Greg Bright

Greg Bright

The third annual Absolute Returns Funds conference for super funds, produced by Investment & Technology, canvassed a range of issues faced by super funds in assessing alternative investments.

GREG BRIGHT and MICHAEL BAILEY report.

Absolute returns strategies using al- ternative investments are far from dead post-crisis, it would seem, although their use in both asset allocation and portfolio construction is changing due to lessons learned from the past two years.

The annual Absolute Returns Funds conference for super funds, held in Melbourne in September, was told, for instance, that “after the flood” the hedge fund industry would be much more attractive to investors.

Greg Moessing, a managing direc- tor of the influential consulting group Cambridge Associates, said that this would be a smaller industry and the balance of power was shifting from dominance by general partners (manag- ers) to limited partners (investor fund structures).

“A little bit of humility has been a good thing,” Moessing said.“Access to high quality funds has definitely im- proved. Most hedge funds have eclipsed their high-water marks and that’s a good thing. There won’t be an exodus of talent (which had been feared).

For Cambridge’s 855 clients world- wide, which include some of the major US endowments, the recommendation has generally been for a maintenance in allocations to hedge funds, although within the sector there has been an un- derweighting of pure absolute returns funds compared with equity long/short strategies.

Eugene Snyman, Cambridge’s Australian head, said that private equity allocations were actually growing and there were some good opportunities at the moment.

“Secondaries investing is very at- tractive given some investors have an over-allocation (to PE),” he said.

The discounts available to second- aries managers in their purchases of private equity stakes, meant that diver- sification benefits did not come at the expense of returns, according to Mat- thew Arkinstall, of Greenpark Capital. His firm, for instance, had an average of 20 investments in managers who in turn had an average of 20 underlying invest- ments each.

“You probably wouldn’t sell a secondary in this market unless you really had to,” he said.

Meredith Jones, a managing director of Pertrac, said that when assessing the hedge fund sector, one could not tell whether a fund was good or bad based on a single average number.

“The industry tries to boil down the universe to one benchmark,” she said. “Last year more than 20 different types of strategies comprised the top 5 per cent of fund performance. CTAs were first, followed by long/short.”
Data from Pertrac, which fol- lows the numbers from 22,000 funds (“which you can see and touch”) shows that ‘younger’ funds tended to outper- form their older counterparts, as has been shown to also be the case among boutique long-only managers.

“You should keep an open mind about manager selection and get away from the view that it’s got to have a three-year track record and $500 mil- lion under management before you invest,” she said.

Gregor Andrade, a principal with AQR Capital Management, said the big issue over the past year had been the correlation between many hedge funds and the MSCI World index.

“Almost every hedge fund strategy has some common element or hedge fund beta and we think that there are probably two or three which are entirely hedge fund beta,” he said.

“We think that hedge funds still show great promise but there some drawbacks… A portfolio of hedge fund betas came through the past year okay – not great, but okay.”

The strategies which did the worst were those with greatest leverage or directional strategies. The equity market neutral universe was impacted by fraud, given a large chunk of it was accounted for by Bernie Madoff ’s Ponzi scheme. Capturing hedge fund betas was not as easy as it seemed, the confer- ence was told by the head of alternative beta strategies at Partners Group, Lars Jaeger.

He said the replication factor strategies favoured by top-down at- tempts to capture hedge fund beta were sub-optimal, because they were linear approximations of hedge fund returns which did not consider the erratic payout profiles inherent in hedge fund strategies, were backward-looking and loaded up on the equity exposure of their reference hedge funds – “the part that is least attractive to investors”.

Partners Group favours a bottom- up, non-linear rules based approach to capturing alternative beta, which identi- fies hedge fund risk premia and sup- ports the analysis by combing through academic research, and then investing in a rules-based fashion rather than mere direct exposure to the explaining factors.

A lot of super funds are also re-thinking their approach to portfo- lio construction following the crisis, looking for investments which offer more genuine low correlations, such as currencies.

However, Guy Stern, head of multi- asset fund management at Standard Life, warned super funds that “nothing should be in the portfolio that you don’t expect to be a rewarding investment
– otherwise you’re wasting your risk budget”.

Global macro is a discipline whose exponents are newly confident of its risk budget efficiency.

The head of alternative investments at State Street Global Advisors, Ric Thomas, said an approach combin- ing typical ‘convergent’ strategies with ‘divergent’ strategies – those which aim to profit when fundamental valuations are ignored by the market – reduced portfolio volatility and negative outliers and increased the chances for capturing upside “fat tails.”

The chief operating officer of Gra- ham Capital Management, Robert E. Murray, said his firm’s ‘systematic global macro’ approach, which uses systemised trading algorithms to trade the global liquid futures and foreign exchange
markets, exhibited the opposite charac- teristics to most hedge funds styles in that it had a return profile with positive skew and low kurtosis.

When assessing risk, funds should not aim to manage their physical exposures nor their economic exposures but rather their market risk exposures, Stern suggested.

Correlations came in for their share of criticism in the light of their move- ments which were largely in step during the height of the crisis last year.

“You can’t trust correlations because they’re linear,” Jon Glass, the CIO of Media Super, said. And more strongly: “Correlation is a fraud in our industry,” Ray King, director of Sovereign Invest- ment Research, said.

And while hedge funds of funds (FoFs) were being increasingly scruti- nised by large super funds even prior to the crisis, because of their extra layer of fees, they too are adapting to the post- crisis environment.

Randall Dillard, the CIO and co- founder of Liongate Capital Manage- ment, said that his firm was one of the first to be very active in portfolio construction, which other hedge FoFs were now doing.

Prior to the crisis there was little competition in the trading strategies of hedge FoFs. Clients could not get out because they had nowhere else to go and were worried they might not be able to get back in.
Hedge FoFs were also looking to better manage liquidity by clearly segre- gating clients on the grounds of liquid- ity through increasing use of separately managed accounts (SMAs).

But SMAs were very expensive to run and most super funds were too small to run their own programs.

Another lesson from the crisis being addressed by hedge fund managers, as well as super funds, is counterparty risk. The prime brokers who handled a range of business for hedge fund managers have recently come under attack from the big custodians, in particular.

Matt Unsworth, head of Australian equities for Merrill Lynch, said that prime brokers might take on a differ- ent look in the future. But their central premise would remain to provide solu- tions across a range of services rather than just “the cheap liquidity of the past”.

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