Transparency? Defined risk management? Short lock-up periods? Fee-sensitive? A fund that can handle critical mass? Do these sound impossible? Think again. These are hedge fund characteristics that investors have been seeking with little or no success in recent years – and with the new problems that lie ahead since the US markets reopened on 17 September, hedge funds will be asked to help solve investor concerns and expectations.

What problems lie ahead?
One is the composition of the investor that makes up the US market. Our sense is that the markets responded as if there remains something of a bullish sentiment. There are tens of thousands of current investors who only began investing for the first time in the 1990s and who have yet to experience a typical bear market, much less what we are currently experiencing. That, plus relatively high valuations, together with the negative impacts of globalisation in a period when things start contracting, create for a broad range of uncertainties beyond that of any typical cyclical decline. In short, tremendous ‘risk’ exists in those markets where these virgin investors participate.
Another problem could be the relative strength or weakness of the dollar. With the US, Europe and Asia all in or teetering on the edge of recession the last thing the world can afford to have is a weak dollar. What if: A weak dollar and a strong yen? The Japanese want to export. A weak dollar and a strong euro? The Europeans want to export. Sounds serious – and it could be. If by some chance the US dollar weakens at a time of global recession, that’s a real global problem, not just a US problem.
A third, and certainly not the last problem that lies ahead, is the mentality of consumers and have they honestly reflected on what has happened to date? Following the stock market crash in 1987, there were eight consecutive months of mutual fund redemptions. Most of the current investors in the US markets have not experienced 1987 or anything like this. From its highs, the stock market has lost roughly 40% of its market capitalisation, going from almost $17trn (e18.8trn) to $11trn (e 9.94trn). Yes, their real estate and housing wealth has continued to appreciate and they have taken out cash from constant refinancings, but one wonders how long this mentality will hold up. As people realise that the market price is closer to or lower than the price at which they bought in, then they become considerably more nervous.

How do we approach the markets?
In viewing the market in good times and in bad, investors must have a disciplined approach to their asset allocation and diversification models. How much risk are they willing to take for their returns? We view the market on both, a micro and macro level, identify the asset classes that will outperform over an extended period of time and allocate money to the ‘best of breed’ managers within those asset classes.
To further the point of asset class identification and picking the best managers within the given asset classes, it is proven that over 90% of a portfolio’s returns come from being in the right asset class. That being said, if you have: 1) identified the right asset class, 2) allocated money to managers who are in the top quartile of their peer group, while taking considerably less risk, and 3) instituted a risk management or hedging programme for downside protection, you have created a winning formula for multi-manager investing.
In the past five years, our research of over 650 of the leading US money managers has not only produced above-average returns for our clients, but because of the uniqueness of our proprietary system, we have created an incentivised and unbiased formula. Very often when institutions, family offices and high-net-worth individuals perform a manager search, whether it be through the large, well-known brokerage firms or consultants, in our opinion these searches are ‘pre-determined’ and the same 12–15 managers are ‘force fed’ to the client. These searches will produce the same household names from firm to firm, asset class to asset class and discipline to discipline. We chose to do things differently.
We have four basic criteria for a firm to meet our ‘long list’ of candidates. These are:
q must be a Registered Investment
Adviser (RIA);
q have a minimum of a five-year track record and be AIMR compliant;
q have a minimum of $50m in assets under management, and
q top quartile of performance, while taking considerably less risk than their peer group.
To receive ‘equity-like returns’ investors must accept a certain amount of risk associated with achieving those returns. The following is a summary of the historical performance from January 1990 to December 1999 of different asset classes with their historical standard deviation (measure of risk) associated with their returns.

Asset class Performance Std dev
Large cap 12% 20
Mid cap 13% 22
Small cap 14% 34
International equity 12.5% 24
Sources: S&P, Lehman Aggregate and Hennessee Group
Street Search, through its proprietary system, has been able to produce above-average returns by allocating to the right asset class and picking the ‘best of breed’ managers within those asset classes. To lower the standard deviation or ‘risk of the portfolio’, we: 1) use the multi-manager approach and diversify an asset class amongst multiple managers, 2) institute a risk management programme and place an option overlay or ‘hedge’ on the portfolio to protect against large downturns in the market. That being said, our multi-manager fund is up over 20% net of fees, year-to-date.
After speaking to numerous institutions and family offices throughout Europe, an overwhelming number stated their disappointment in hedge fund managers not being able to handle a large amount of assets. Some managers open their fund, are seeded and close their doors too quickly for some allocators to react. These managers, because of their styles, have ‘capital constraints’ and cannot manage a large amount of assets. Since we don’t purchase units of other hedge funds, we do not have capital constraints and can handle a large inflow of capital and place it in the market within days.
It truly is a new era. In our present situation, the speculative ‘tech bubble’ has been correcting for well over a year. The global economy has been in a recession and stock prices have been under persistent selling pressure. The one thing up until now keeping the US economy officially out of recession has been the consumer. September 11 most likely will now push the consumer into recession, so having proper asset allocation is imperative. We continue to believe some asset classes will dramatically outperform others for the next five to seven years and we have allocated accordingly.
The aftermath of last month’s terrorist attack may be with us for a long time and will result in periodic market disruptions. We believe our multi-manager approach with a risk management component becomes more important than ever in this new era.
Jeffrey J Podesta is the founder and president of Street Search Advisors in Red Bank NJ

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