Risk controlled route

The returns posted by some hedge fund of funds are not to be sniffed at, writes Henry Smith.

The search for added investment return amid uncertain stock markets is fuelling interest in hedge funds. Investors, keen to diversify their portfolios away from poor-performing equities, have been forced to re-examine their attitudes to risk and return. Happily for those worried about another LTCM-style debacle, the proliferation of funds of hedge funds offers a risk-diversified route into a much-maligned but potentially lucrative asset class. Risk management is a key selling point for fund of fund managers who should be willing to answer queries regarding the selection and monitoring of underlying hedge funds. In the current climate of low interest rates and negative equity performance, the one-year returns posted by the funds of hedge funds listed below are not to be sniffed at. The fifth-ranked E10m Multi-Europe Fund (MEF), which is advised by Fortune Asset Management, an affiliate company of London-based Global Fund Analysis (GFA), generated a return of 2.25 per cent over the last 12 months on the strength of 11 underlying hedge fund strategies. Launched in January 2001, the minimum investment is $50,000 (e57,000). The fund invests in European assets, predominantly though equity and equity-related strategies. Current exposures are 75 per cent to equity long/short, 16 per cent to merger arbitrage and 9 per cent to convertible bond arbitrage. Despite the preponderance of equity long/short funds, Owen Brolly, head of portfolio management at GFA, says MEF will consider all types of hedge strategies, including macro, fixed income and distressed debt, as long as they comply with the fund’s investment guidelines. He believes European distressed debt is a growing opportunity, because US specialists are launching dedicated funds. But he notes that the distressed cycle can be three years or more, which is a long time horizon for a fund with monthly liquidity. Mr Brolly explains that MEF strives to achieve “meaningful transparency” through the examination of monthly reports on aggregate trading positions, submitted by the underlying managers. He says: “For an equity fund, we think country and sector, gross and net exposures are the minimum requirements for risk management.” The biggest single manager selection criterion, he adds, is originality of thought. “For example, if a manager’s return through 1998 and 1999 lagged [behind] the peer group because they could see the Internet bubble for the mirage it was, but they did not have a great 2000, then their strategy is probably more suited to a single strategy investor than a fund of funds.” Risk management for MEF is carried out using a combination of quantitative and qualitative analysis. Significant qualitative factors include properties of the equity markets such as directional trend, propensity to change, realised volatility and implied volatility of stocks and indices. Mr Brolly adds: “Qualitative factors include entrepreneurial risk, which was low in 2000, as every new fund had access to capital, but is high now as some under-capitalised managers start their fourth successive year with cash-type returns. Liquidity is more qualitative, since forecasting it is notoriously difficult. At present, its significance is rising and, although managers tell us they are being paid to take it, we do not want a portfolio full of illiquid securities.” Equity long/short was the best performing strategy for MEF last year, according to Mr Brolly, with well-diversified managers outperforming the more directional styles. Merger arbitrage was weak due to a lack of deals – a scarcity which has continued into the new year. “Two underlying long/short equity funds are on the watch list because their responses to market events in the last quarter surprised us,” he says. “One fund was more profitable than we expected, while the other was disappointedly flat. We received satisfactory explanations from the managers but now a doubt has been introduced. “We do not want to be complacent,” he added, “just because they are well-capitalised businesses.”