has been active in the hedge fund industry since 1990 and has witnessed first-hand how it has evolved and adapted to new challenges, be they on the investment front or from a business perspective. Industry progress has been extraordinary over this period, growing from approximately 610 funds managing around $20bn to over 10,000 funds managing around $2.5trn today (see Fig. 1). This growth has come despite some of the most tumultuous markets in history, including the crash of 1998, the bursting of the dotcom bubble and subsequent bear market of 2000-2002, and most recently the 2008 credit crisis, the aftermath of which is still impacting markets. The industry has also had to survive some high profile failures such as Long-Term Capital Management, which nearly collapsed the global financial system, and more recently the downfalls of a number of prominent, well known, multibillion-dollar firms, not to mention its fair share of high profile frauds.
It has been widely reported that hedge funds have been forced to institutionalise. Firms have invested huge sums in building out their infrastructure, back office systems, compliance and improving their transparency to deal with the demands of a more sophisticated investor, as well as a more involved regulatory regime with both SEC registration and the AIFMD. Hedge fund firms are ultimately entrepreneurial, and while the 2008 financial crisis uncovered a number of shortcomings for the hedge fund industry as a whole, there are a wide number of firms that survived the crisis and learnt valuable lessons. While no crisis is ever the same, the ability to survive and learn from past experiences is hugely valuable. The steps that both investors and the hedge funds themselves have implemented place the industry on a firm footing.
Performance on an industry-wide basis, as reported by the various fund of hedge funds indices, remains anaemic. However, many funds have bucked this trend, taking advantage of an increased opportunity to produce attractive returns. No hedge fund or fund of hedge funds is the same and investing in them requires detailed understanding. The significant gulf between the performance of the top-performing managers and the fund of funds index can be highlighted by comparing the return of the Headstart Fund of Funds and the HFRI FOF Index since January 1 2009. Through October 31 2013, based on almost five years of data, the Headstart Fund of Funds has returned 71 percent with a Sharpe Ratio of 1.81; meanwhile, the HFRI FOF Index returned an estimated 25 percent with a Sharpe Ratio of approximately one.
After a 30-year bull market for bonds, interest rates are at historic lows. Meanwhile, global equity markets are at or approaching all-time highs. This is at a time when governments continue to intervene in markets and capital allocators are faced with the significant issue of having to re-allocate vast amounts of capital away from what was previously considered a risk-free fixed income market which is producing a negative real yield. In this environment a well-managed portfolio of hedge funds can offer a truly diversifying return stream uncorrelated to traditional assets, having proven itself capable of navigating across market cycles.
While the case for investment in hedge funds is particularly compelling given the investment landscape, history has shown that you should not invest in a hedge fund on the basis of size or brand name (a misconceived safety), a ‘star manager’ or past track record alone, and that in-depth due diligence, transparency, experience and a portfolio approach is required. In addition, many of the most established, successful and well-known hedge fund firms have seen their assets under management rise to all-time highs, both reaching capacity and closing to new investment or in some cases returning outside capital in part or entirely, and transitioning to a family office. The vast majority of these funds continue to have draconian investment terms with typically poor liquidity and high fees, as well as there being a direct correlation between a significant growth in assets and the degradation of returns. Simply, very large hedge funds can often find themselves paralysed by their size and find it significantly more difficult to create attractive risk adjusted returns. There are, however, a number of high quality managers who have remained closed to new investment for many years. These managers have typically controlled the growth of their assets under management and maintain significant investments in their funds, aligning their interests with investors. In addition, since 2008, a number of these managers have also improved the liquidity terms of their funds. Fund of hedge funds can offer their investors exposure to these managers that they would not otherwise have access to.
[M]any of the most established, successful and well-known hedge fund firms have seen their assets under management rise to all-time highs, both reaching capacity and closing to new investment
Investing directly in hedge funds requires more than just capital. Many fund of hedge fund portfolios, such as the Headstart Fund of Funds, are effectively not replicable. Hedge funds should be considered long-term investments. It is vitally important for the hedge fund investor to build a relationship with the hedge funds and their management in order to best understand their trading strategies, positioning and how that fund fits within the investor’s portfolio.
Managing a portfolio of hedge funds is just as much art as it is science and comes down to experience and a strong understanding of the strategies of the underlying managers and how they correlate to one another. It is important that within a portfolio you have true diversification. Managers should not all be making money at the same time otherwise the likelihood is that they are all correlated to one underlying risk factor. The skill is in identifying managers who, when there is a lack of opportunity in their strategy, do not chase returns and thus increase risk. This enhances the stability of returns within the overall portfolio, limiting drawdowns and allowing for the compounding of returns at the portfolio level. One of the most important aspects of managing a portfolio of hedge funds is understanding the right time to redeem. While hedge fund investments are ideally long-term in nature, changes in the investment landscape or at the asset manager can happen quickly, and the management of the portfolio requires an active approach.
The hedge fund cycle
The ability to offer exposure to a seasoned balanced portfolio of funds is a key benefit that a fund of funds can continue to offer to an underlying investor who does not possess the capital, experience and infrastructure to manage a portfolio directly. Importantly, however, a fund of hedge funds can offer an investor the ability to invest into the next generation of hedge fund managers. One of the major developments that we are witnessing is the ability to access a new array of talent leaving existing prominent firms and starting new hedge funds.
Having the necessary contacts and importantly experience allows a fund of funds a first mover advantage, where the prize is the ability to gain capacity as well as attractive fee breaks in talented managers when they are at their most nimble, asset wise. However, correctly identifying the right early stage manager requires experience.
Typically, a hedge fund requires a strong business model and a repeatable investment process. Having managed a successful hedge fund strategy, Headstart is in a position to better assess the trading hurdles, of which there are many that managers will inevitably encounter. Managing a hedge fund is as much managing a business as a trading strategy and requires a significant investment from the principals in both capital and time.