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High-maintenance Hedgie Seeks Indulgent Insto, VM

Without question my favourite car is a 1960 Mercedes Benz 190SL. Recently I was thinking that maybe my expectations from such a car are similar to the way institutional investors think about hedge funds. It’s certainly uncorrelated to my other car.

The idea of hedge funds, like this Merc, is very agreeable. Who doesn’t like the prospect of alpha being captured because of fast-moving, out-of-the-box thinking? But the reality is not quite as persuasive.

Hedge funds continue to be divisive with a love/hate relationship dividing opinion on the strategy. (There also seem to be a number of flaws in the way investors have approached their allocations – for one thing, it’s questionable whether hedge funds should sit in an “alternatives” bucket or more accurately be portrayed as a strategy across various asset classes.)

Of course many institutional investors have had positive experience with hedge funds, and pension funds such as Texas Teachers, which recently upped its exposure to hedge funds, together with managers charged with corporate pension plan management, such as GE Asset Management, sit on one side of the fence.

But as the recent crisis found, the expectation that hedge fund strategies would be uncorrelated with other investments, just didn’t play out. Now with academic research such as the recent work out of Maastricht and Yale Universities, “Can Large Pension Funds Beat the Market?”, concluding among other findings ‘why bother with hedge funds’ the debate continues to rage.

Some of the persistent concerns around transparency, liquidity, reporting frequency and fees are seemingly being addressed by the hedge fund industry.

The Alternative Investment Management Association’s Investor Steering Committee paper, A Guide To Institutional Investors’ Views and Preferences Regarding Hedge Fund Operational Infrastructures, for example was well accepted by institutional investors, which also collaborated on the paper.

Among other things it says hedge funds’ investment objectives and strategies should describe:

  1. the assets to be invested, geographic sectors where the assets may be limited and management trading style;
  2. that hedge funds have predominantly independent boards of directors who are materially free of conflicts with the investment manager;
  3. that hedge fund risk reporting should give investors the necessary tools to understand how much risk managers are using within their portfolios;
  4. that investors should be able to track the performance of hedge funds based on quantitative and qualitative reports that are updated at least monthly; and
  5. that hedge fund managers should give investors the information they need to analyse a fund’s goals, strategy capacities and resources to achieve those goals.

But perhaps the biggest question about whether to invest in hedge funds is not about the hedge funds themselves. It’s an efficiency issue regarding the time and cost of maintenance.

Similarly, I know for a fact I don’t have the patience, skill or time to maintain a 1960 Mercedes Benz 190SL, which is the main reason I don’t have one. The potential benefits are plentiful (looking amazing and attracting attention are two worth mentioning) but the huge amount of man-hours and cost required in maintenance seem to be disproportionate to the benefits.

Admittedly a few years old, and its practice has probably changed, I recently came across a document that outlined how one large US fund monitored its hedge fund portfolio, which it had been investing in since 2002.

“Three sets of eyes monitor our hedge fund portfolio: internal investment staff and two outside advisors … Within the fund, a committee of highly skilled investment professionals reviews every hedge fund investment before it’s added to the portfolio. The committee also oversees manager due diligence, selection, contract negotiation, portfolio construction, risk analytics, manager monitoring.

“Investment staff and program advisors spend hundreds of hours researching individual hedge funds, auditing their investment process, interviewing the hedge fund manager, checking references, reviewing broker statements, talking to their auditors, examining their compliance systems, and plotting their performance before an investment is made.

“We continue to monitor monthly returns and risk profiles to ensure managers deliver as promised – with the same questions, scrutiny, examination and thoughtfulness that went into selecting the manager in the first place. Staff speak with every hedge fund manager monthly and visit them semi-annually.”

While the reasons for investing in these strategies are also risk-related (with risk in this case limited to half that of the equity portfolio), this seems like a lot of time and effort for a portfolio that has a return goal equivalent to one-year treasury bills plus 5 per cent.

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