HNWIs sniffing out new investment opportunities

High-net-worth individuals (HNWIs) have started investing in wine and art instead of hedge funds, according to Chris Woods, head of absolute return strategies with State Street Global Advisors, speaking at a recent seminar on the institutionalisation of hedge funds. It was a tongue-in-cheek observation, of course, but it raised a seldom-asked question: how has the influx of institutions affected traditional hedge fund investors? “We have pre-2000 and post-2000,” says Phillipe Bonnefoy, founder and director of Cedar Partners, a specialist arbitrage and global macro fund of funds manager which rolled out its first single-manager macro fund at the end of last year. “Prior to the late-1990s this was an industry dominated by high-net-worths.” As demand for absolute returns grew from investors burnt by the equity and bond markets, private banks began to package, market and risk-manage hedge fund products much more rigorously, pooling them across distribution platforms. Soon they were no longer discrete products for ultra-high-net-worths. “The next wave, since 2003, was institutions really buying in,” says Mr Bonnefoy. “The fund of funds flows from high-net-worths has slowed somewhat while the ticket sizes from institutions have grown exponentially.” Since 2002-2003 research from providers such as HFR and HedgeFund.net has shown the fund-of-funds share within hedge fund inflows dropping, and the share of some single-manager funds – particularly multi-strategy – rising. Within that trend, HNWIs and family offices appear more willing to diversify into the single-manager route. On the face of it, the extra layer of fees would be enough to drive this move. But here, at least, institutionalisation has been benign, exerting some downward pressure. “You can’t expect to charge the same on a $500m (?370m) allocation as you could on a high-net-worth who gave you half a million dollars,” says Gary Vaughan-Smith, whose Silver Street Capital diversified fund of funds recently debuted with a single, $500m discretionary mandate. Discouraging reasons Institutionalisation has really discouraged HNWIs for much more fundamental reasons. “For some of our ultra-high-net-worth clients hedge fund investing is almost a hobby,” says Eleonore Dachicourt, head of Hedge Fund Advisory with Credit Suisse Private Bank. “Many like to spend time meeting with the managers, and that’s something not all funds of funds managers are happy to accommodate. Many run one-size-fits-all multi-strategy funds and it’s difficult for clients to give their input into the construction of the portfolio.” Increasingly UHNWIs seek to co-invest, which can involve them sitting on investment boards, she adds. “I think that clients are starting to appreciate some of the constraints around the fund-of-funds space,” says Nick White, JPMorgan Private Bank’s international head of alternative investments. “We’ve seen some good multi-strategy single managers grow their assets significantly on the back of some very good performance.” He observes that some fund of funds have become less flexible in tactical strategy allocation due to the increased illiquidity of some underlying managers – whereas the risk manager and investment committee at a single-manager fund can signal traders to change allocations immediately. Most importantly, he points to pension funds’ appetite for low-volatility hedge funds as a proxy for overpriced bonds. HNWIs were happy to see risk come off the table in 2001-2002, he says, but since then their risk tolerance has recovered along with the markets. “The problem is that investors have found that even after the recovery began in 2003 many of the funds of funds were keeping their volatility at 2.0-2.5 per cent. I think it has been difficult for some funds of funds to react because the lack of flow from high-net-worths has been replaced by inflows from institutions looking for them to continue with what they are doing.” Cedar’s Mr Bonnefoy agrees, pointing to a much-admired multi-billion dollar hedge fund. “Great firm, smart people. But if you’re the CEO, what on earth is the upside of trying to make 20 per cent a year? You can raise $10bn over five years and all you have to do is not lose money. High-net-worths might buy that argument, but they then ask why they have to be locked up for 90 days with no transparency but lots of fees – that really sucks.” As the allocator’s asset-ownership base expands risk becomes a political issue, and appetite decreases. Recent family-office research from wealth management consultancy, the Scorpio Partnership found that multi-family offices tend to pursue more ‘balanced’ hedge fund strategies (30 per cent funds of funds) than ‘aggressive’ single family offices (up to 95 per cent single manager); and third-party asset managers dealing exclusively with family offices tend to be “conservative” (60 per cent funds of funds). “A family office’s tolerance for the risks associated with hedge fund investing fall significantly once multiple investors are involved,” observes Scorpio’s managing director Sebastian Dovey. But as the figures show, even the most aggressive family offices are not entirely lost to funds of funds, and among HNWIs the typical strategy retains a core multi-strategy fund of funds allocation, re-allocating some capital into single-manager multi-strategy and in some cases building satellite single-strategy portfolios. In these cases, private banks advise clients as they create, effectively, a more concentrated sort of fund of funds, typically with 12-20 underlying funds. “We like to differentiate ourselves from the fund-of-funds industry,” as Ms Dachicourt puts it. “A lot