Participants
Eliza Lau, managing director, SAIL Advisors
Helen Lo, managing director, Swiss Capital Group
Nigel Webber, head of investment management, HSBC Private Bank
Stephen Pak, vice-president, Credit Suisse
Jacqueline Ho, managing director, alternative investments, SHK Fund Management
For a high net worth individual is it better to invest in a fund of hedge funds rather than a single hedge fund?
Eliza Lau: By investing in a fund of funds rather than a single hedge fund you get more diversification. Risk levels decline as diversification increases. It depends on investors as to whether they want a low risk product. Some fund of funds offer consistent absolute returns. They could offer better transparency and liquidity than some single funds. You are also better off going with funds of funds in terms of the due diligence process that they can deliver. Individual investors may not have the expertise, the systems or the team in place to do the necessary research and due diligence on these hedge funds. I would therefore think that it is far better for individuals to put money with funds of funds for a better risk-adjusted return profile. On the flip side given the diversification of funds of funds, returns will be lower than those achieved by some of the higher octane single hedge funds. For example if you put money with the manager of an India fund last year you probably got returns of about 50% to 100% last year whereas funds of funds would be much lower. Our funds, for example, returned low to mid-teens last year. You couldnÆt get that kind of market beta with funds of funds, but investors should focus more on consistency of returns over time.
So should clients expect mid-teens returns?
Helen Lo: I would say industry performance over the past couple of years, over a broad range of strategies has been lower than expectations although it is picking up this year. I think one key factor is that a couple of large funds of funds in the market have come to a size where they are on the verge of being over-diversified. In addition, the volatility of the market is much lower than in the late 1990s and early 2000s.
Nigel Webber: I think it depends largely on the size of the client. Obviously one advantage of the funds of funds is that youÆve got a smaller bite size and youÆve got diversification for a relatively small amount of money. For less than a million dollars you can get a well-diversified portfolio. I think in excess $2 million we would advise clients to build a diversified portfolio of single funds rather than just buying an off-theshelf fund of funds. That allows the portfolio to be more tailored and the investor can build-in his own preferences and biases.
Stephen Pak: For us the most important point for individual investors is to acquire proper diversification through fund of funds and to achieve the kind of risk adjusted return they expect. For an investor with a million dollars or less it is very difficult for him to build his own portfolio using single manager hedge funds. For a quality fund you typically need at least a million dollars. Sometimes hedge funds wonÆt even let you in on an individual basis. Hence, investing in a fund of hedge funds may be the quickest and most efficient way to achieve diversification and returns.
And how many funds of funds would you actually track at Credit Suisse?
Pak: We track the majority of them that are available to us via our own internal database. This is to create a peer group for performance comparison.
But would you typically try and restrict yourself to a universe of say 10-20 very large fund of funds as it is quite hard to maintain a relationship with a large number of funds?
Webber: I think its more a matter of specialisation rather than size. So we would be a bit more selective and track and recommend only those funds that met certain investment goals that we perceived our clients might need. Its not just a function of size.
Jacqueline Ho: I think the knowledge base of the client in hedge funds is also an important criteria in choosing between fund of hedge funds and single manager hedge funds. If the client is new to this asset sector and wants to get exposure to absolute returns, liquidity or diversification - a fund of funds approach is probably the easiest way to get access to this sector. But if an investor is comfortable and experienced in this particular sector, then I think from an economic perspective, he may want to think about investing directly into certain strategies.
So has this proliferation of funds of funds resulted in too much money chasing too few opportunities and brought down overall returns?
Lau: I donÆt think so. It really depends which strategies you are looking at. For equities long/short in Asia, that could be the case. But for strategies such as fixed income, multi-strategies and relative value, there is a shortage of managers and we need more. This is also true in global areas too depending on where we are in the cycle. Fixed income as a relative value play would appear to have more opportunities now compared with the years through 2002-04.
How important is track record? Would you be prepared to go into a hedge fund with a track record of a year or less?
Lo: We donÆt have any hard and fast rules about how many years track record a hedge fund manager has before we invest. But we are fairly conservative on this. This is mainly because we recognise that new fund managers are all good traders and if they werenÆt they would not aspire to starting their own hedge fund shop. However it is also true that the first six months is a settling down period. Most of them come from big banks where there would be somebody to tap them on the shoulder if they stepped over their trading limits. This is not something they are aware of when they start their own shop. So usually when the hedge funds start we like to watch them for a period of months to see how their business develops, and how their trading style evolves. Having said that, it is interesting to see that with a lot of money chasing a small pool of very good fund managers, good hedge funds close very fast. So this has changed the due diligence style of funds of funds.
So if you are looking at a fund of hedge fund managers û how do you get comfortable that their due diligence processes are rigorous enough?
