Pension funds and their consultants are wary of hedge funds, largely because they cannot pigeonhole them into any of the traditional asset classes, and therefore find them difficult to benchmark.
As a result, they have tended to approach them through the multi-manager route, rather than directly. By apportioning a mandate equally among a dozen or so managers within a fund of hedge funds, they hope to reduce the risks of what they see as an unpredictable style of investment; in particular hedge funds often take much bigger bets than is normal for institutional investors.
However, although this even-handed approach may reduce the risk it does little to provide what pension funds are buying into hedge funds for outperformance against a benchmark.
One way to square this circle is to apply risk management to multi-management selection, according to two investment experts, Jason MacQueen and Piotr Poloniecki.
They have extensive experience of both risk management and multi manager selection. MacQueen is the founder of Quantec, a UK provider of investment technology and risk models for institutional investors, and now chairs Alpha Strategies, a quant specialist. Poloniecki is the founder of multi-manager specialist Eldon Capital, and now heads Apollo Advisors an investment management company specialising in multi-manager strategies.
MacQueen explains: “It seemed to us that multi-management only begins to address the central issue of making hedge funds palatable to pension funds and other institutional investors. Our view was that simply putting together different hedge fund managers in some arbitrary proportions is a very naïve way of managing the portfolio risk.
“You put together four or five funds that are not perfectly correlated and you end up with something that is less risky than most of them. You have made a first stab at reducing the riskiness of these things, but you haven’t done anything at all to fit them into a pension fund pigeonhole.”
To remedy this, MacQueen and Poloniecki have constructed a fund of funds risk management tool along the lines of a completion fund. A completion fund uses risk analysis to tailor the overall risks taken within a portfolio of active managers.
The Apollo funds work in much the same way, MacQueen says. “We know that certain managers are good at picking stocks and good at generating performance within their particular area of speciality. We also understand and recognise that while they’re doing that they will inevitably incur other exposures as well. Sins of omission or sins of commission, so to speak. So this fund fixes all of those mismatches and potential problems and reduces the whole risk down to some acceptable level.”
Hedge fund managers are taking a series of bets that must be hedged if they are to stay within a pension fund portfolio’s tracking error, says Poloniecki. “Our approach is to undo those bets relative to a benchmark or make them more uniform. You’re using some hot managers to generate excess returns with a managed tracking error.”
Poloniecki compares the process with turning down the volume of a collection of ‘noisy’ managers, who all have large volatilities relative to the benchmark. “By adding the completion component you are turning the volume down to a level where the loudness is acceptable to institutional investors.”
“You can pick any set of specialist managers you like with this. They don’t have to be hedge funds in the sense of being long-short, they can be long-only. You can then choose any benchmark you like. Then you build a fund between the two. The aim is that when you bolt all these bits together the whole thing has an acceptable degree of risk relative to the benchmark.”
There is no ‘black box’ at the centre of the system, Poloniecki emphasises. All the processes are already known. “Apollo hasn’t really invented either the manager selection process or the risk management process but it’s brought them together in this particular application to provide something in which we think institutional investors are interested”.
MacQueen cites a typical example of a US pension fund that is looking for an investment manager to handle a $200m portfolio of European equities. The benchmark will be the MSCI Europe ex-UK, the standard benchmark for European equities.
“One option is to go out to Merrill Lynch, Schroders or Gartmore and just buy their European equity product and accept whatever the performance is. And one of the things they’ll tell him is that the tracking error has been around 4% or 5% annualised against this benchmark. So the pension fund will expect about 4% or 5 % tracking error.
“What Apollo can do is build a multi-manager fund including our completion fund so that when it’s fitted together the overall product has a tracking error of 4 or 5% against the benchmark. So it’s now exactly as risky as the standard active European equity product you might buy from a large asset manager. It’s not more risky, but you probably now have a much better chance of outperforming.”
The choice of benchmark makes no difference to the way the completion fund operates, MacQueen says. “A UK pension fund might say it wants the benchmark to be the FTSE Eurotop 300 with a tracking error of 3% to 3.5%. Either way you can tailor this and anchor it to some required benchmark.”
One advantage of this method is that it allows the individual hedge fund managers to operate on their own, in their own style, and without interference.
“One of the other things that makes it difficult for pension funds to invest in hedge fund managers or indeed in individual specialist fund managers is that these guys typically don’t like to be interfered with,” MacQueen says. “They like to run money the way they want to run money. They don’t want someone else coming along and telling them not to overweight or underweight sectors relative to the benchmark by more than plus or minus 2%.
“With this fund, you can let them do their own thing. It’s not intended to alter the performance at all. It’s simply supposed to undo those aspects of the risk characteristics that you don’t want. Provided that they are willing to tell you regularly what holdings they’ve got, then you can design a fund that undoes all the things you don’t want without affecting performance.”
For example, with a group of managers specialising in sector investment, there are always likely to be number of sectors that are not represented when compared with the benchmark. The completion fund will compensate for the missing sectors. Alternatively, if all the managers prefer southern European stocks to northern European stocks within their particular sectors, the fund will compensate for the northern European underweighting.
It can also happen that managers will find themselves with a large bet on a single currency as an accidental consequence of their stock picking. The fund will undo their currency exposure. Or it could operate the other way round. If the managers are under-exposed to a particular currency relative to the benchmark then the completion fund will top up their exposure.
From the pension fund’s point of view, the completion fund acts as a kind of comfort blanket. Poloniecki points out that pension funds are nervous of long-short strategies principally because they are unsure of the market exposure. “They know there are some stock skills in the long-short area, but they’re very uncomfortable with variable market exposure, variable beta.”
He suggests that a suitable strategy for nervous institutions would be mainly long but with the freedom to generate some excess returns from short sales. “That fits in very well with the kind of things we’re doing, because this benchmark is predominantly a long benchmark, and you’ve got managers with specialist skills who are generally long at the market but have some short selling capability.”
The Apollo approach appears to reverse the old adage that the best is sometimes the enemy of the good. Looking for outperformance, it seems, need not threaten overall performance.

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