tend to hide behind a large number of underlying hedge funds (sometimes up to 100 names) because they don’t have strong conviction with regard to managers or strategy. But there’s a lot of research to show that with just 12 managers you can achieve sufficient diversification.” Some HNWIs make tactical strategy, sector or geographical allocations and in these cases funds of funds can still provide valuable manager diversification. “We assist those who can afford to invest $5m or more into hedge funds in the construction of a tailor-made portfolio of single-manager funds,” says Ms Dachicourt. “For those who don’t have $5m to invest we can construct a core-satellite portfolio taking into consideration their risk/return profile – typically a core of smaller, quite spicy and focused fund of funds and single-manager funds around the core to beef up the performance. We are seeing smaller funds of funds managers developing niche strategies or focusing on regional markets to continue to attract high-net-worth individuals. We have seen interest in special-situations funds; we are seeing quite a lot in asset-backed lending and re-insurance, higher-risk types of strategies.” Mr Bonnefoy, who spun Cedar Partners arbitrage fund of funds out of Commerzbank’s proprietary hedge fund portfolio in 2002 and has since achieved annualised returns of 12.5 per cent, says he “kind of built the business to cater for this client base,” which was looking for leverage, “pick-and-play” funds of funds and speciality funds. “Hence our Cedar and Macro funds. Some generic fund-of-funds products have a very high component of net-long long/short equity, but you can get a leveraged long play in other parts of your portfolio if that’s what you want.” But if HNWIs want to get some exposure away from plain-vanilla long/short equity, it is not clear that they feel confident pursuing decorrelation in cutting-edge strategies outside of the fund-of-funds structure – whereas family offices do, according to the Scorpio Partnership research. After all, moving from funds of funds involves shifting selection risk from the fund manager to the investor or his bank. A sign of sophistication “You find that there is some hesitation from our more sophisticated hedge fund investors,” says JPMorgan’s Mr White. “They like to invest in what they understand. It’s sometimes difficult even for their adviser to explain correctly and succinctly what it is the manager does and at that point the level of comfort a client has in that strategy decreases rapidly. We probably see less money chasing hard-to-understand strategies which are outperforming than we see money chasing familiar strategies playing in geographic regions that are outperforming.” A number of commentators point to the way that the Amaranth blow-up, despite being focused on a single, specialised position, has frightened investors away from commodities in general. Similarly, US sub-prime issues are affecting perceptions of credit strategies. And that reaction is not irrational. Mr Bonnefoy warns that many “benign, annuity-like strategies” in the credit space which look very attractive for the HNWI risk-return profile are non-transparent in their pricing and have yet to be tested, potentially concealing fat tails. Although institutionalisation of reporting standards have made shopping around easier, the average HNWI is still very much aware that he doesn’t possess the due-diligence capacities of a good fund of funds. “Our clients are getting more savvy about the role that the risk manager plays in the fund,” says Mr White. “Every fund has one, but does he have a voting participation in the investment committee? Can he veto a decision based on his assessment of the portfolio? What is the manager’s approach to concentration limits? Those are things that high-net-worth clients have paid more attention to, certainly post-Amaranth.” Those are just qualitative issues. How does a HNWI construct a portfolio without the quantitative risk-management that might anticipate an Amaranth, or portfolio-construction systems for assessing the underlying exposures of his allocation? “Typically you’ve ended up with two funds of funds, a multi-strat fund a golfing friend told you about, William Von Mueffling’s long-short equity fund, and maybe something in emerging markets or speciality credit,” says Mr Bonnefoy. “Now I think we’re seeing private banks marketing their platforms as an outsourced resource for the family offices, which pays very well to the higher end of the high-net-worth. They have to evolve that way, because if they don’t they’ll lose the business.” Ms Dachicourt agrees. “We have actually noticed that some high-net-worth clients’ hedge fund portfolios tend to look more like a collection of hedge fund names with no true thought process behind the portfolio construction, which can sometimes result in a high concentration of one strategy (typically equity long-short) or one region. That’s where we can help, and we’ve been very active in that space: restructuring clients’ portfolios - producing risk reports explaining where most of their risk is in terms of regional and strategy exposures, how much beta they have in their portfolio, how they could improve diversification, how they can come up with a portfolio hedge using long-volatility funds, and so on.” Ironically, the desire of HNWIs to escape from the low-volatility world of the institutionalised funds of hedge funds into more concentrated exposures (including more specialised funds of funds) involves the “institutionalisation” of their approach to the industry – because one’s risk is only as good as one’s risk management.

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