as operation and infrastructures are correct. The average size of our managers has gone up from $150 million to $250 million because during periods of stress, manager viability is essential.
FINalternatives: As a participant on both the buy-side and the sell-side, what trends, if any, are you currently seeing as a fund of funds manager?
Balter: I absolutely feel we’re reaching a point where funds of funds with either charge a flat fee and zero incentive fee or zero management fee with an incentive fee. We find investors appreciate the fact that we offer one or the other and, in the end, 99% of them choose the flat fee. But the fact that you’re offering the other one shows them that you’re thinking about them as investors.
If you want to try and make $100 million a year, go try and run a hedge fund. These are not $100 million businesses, they’re asset management businesses and those do not require incentive fees.
I feel there’s room in the market for a purely hedge fund-focused boutique. We run a fund of funds that focuses on smaller managers and that becomes a sourcing mechanism for our custom portfolio. So many clients put on a position in the fund of funds and if they want to put more in hedge funds, I’ll build direct investments around that. In the custom portfolios, clients do ask for more esoteric strategies and I’ll go source it for them, monitor it and use it.
And then there are wealth managers who don’t have internal hedge fund teams so they pay us a retainer to oversee everything.
by Hung Tran