Hedge funds seek to make money in markets irrespective of market direction – a laudable aim, particularly in the current uncertain times. Hedge fund managers have the ability to leverage up if they are overwhelmed by opportunities, or go into cash if market conditions are not promising for their particular strategy. But how much money they make depends crucially on the state of the market in which they operate, be they exploiting pricing anomalies or a perceived information advantage.
Enter the fund of funds, whose mandate is to select the best managers in each strategy and weight them according to the likely returns. This involves a deep knowledge of the individual strategies that hedge fund operates, how to evaluate managers in each of these market segments and lastly an evaluation of how market conditions are likely to impact the manager’s future returns.
The mechanics of creating a fund of funds might appear simple – a model portfolio based on managers’ past returns can be created at a mouse click using data from publicly available databases and a off-the-shelf optimiser. Meeting the selected managers might provide some comfort that they are not complete charlatans. But, as recent equity markets evidence, past returns are no predictor of the future, and any apparent correlations between hedge fund returns to each other and to stock and bond markets are state-dependent and highly variable.
As Ian Morley, chief executive of Dawnay Day Olympia, maintains: “In the fund of funds market, nothing beats a chequebook. Doing your own DIY might save you money, but you are more than likely to end up with a bodged job.” Ideally, a well-run fund of funds should provide consistent, positive returns and, through detailed due diligence, assiduous monitoring and industry intelligence, reduce the risks of fraud, liquidity, style drift, deterioration in returns, manager availability, poor administration and shaky business foundations.
Rigorous screening at the initial stages reduces the panoply of 5,000 managers worldwide to more manageable number. Many fund of funds screen firstly on performance, but for Norman Chait, chief executive officer of Rutherford Asset Management, formerly head of the hedge fund investment team at AIG, who sees hedge funds as a talent pool rather than an asset class, the actions of managers are all-important in his elimination exercise. For Chait, one of the red flags is poor shorting skills and the use of shorts purely as insurance against the long positions, rather than as outright bets. Any evidence of lack of business integrity, such as extending a previously hard closing date, ratcheting up of performance fees for new investors, improper fee-compounding and hefty charges on exit is cause for caution.
Says Chait, (in the event that an institution such as a mutual fund is setting up a hedge fund): “Alarm bells ring when I hear more about the qualities of the institution than the manager running the fund, and, if an institution is making other simultaneous hedge fund launches, one questions how much talent they can realistically claim. The presence of a customer service team, and secondary trading in the fund, means that the manager may not have a deep understanding of his investors’ requirements.
“Use of third-party money raisers makes me concerned about the nature of other investors and whether the fund could be at risk of a flood of withdrawals. Start-ups without a competent CFO show a lack of appreciation of the business aspects and often, former proprietary traders at banks have a poor understanding of working with a finite capital base as opposed to a line of credit.” Exclusion on such diverse grounds must lead to a smaller investable universe but, as Chait counters, “by taking a rules-based approach to investing, you may pass up on the odd ‘must do’ opportunity but are more likely to avoid disasters”.

A clear and focused mandate, with objectives for concentration, size of funds used, up and down moves per month and standard deviation, facilitates portfolio construction, without imposing excessive constraints. The fund of fund manager has many tools at his disposal in the diverse strategies employed by hedge fund managers. Some strategies exploit trends, break-outs, and market direction, whereas others identify mis-pricings, relative value, and spread deviations. Established equity market styles such as growth and value also have their place. By bringing together funds whose returns emanate from diverse sources, the fund of fund manager seeks to increase the likelihood of consistent returns whilst minimising risk of loss or volatility.
Once managers are selected and funds invested, the work goes on. For example, Weston Capital, manager of the top-performing £300m (e480m) Wimbledon family of funds, employs different levels of monitoring which intensify from daily NAV and performance attribution through monthly asset allocation to quarterly meetings and review, all the while looking out for warning signs, like unexpected performance blips, a change in assets held, style drift or a different mode of implementation, and personnel change. The 25% turnover of the fund on an annual basis comes from active rebalancing and re-allocation based on an estimation of which factors are most likely to drive returns. Factors such as market direction, liquidity, credit and currency are key drivers and Weston monitors the proportions of each in the overall fund of fund.