Webber: I think that comes with the experience of doing due diligence over many years. We now have a very significant team around the world which has built up extensive experience at not only looking at the manager in terms of performance but also the infrastructure of their business, their systems and their risk controls. I think this is something that is a real added value for the client and it is all done for them. Any fund that we recommend either for our fund of funds or our segregated portfolios has been through this process. We try and minimise the operational risks through that process. As a result I would say we are quite comfortable with buying brand new managers and getting in at the beginning. We have been doing that for many years and will continue to do so. We rely on the due diligence process to raise the warning flags.
Would you have concerns about funds of funds investing in new Asian funds that donÆt have a very long track record?
Webber: I think the fund can be new but the people need to have a track record which is demonstrable somewhere else. What weÆd never do is buy a fund from some guy that walked in off the street and says heÆs got a great idea but canÆt show you where heÆs done it and how heÆs done it before. Somebody has to be able to demonstrate that they have a reputable past and that they have done something similar to what they are proposing in a different environment. But we could easily buy a brand new fund and be a founding investor.
What sort of investment horizon should clients have when they are thinking about investing in funds of funds?
Pak: They are certainly not going to be a 3-6 month investment. Investors have to understand that when you put together a portfolio of various different styles of hedge funds that you are taking a diversified approach to investing and are getting the average among the different strategies. So over time you will be able to achieve a pretty satisfactory risk-adjusted rate of return, something around the low teens with 5- 7% volatility. But that number cannot be achieved in one or two years, and typically we would advise our clients to look at these investments over a business cycle of 3-5 years.
Do you think clients in Hong Kong tend to have more of a trading mentality than would be suitable for these types of products?
Ho: Yes, but holding onto a product ultimately depends on how the product is presented to the client. If this is presented as part of a well diversified portfolio, then there may be less of a trading mentality. We generally find that Southeast Asian investors tends to be a little less trading orientated than Northern Asia investors where thereÆs more of a trading mentality. We generally write into the fund objectives an expectation of 3-5 years to give clients the idea that this represents a medium-term buy.
However, Asians are traders and I have seen many cases of investors having made a good profit that year, capitalising on this and moving on to the next investment.
What would be the minimum and maximum number of funds that a fund of funds would contain?
Lau: It really depends on the size and the kind of portfolio you are trying to construct. If you are constructing a billion dollar portfolio with diversification, low risk and stable growth, and say low-to-mid teens type of returns expectation, you probably need 40-50 funds to get real diversification globally. But one more tailored for Asian funds of say half a billion dollars, you probably need 20- 30 names depending on how you want to construct your portfolio and what the risk and return targets are.
So how do you deal with a fund if it is not performing well?
Lau: It is very much cases by case. If the managers do not perform you need to figure out if they made the wrong calls in a difficult market or whether it was because of personnel changes, operations, or risk management û there are many things we can look into. Is the market or strategy really not on the managerÆs side? If we have done our homework right and we have a strong conviction that our managers will perform well over time, then we should stand by them during a difficult period. We could put an overlay on to hedge our overall portfolio risk when itÆs necessary to dilute down the volatility. But if the manager has underperformed because of style-drift, operational issues, or personnel changes, then we need to make a call.
What would you do in a situation where the hedge fund manager has said his target strategy will return between 15-20% a year and it returns 50%? Would that set alarm bells ringing because you think they are doing too well and taking on too much risk?
Lau: Again itÆs really case by case. We wouldnÆt redeem a manager because he made so much money. We would need to assess the risk and see what it was that is making him perform so well. It could be that he was taking on additional risk or it could be that he was being helped by funds flows, market beta or simply made the right calls. The bottom line is to understand your managers, their trading styles and positions, and most importantly understand how they make or lose money in different cycles.
Pak: You have to understand the space the managers are operating in and what exactly they are doing. You have to look at the kind of trades that they are doing and to consider if we are getting enough transparency from the manager. From talking to them, we need to get a sense that he understands the kind of risk he is taking relative to the return he is looking to achieve. We donÆt penalise people just because they do well nor when they do badly, just as long as they can justify what they are doing and we can understand the risk they are taking.
When you are talking to clients, particularly sophisticated clients who care about fees, do they ask why they are paying fees to the fund of funds which is then paying fees to the hedge fund? IsnÆt this a doubling up of fees? What do they get for this?
Webber: It is a key point, but I think that once clients understand what they are getting for that fee its generally not a very difficult discussion. You have a choice in that you either pay a fund of funds for its due diligence and portfolio construction in vetting funds or you do it yourself which involves a lot of cost.
