Hedge convergence

(January 2007) There is convergence between traditional and hedge investing, folks. Says who? Blake Grossman. Blake who? Grossman, chief executive of Barclays Global Investors, the world’s biggest money manager, that’s who. Says he in a recent Financial Times interview: “The notion that there is a traditional way of investing that is long only, and then there is hedge funds, is crazy. We’re seeing real convergence.”

A priori, it may seem that we may even be beyond convergence. Several large institutional investors — pension funds, endowments, foundations, remarkably wealthy individuals — may be simply sidestepping hedge funds altogether. In fact, the buzz seems to be more on the private equity and real estate components of alternative investments. It remains that hedge funds have garnered a significant proportion of institutional portfolios.

Under the rubric of convergence, there is some coming together of the management of hedge fund managers. For instance, several hedge fund investors will want a diversified, balanced mix of hedge funds in their portfolios, as supplied by fund of hedge funds (FoHF) managers, instead of taking their own chances on selecting single-strategy funds on their own. The typical, and until now largely favoured, approach to do so was to enlist the services of FoHF managers, who will create hedge fund short lists, conduct due diligence on them, and select the ‘best’ managers to be part of their fund(s) of funds.

These services come with a few perceived drawbacks, though. First, the “list price” on the services provided by FoHF managers is seen as steep, at 1% of assets plus 10% of performance above a threshold. This is in addition to the underlying single-strategy hedge fund managers’ fees, the retail rate typically being two and 20 (2% of assets plus 20% of performance above a threshold).

Second, large institutional investors like to have their own investments, rather than pool with others through a FoHF structure.

Third, large investors with buying power, complex portfolios and significant in-house research and management teams may prefer a “made-to-measure” approach. By selecting individual single-strategy hedge funds in the proportions best suited to their own investment policy, risk budget and experience, these investors can fine-tune their hedge fund positions and exercise full market power.

To do so, investors will need to have an internal team of analysts and managers (a de facto FoHF, in-house). Another solution is to retain the services of an “on-demand” hedge fund management services and consulting firm. These firms (a well-known one is Albourne Partners) will offer the fund scrutiny, selection and overseeing functions for their clients. Investors using these services appreciate the added transparency, precision in asset allocation and purportedly lower FoHF fees (inasmuch as the investor cannot negotiate fees with an FoHF).

The Montreal CFA Society’s annual hedge fund summit held in November was a good showcase of mainstream/hedge convergence. Farzine Hachemian, managing director of New York-based Celestar Capital Advisors, presented cogent views in favour of third-party hedge fund management services. His firm, one of the fastest-growing services firms in the market, offers manager search, due diligence, selection, and risk management to clients opting for the “bespoke” fund-of-funds approach. Interestingly, wider adoption of hedge funds across all regions is happening in the institutional world.

Another convergence theme bears upon operational risk, one of the three pillars of risk management (the other two being market risk and credit risk). In a nutshell, operational risk is presumably well under control in the long-only world, with highly liquid asset classes, index-replication market substitutes, and tight regulatory requirements. Not so in the alternative world.

Beyond finding alpha (i.e., skilled managers), appropriate asset allocations, and other asset management issues, the issue of appropriate business processes, key person risk (e.g., the risk of losing top money managers), and the like, need to be assessed. Christopher Addy, president of Castle Hall Alternatives, specializes in operational due diligence and stresses how important it is to go behind the scenes and kick the proverbial tires.

In effect, a risk rating needs to be produced on hedge fund managers considered for investing- and someone has to do it, either the FoHF manager, the third-party services provider, or the investor. As Addy says, “operational risk is risk without reward;” you want as little of it as possible, and above all, it’s business that needs to be taken care of.

In brief, the bottom line about convergence should mean fee compression, commoditization, a sharper focus on value added for money (i.e., alpha, whether portable or not) and wider acceptance. Let’s see what happens.

This article originally appeared in Advisor’s Edge Report. Pierre Saint-Laurent, M.Sc CFA, CAIA is president of AssetCounsel Inc. He can be reached at PSL@AssetCounsel.com

(01/03/06)