Systematising your satellite hedge funds

As hedge funds have entered the mainstream of private banking, core allocations are more likely to be with institutional-quality diversified funds of funds, resulting in more robust operations and risk-adjusted returns. But the more institutional the big names become, the more their portfolios overlap and their returns correlate – both with each other and with the wider markets. This has led to a move towards core satellite hedge fund investing, but initially, at least, the big-name funds of funds have been supplemented by fairly ad hoc single-manager solutions. It doesn’t have to be this way. “I would never advise a client to invest into my top single-strategy manager,” says Ben Funk, head of research at Liongate Capital Management, a $3bn (E1.9bn) shop running a 40-manager Multi-Strategy Fund alongside a “best-ideas”, 25-30 manager version called Select Fund. “In fact, I probably wouldn’t even advise them to invest into my top five or 10. You really need a more systematic way to bring down operational risk.” The fund of funds industry continues to throw-up firms like Liongate, offering niche multi-strategy products, or others with single-strategy exposure, and core-satellite investing spurs that on. “An allocation to Select Fund alongside a vanilla fund of funds has been an attractive package for private banks,” says Mr Funk. “Private bank clients want big, branded names, but because you don’t necessarily get exceptional returns there you have to add something a bit more punchy to keep the returns-stream attractive,” confirms Polly Smith, sales director with PSolve Alternative Investments, which runs niche funds of funds and sits next to PSolve Asset Solutions, a consultancy engaged with the same trend in the institutional sphere. It is a trend that Katie Partridge, director of client relations with Eddington Capital Management, has seen in response to their “high-octane” fund offerings, the multi-strategy Triple Alpha Fund and strategy-focused Macro Opportunities and Equity Opportunities Funds. “Private clients are typically more prepared to take risk, and they came to us because they’ve not found products that really cater for these needs among mainstream fund of funds,” she says. How much diversification do these products offer? Liongate’s funds have delivered less than 70 per cent correlation with the HFRX Global Hedge Fund Index since inception, and over the last 12 months that has come down to about 20 per cent. To understand why, think about what you are paying for with the big names. On the investment-risk side, they typically make a fairly static top-down strategy allocation and then focus on managing the (correlating) betas that come attached to managers’ (non-correlating) alpha, resulting in fairly high correlation with broader markets, but steadier volatility. Liongate implements much more active strategy re-weighting: about 3-5 per cent of the portfolio turns over each month, or 40-45 per cent each year – against maybe a 15-20 per cent industry average. “I think it’s arrogant for a fund of funds manager to think they can call the right strategy for the whole year ahead,” observes Mr Funk. “Look at 2007 – the allocation you’d have wanted at the beginning of that year is fundamentally different from what you would want now: we redeemed almost all of our equity long-short and replaced it first with managers who were short subprime and then with managers who were short credit; more recently we have been allocation to managers who are shorting financial-sector equities, perhaps trading volatility, or macro managers focused on agricultural commodities.” On the operational-risk side, you benefit from big funds’ due-diligence capacity. You also get priority access to managers who are big names themselves. If you are a $7bn fund of funds with 40 underlying funds and a rule preventing you buying more than 10 per cent of their AuM, they must all manage at least $1.75bn. That inevitably increases overlap with other big funds. Smaller funds portfolios will look quite different simply because they cannot access those household names anymore. “We can’t compete with the big groups, so we have to identify what our skill or USP is and genuinely offer something different,” says Ms Smith. “With us it’s new strategies. It might be finance, like Eden Rock, or high-octane at Eddington, or emerging managers, or a geographical focus.” Eden Rock Capital Management is a good example to show that the smaller firms are selling specialist expertise. Since launching its award-winning multi-strategy Solid Rock Fund in July 2002, inflows have stalled at about $80m. “Investors are very comfortable, but it’s difficult to differentiate a multi-strategy offering,” concedes managing director Ed Horner. “We’ve found it much easier to specialize and push that experience.” The result was products like the even more award-laden Structured Finance Fund, and a recent spin-off, the Asset-Based Lending Fund. “These managers aren’t in public markets, they’re making private loans, so we’ve had to adapt our entire due diligence approach