While high fees and a lack of transparency have left many investors cool towards fund of hedge funds, BlackRock risk management expert Mark Everitt says the asset class is staging a comeback.
Everitt, BlackRock Alternative Advisors’ director of risk management, says institutional investors are again looking at hedge fund of funds to boost their asset allocation to alternatives and get a greater exposure to returns uncorrelated to equity markets.
“People increasingly look to allocate to alternatives and I think it is becoming a more significant part of portfolios as people are seeing returns 2009 and 2010 that have been pretty reasonable in those asset classes,” Everitt says.
“The tightness of the global credit markets and the challenges and volatility in equity markets make alternatives a compelling proposition and I think that is what is driving increasing asset allocations.”
Everitt says their investors typically fall into two categories: those looking for the traditional advantages from this form of alternatives such as uncorrelated equity-like returns with less volatility, and those looking to take advantage of particular opportunities in the marketplace.
BlackRock sees opportunities in longer-dated co-mingled funds that target opportunities presented by financial institutions in Europe and North America having to restructure their balance sheets after the financial crisis.
These involve both real estate and loans that are available at what BlackRock thinks are attractive prices as banks deleverage.
Investors in a fund of this type would typically be required to lock their money in for a two- to three-year time horizon, Everitt says.
“We have seen estimates for these sorts of waves of opportunity (that) are very large, we have seen estimates of between $5 to 10 trillion over the next few years,” he says.
“We believe that the opportunities are smaller than that. But regardless, it is still many multiples of the opportunity set that came about from after the Savings and Loans Crisis where we would estimate the opportunity set was $250 billion over five to six years.”
In more liquid investments Everitt says they are excited by the opportunities in hedge fund business models that look at event-driven investing and risk arbitrage.
“At the more liquid end of the spectrum we think if one looks at the amounts of cash on corporate balance sheets in corporate America and one looks at depressed asset valuations you see a very ripe environment for event-driven investing and risk arbitrage,” he says.
Rejecting the idea that fund of funds are effectively dying off, Everitt says that BlackRock’s systematic risk analysis is meeting increased demands for more transparency from investors, while keeping fees down.
“A lot of risk management is about viewing the portfolio to make better investment decisions whereas I think a lot of other people think risk management is about making an investment decision then measuring its impact on a portfolio,” Everitt says.
“We say: ‘no, it’s about evaluating a risk and then sizing it appropriately in a portfolio so risk is an input in the process rather than an output of the investment process.”
BlackRock Alternative Investors has more than $100 billion in assets under management in a number of products across alternatives including a variety of single-strategy hedge funds, fund of hedge funds and private equity options.
BAA is BlackRock’s customised hedge fund provider that manages about $20 billion of assets under management. The platform it uses has 120 underlying hedge funds.
This consists of about $9 billion in core, co-mingled fund of hedge funds in which a number of clients are involved. Another $9 billion is in custom portfolio solutions of fund of hedge fund products for specific clients. The remaining $2 billion is specialised products that focus on longer dated products.
While acknowledging that there has been a move by investors out of fund of hedge funds because of cost versus performance and transparency concerns, Everitt says BlackRock offers value-adding processes that justify its fees.
Everitt says the fee value-add comes from BlackRock’s capacity to source successful hedge funds, its power in the marketplace to get favourable terms and conditions, and its risk management processes.
While BlackRock looks at the more traditional risk factors in the hedge fund, Everitt says their analysis of what he calls “secondary risks” is also vital.
Their risk analysis also looks at what he describes as overlapping or crowded trades across different hedge fund strategies in the fund of funds which may result in concentrated risks.
Despite sophisticated risk analysis platforms, Everitt says qualitative judgements still form a large part of assessing the potential success of various hedge funds.
“We have a process of thinking about the edges and handicaps in a manager and the reasons why they might succeed or fail,” he says.
“This involves thinking about the manager holistically and thinking as much about its business and operational risk as much as its investment risk because it turns out that business and operational risks are two legs of a three-legged stool when thinking about hedge funds.”
In sourcing its various hedge funds, Everitt says there is a focus on newer funds with what he describes as “uniqueness”.
Half of the hedge funds in which BlackRock invests are start-ups or in the first six months of their existence.
And, he questions if investors focusing on top quartile performers could obtain the same alpha.
“We think we are skilled at finding early-stage hedge funds that go on to be highly successful hedge funds,” he says.
When it comes to structuring hedge funds, BlackRock has seen a drive to cut fees below the standard 2 plus 20 industry standard and negotiate hard on governance issues and a range of other terms and conditions.
“We always drive fees as hard as we can to get fees below the 2-and-20 model that the hedge fund is charging as its rack rate,” he says.
At the bottom of the crisis, hedge fund of funds were starved of capital but as funds start to flow back into the asset class, Everitt says it is could get harder for investors to achieve the same bargaining power around terms and conditions and transparency that they did in the past.
“We made pushes on enhanced governance, investment guidelines around investments, portfolio transparency, reduced fees and we built that into all of our underlying investments,” he says.
“What you are starting to see now, is that some hedge funds actually close and reach capacity. As a consequence you might start to see that mood become less ebullient and it might become harder to do that. As someone who has a large amount of money to allocate you can use your size. So I think larger funds of funds have a much greater probability to continue to extract that quality of information from managers than smaller investors.”