About half of the effort involved in running a fund of funds goes into manager selection and the portfolio construction is eased by access to a high-quality pool. The length of track record is important to some fund of fund advisers. Permal, which runs $7bn (e7.6bn) in 27 different fund vehicles, favours managers with more than three years’ experience and proven performance in both up and down markets. Conversely, Cross Border Capital prefers new managers, citing studies of returns by age of fund that an erosion of performance with time and maturity. Credit Agricole Alternative Investment Management continues to class as emerging any manager who has been in operation for less than three years with less than $200m.
But capacity can be reached quickly and waiting for a manager to become established might mean missing the boat. Making a small allocation to new managers is a stepping-stone to increasing allocations once performance comes through. Most fund of funds avoid ‘trading’ managers, as hedge funds tire of accepting money from previously fickle investors.
As the market for funds of funds becomes deeper and more segmented, a trend is developing for specialist funds of funds with a narrower mandate than the broadly diversified product historically popular with the private investor. Funds of funds that centre on particular strategies, an asset class or region are an increasing feature of the market. But this limited opportunity set could mean flat returns over periods when the strategies are not performing and potentially higher volatility if less diversified.
Two particular adaptations of the fund of fund product are becoming prevalent, particularly with reference to the institutional market. Funds of funds investing solely in equity long/short managers appeal because of the simplicity and relative familiarity of the strategy (often simply a variation on traditional equity ‘stock-picking’). And market and risk neutral funds of funds with extremely low volatility are often pitched as an alternative to bond investment.
A good example of the equity long/short style is Argyll’s European Masters Fund (recently acquired by Permanent Asset Management and now called the Permanent European Masters Fund), which focuses on equity long/short funds that are predominantly European-based. Richard Hills, Argyll managing director, emphasises the wide range of styles in use across the sector, citing market capitalisation, growth vs. value, derivatives usage, net exposures, concentration and holding period of stocks as just a few of the differentiators.
Studies performed in-house show that different market conditions favour different long/short strategies and performance of funds can vary widely depending on their approach. During a variable bear market of late 2000 into early 2001, Argyll found a variation of between –30% and +20% across its shortlist of managers. The best performers were market neutral and those exploiting value/growth. One important conclusion was that very few managers make money all of the time, and in bear markets simply not losing money was the best that most managers could hope for.
Strictly market neutral funds of funds try to extinguish all risk factors and unwanted sources of return, aside from the particular arbitrage or market inefficiency exploited. Good examples of this are the Gottex-managed GVA Market Neutral fund, run by former JP Morgan derivatives head Peter Bennett, and the Greenway Long/Short Equity fund, offered by Credit Agricole AIM. Bennett and his team run detailed analytics on fund positions and conduct scrupulous interviews with managers to determine if any risk factors could creep in through sloppy implementation.
For Charles Bathurst, head of the London arm of Credit Agricole AIM, beta neutrality is more important than simply being market neutral, because simply having no net long or short exposure does not guarantee immunity from market moves. Market neutral strategies are sometimes for being at risk to market dislocation. Disruption to normal trading regimes causes mark-to-market losses that may outstrip the small but consistent monthly returns typical of these strategies.
Current market instability is causing Bennett to review allocations, and merger arbitrage, which had been suffering from lack of deal flow, is looking more attractive from a risk versus return standpoint, because spreads have widened since the US attacks. Bennett is also increasing weightings to mortgage-backed securities (because of the protection offered by the agency guarantee) and distressed debt, because of the many opportunities that present themselves at cheap prices.
Most fund of fund managers allocate on the basis of qualitative assessment of the prospects for each strategy, based on their experience of how strategies and individual managers react in different market circumstances. Cross Border Capital (CBC) is notable for developing a quantitative model for asset allocation on the premise that hedge fund returns are linked to rate of change of and the absolute level of global liquidity. CBC has constructed a proprietary index of liquidity based on data gathered from central banks and movements in the index.
Plotting the level of the index (analogous to market risk) and the rate of change (which equates to credit risk) over the course of a financial cycle generates a phase diagram, and the quadrant occupied at any particular stage pinpoints the hedge fund styles most likely to perform in that scenario. Already buoyant liquidity, heightened by central bank responses to the shocking events in the US, favours directional funds, such as global macro and emerging markets and discounts arbitrage strategies.
Claire Smith is a freelance journalist specialising in hedge funds

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