and team - which now includes four ex-auditors,” says Mr Horner. “It’s a totally different approach from the standard fund of funds, and we actually have funds of funds allocating to us precisely because the expertise we’ve built up is not so easy to replicate.” Correlation of the ABL Fund with HFRX Global is 55 per cent, but beta is astonishingly low at 0.08 – because it aims to get its 8-11 per cent annual returns with less than 2 per cent volatility. “Most of a private client’s portfolio is likely to be in equities,” observes Mr Hroner. “Do they want to take on more volatility, or do they want the stabilizing effect of an ABL fund? It’s horses for courses.” Indeed, selecting a strategy-focused fund of funds for a satellite portfolio may well be about isolating specific, desired betas that are related to broader markets but can be managed at fund-of-funds level. Emerging markets is a good example – not least because the difficulty hedging in these markets means even most hedge fund managers are significantly net-long. John Cleary, CIO at Focus Capital, a fund of funds launched in 2006, had been researching emerging markets for years and had found that top-down asset allocation could add significant value. Focus Capital conceived to put this theory into practice, and the fund of funds structure followed as the best means to that end. Investment decisions “Our first decision is about whether we are in the right point in the economic cycle to invest,” Mr Cleary explains. “Our second decisions are country-allocation decisions. Then we look at which asset choices we have in those countries and decide which part of that sub-component is going to give us the best risk-adjusted return. “We wanted to get about 80 per cent of our performance from strategic asset allocation, and with even the biggest cheque book you are unlikely to get all the best managers together in one room collaborating effectively, so we outsource the bottom-up decisions to external managers – long-short or long-only - who are much better-resourced than we could ever be. The fund-of-funds structure means that we re-weight without having incurred the costs of employing a manager ourselves, or paying his salary while his market is in a downturn.” Returns are dominated by beta, with alpha generated by active management at the fund-of-funds level – but unlike a multi-strategy fund which manages correlations through strategic diversification, Focus Capital takes concentrated directional top-down bets (the single-fund limit is set at 20 per cent). It targets emerging-market returns with a third of the volatility, resulting in a Sharpe ratio of about 2.0 – which is pretty much what the fund achieved in 13 months to March 2008. For those looking for a single-strategy fund of funds to generate spicy returns by sourcing pure alpha (rather than manage beta correlations or allocate tactically to directional beta), we might return to Eddington Capital – and in particular its Equity Opportunities Fund. A high proportion of alpha allows a high degree of concentration: the fund consists of just 8-10 long-short equity managers who are themselves running high-conviction “best ideas” portfolios. “Our managers are almost all pure-alpha generators, and others offset any residual beta,” says CEO Glenn Baggley. “So we have a manager who is long equity-index put options, for example, and we can afford the premium we pay for that protection because our target return is so high to begin with. Our payout is more like a straddle’s, whereas most single-strategy funds of funds have a long-beta payout profile.” So there are funds of funds out there for a satellite portfolio which can provide pure alpha, specialist knowledge, or beta management that has low correlation with the core diversified funds of funds. As a result, some of the larger groups have already acknowledged the commoditisation of what they provide by reducing fees. “We want to compete on performance and not on margin,” says Liongate’s Mr Funk, “and the differences opening up with the vanilla funds are one more reason why core-satellite investing will continue to grow.” Indeed, if the core funds are increasingly “vanilla”, what is to stop investors exchanging them for investable-index exposure or one of the hedge fund beta replication engines now on the market, freeing some fee budget to beef-up their satellite portfolio? “I think it’s an interesting concept,” says Mr Funk. “Replicators continue to improve and I think they will be good proxies for the more beta-sensitive strategies like equity long-short. Replicating more discretionary strategies like credit distressed or event-driven will prove more difficult.” Arguably, that’s not a problem in a core portfolio that is one bucket in a correlation-based asset allocation – indeed, in itself it could be yet another push-factor towards more single-strategy funds of funds in the satellite. What is clear is that hedge funds lend themselves particularly well to the core-satellite approach, and that the concept has a long way to go in the private banking context.

Ben Funk, Liongate Capital Management