Lo: The cost of doing due diligence has risen. Four years ago there were only about 3,500-4,000 hedge funds but today there are about 8,500-9,000 funds. To monitor so many hedge funds and to choose the best ones for your clients is getting more and more expensive.
Another big advantage of this funds of funds industry is that people might think of hedge funds as a bit of a black box that they canÆt understand. Is it the case they can sleep well at night knowing that they own a fund of funds, because its not a black box, is more diversified and therefore wonÆt blow-up?
Webber: It depends who manages the fund of funds. You could have a blow-up û it could easily happen. Not all funds of fund managers perhaps do the same due diligence. You have to exercise some discretion in choosing your fund of funds. But if you stick with a reasonable name and you can satisfy yourself that the house is doing sufficient research, you should be okay. But its no guarantee by any means.
Have we moved to a situation where there are funds of funds of funds: where you put together various funds of funds that adopt various single strategies and put them together to diversify across strategies?
Ho: Yes there are. We know of several specialist fund of funds eg, Latin America Fund of Hedge Funds or in Asset Backed Fund of Hedge Funds, which are part of large Fund of Hedge Fund portfolios. Even within a fund of funds, if you have six to 10 managers that may focus on different aspects of fixed income, that could be spun out to form a specialist fund of funds in its own right.
Webber: We did one. We put a wrapper round some existing funds of funds. It allowed us to introduce some leverage into something that wasnÆt inherentlyleveraged - and so worked out pretty well. We did not charge triple fees however.
Did that bring down the returns as a result of the further diversification? Webber: No, not particularly. So returns are still mid-teens?
Webber: I disagree that the returns of funds of hedge funds over the last couple of years have actually reached the levels we have been talking about. That particular strategy happened to be an equity long/short strategy. So it did achieve those levels. Generally speaking I think funds of hedge funds returns over the least three years have struggled to exceed single digits. TheyÆve been more like 8-9% for the big globally diversified and strategy-diversified funds.
What proportion of a portfolio would you advise putting into a fund of funds?
Webber: For a standard neutral sort of portfolio, weÆd say 20% but obviously that can change significantly depending on the client and their profile. As a standard basic allocation 20% is about right. If equity markets look like they are reaching a top which is not necessarily the case yet, but if they are, its one area we could recommend an increase in allocation in the future.
WeÆve just had two very good years in Asia. But do you have a sense that with rising interest rates, high oil prices, and inflation, there is a bit more fear and uncertainty coming back into the market?
Pak: I certainly think so - recently weÆve seen the market correcting sharply. Basically between 2004-5 there was nothing that you could do wrong. You could invest in anything and it would go up, and peopleÆs risk appetite has gone up. We have seen clients investing not only in energy, but in corn, sugar; anything so as to pick up additional yield. Interest rates have gone up but people are still optimistic that the worldÆs growth engine is still turning. The figures for the US are mixed but still suggest fairly steady growth. I think this correction is a pretty good thing in terms of timing. It gives people a sense of reality. That is, you cannot achieve alpha out of nothing and you still have take risk smartly. We have looked at that risk in the market and are telling our clients to shift from overweight in equities to a more neutral weight.
And as fund of hedge fund managers does this rise in the level of uncertainty benefit you?
Lau: Yes, I think its positive and the timing is right, the recent market correction is welcomed by most of the investors and considered as a healthy one in the equity markets. We look for managers who can generate good alpha and current market condition should be good for those alpha generators.
Lo: In the context of Hong Kong a lot of private investors hold very high performing mutual funds which are very liquid and they can trade them on a daily basis. So in this environment if they hold these high performing mutual funds and are also holding some hedge funds it will work out very well. They have the downside protected or if they invested in long/short equity, they should benefit from the recent correction.
Webber: WeÆve gone more neutral in our long-only equity allocation from being overweight. WeÆve probably put that money into cash right now rather than reallocated it to bonds or to hedge funds. 5% on cash is a nice return. But thatÆs a very short-term decision and in the next couple of months weÆll decide whether to add to bonds or to hedge funds.
We have got so used to having very little inflation over the last 15 years. Is it something that people are now concerned about again?
Webber: I think you have to look at how the inflation numbers are compiled to realise that they do not necessarily reflect reality. And that building in adjustments for technological innovation does not reflect what we actually pay out of our pockets to buy anything. So you have start with the assumption that inflation is dramatically understated and governmentÆs do it because many benefits are linked to inflation. They want to keep their spending down so they have every incentive to understate inflation numbers. I think the rise in commodity prices is telling you something that has not been properly absorbed by markets yet. We are worried about inflation and in fact have been encouraging clients to buy inflation-protected investments over the last 12 months. Our bet is that inflation will eventually come through and that governments will eventually have to start representing the real position. We think it is significantly more relevant than most investors are assuming at present.
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