JANA Investment Advisers believes identifying the beta drivers in hedge fund returns has enabled it to halve fees in the notoriously expensive asset class, as the consultant recommended clients allocate as much as 15 per cent of their portfolios to the strategies. Michael O’Dea, portfolio manager of JANA’s Triplepoint hedge fund-offunds (hedge FoFs), said investors in hedge funds should only pay for manager skill and use a managed account structure to monitor risk and control counterparty relationships. “The only thing worth paying a performance fee for is the skill.

The other exposures can be gained by buying futures contracts and an index fund,” O’Dea said. He said hedge fund returns were primarily generated by four sources: about 30 per cent came from market beta, 30 per cent from the manager’s ability to select outperforming securities, 20 per cent from illiquidity risk and 20 per cent from underwriting risk, which entailed writing options to hedge positions. In contrast, most balanced funds derive between 70 and 80 per cent of their returns from beta, between 10 and 20 per cent from manager skill and 10 per cent from illiquidity risk, O’Dea said.

By separating manager skill from other return drivers, JANA halved the fees it pays to the managers in Triplepoint and sliced 75 per cent off trading costs. The Triplepoint fund runs on a base fee of 80 basis points, while performance fees apply only to 30 per cent of the portfolio, and are paid only when returns from these strategies outperform the cash rate. This is possible because only 40 per cent of the hedge FoF is invested in active hedge funds, which are all market neutral strategies. From the remainder, 20 per cent is invested in hedge funds replication strategies and 40 per cent to traditional market exposures.

Of these return drivers, only skilled managers – “people who select securities and people timing the markets, whether they be quantitative or discretionary” – deserved high fees, O’Dea said. Since 2001, most superannuation funds advised by JANA have increased their investments in hedge funds from 2 per cent to between 5 and 15 per cent. “Now, we’re at the upper end of the range,” O’Dea said. Running these strategies through a managed account gave investors full transparency and control over relationships with service providers, and mitigated the liquidity and counterparty risks that have plagued hedge funds during the financial crisis.

When word of liquidity stress at Bear Stearns, and then Lehman Brothers, emerged in 2008, JANA was able to terminate both investment banks as prime brokers to the underlying funds in Triplepoint. “That structure enabled us to keep a currency hedge in place last year,” O’Dea said. Managers refusing to offer a managed account were often hiding operational flaws in their funds, he said. “They’re almost at capacity, or it normally identifies a problem with the manager’s operational infrastructure. It means they can’t split trades between the main fund and your fund.”

O’Dea said the liquidity problems afflicting many hedge FoFs originated from their response to a 2006 ruling by the Securities and Exchange Commission (SEC) in the US, which required all hedge funds to register with the regulator. To escape regulatory oversight, HFoFs implemented lock-ups of between one and two years, which placed them outside the SEC definition of a hedge fund. “That was a problem leading to the issues of last year when the Australian dollar fell and hedge FoFs weren’t able to liquidate underlying investments to fund forex margins,” he said.

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