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Hedge funds reassert alpha male status

For much of the last decade, family offices, in common with other investors, were lulled into believing that hedge funds or a diversified portfolio of hedge funds would deliver consistent, predictable return streams. The events of 2008 gave the lie to that notion as many hedge funds were very highly leveraged, wreaking havoc on portfolios.
 
As liquidity evaporated in the fourth quarter of 2008, many small funds with single prime brokerage relationships had to liquidate positions because the prime broker could not fund them. Larger funds with several prime relationships, though better positioned, also had difficulties. Those with liquid strategies could meet margin calls, but were often unable to take advantage of market opportunities. Those with illiquid portfolios were forced to de-leverage. For investors in commingled funds, this became a nightmare, as many managers holding illiquid investments suspended redemptions or put up gates.

"It really was a liquidity issue that created a very negative return stream for many hedge funds," says R Thomas Manning Jr, chief investment officer of US multi-family office Silver Bridge Advisors. "It created situations where families couldn't get their capital back."

To add insult to injury, many investors discovered the nature of their hedge funds' holdings after it was too late. "Most hedge funds reported little to no information on their portfolio investments—only their portfolio returns," according to a July 2010 Citi Perspectives report.

Despite the difficulties hedge fund investors experienced during the financial crisis, these alternative investment products appear to be still integral to the family office portfolio, although families have changed the way they approach the sector.

Anecdotal evidence indicates that after a pullback from hedge funds, family offices are starting to move assets back into the sector. Manning says that demand for hedge funds, which had dried up almost completely after 2008, began to grow early this year: "We saw some evidence of that in the second quarter and now in the third quarter as markets have normalised." More broadly, Hedge Fund Research Inc reported in July that capital inflows over the first half of 2010 totaled $23 billion, and total industry assets stood at some $1.7 trillion.

Family offices continue to invest in hedge funds for many of the same reasons high-net-worth investors have always allocated to them. For one, hedge fund investors seek reduced volatility, improving returns and better risk-adjusted performance.

In the first half of 2010, the HFRI Fund Weighted Composite Index was down 0.2%, while the S&P 500 with dividends index was down 6.6%. Last year, the HFRI index finished up 20%, trailing the S&P 500 close of 26.5% including dividends.  

"When the broad markets are down or performing poorly, the alpha premium of the hedge fund space is very attractive," says Kenneth Phillips, founder of Santa Monica consultancy HedgeMark. "When the broad market is performing really well, then it's easy to suggest that hedge funds are not adding as much value. But that's what a hedge fund is supposed to do: capture only a portion of the down and thereby capture only a portion of the up."

Investors also look to hedge funds for diversification benefits. Because hedge funds use derivatives, non-equity investments or short sales, they tend to be uncorrelated with broad market indices, depending on their strategies. If added to portfolio of traditional investments, they thus have the potential to reduce total risk in the portfolio.

Investment talent is another major drawing card for hedge funds, often regarded as the repository of the best minds in the investment universe—along with less savoury characterisations (ie, ostentatious lifestyles before 2008 and Bernard Madoff).

"Hedge funds still are one of the few ways for investors to access managers that have the ability not only to go long in the market but short segments of the market, whether equities or fixed income, or invest in asset classes not readily available to the general investing public that are lowly correlated with traditional asset classes," says Manning.

Hedge fund managers who demonstrate these skills will continue to attract family offices. "Hedge fund managers tend to think the way our clients do, as entrepreneurs," says Peter Schuppli, managing partner of Zurich-based Cottonfield Family Office, which serves wealthy Swiss and German families. "They look at their P&L in their company, and they have an absolute approach: they don't want to lose money."

Now, the hedge fund space promises to become an even richer reservoir of investment talent, thanks to the recent enactment of the Dodd-Frank financial regulation reform law in the US. This requires banks to phase out their proprietary trading operations within four years. News reports indicate that prop traders are already moving to hedge funds or starting their own firms and some are joining family offices that are expanding their in-house investment capabilities.

According to the HFR, the industry as a whole experienced the largest number of hedge fund launches since the onset of the financial crisis in the first quarter of this year, with 254 new funds starting up. Analysts point out, however, some of these new firms will fail because not all talented traders are up to the task of running a business.

Molecular level detail

The financial crisis has had significant and probably long-lasting effects on hedge funds and investors into the sector. Investors question the leverage that was being employed in portfolios. Many family offices pulled back from hedge funds because they did not like the governance structure – "the idea that the hedge fund manager, by himself, completely controls all aspects of the vehicle", according to Phillips. Now, transparency is one of the top family office requirements for entry into hedge funds. "Clients don't want these black boxes anymore; they want to understand what's going on, they want to know the people," says Schuppli.

Citi Perspectives reports that many hedge fund managers are acceding to investors' desire for "molecular level detail" on portfolios by providing snapshots of their portfolios on a lag. Other managers are allowing investors to see their prime broker or fund administrator reports directly. Operational due diligence has also become a norm for investors.

Further, family offices want liquidity. They are demanding better terms from highly liquid strategies and incentives to invest in less liquid ones. Cottonfield's clients do not like long lockup periods, says Schuppli. "So, we are looking for hedge funds with high liquidity, which means a month, 30 days of notice with high transparency," he says.

Another result of the financial crisis is a falloff of support for funds of hedge funds. In July, Financial News reported that Geneva-based family office GWM had launched a Ucits III fund, 7H Absolute. A spokesman explained that the firm has a high level of in-house hedge fund expertise, and so was able to respond to clients' demand for low-risk exposure to alternative assets. And an analyst said a move back to single hedge fund strategies is underway as "sophisticated investors prefer to select themselves and avoid double fees. This also allows them to better measure their risks by demanding regular portfolio constituents to look through".

A recent survey by London-based research outfit Preqin supports the analyst's assertion. It revealed that only 35% of institutions surveyed—including family offices—invest in hedge funds solely through funds of funds today, compared with the 64% that did so in their initial allocation to the sector. Today, 31% invest directly, while 34% use both methods. Direct investing has gained traction because of lower fees and the ability to better control their hedge fund portfolios. In addition, some institutions have learned how to construct their own portfolios, and have built up their in-house investment teams and added resources over time, enabling them to make direct investments.

Consider the single family Jordan Family Office in Chicago, which invests only directly into hedge funds. "We want to develop relationships with our managers," says investment manager Clay Drury. "We're looking for long-term partners who are also open to the exchange of ideas. As well, we think we can pick managers better ourselves. And we don't want some of the exposures or names in some of the fund-of-funds portfolios."

Silver Bridge, which currently offers its clients six different funds of funds across absolute return strategies and equity long/short, is also moving toward direct investment, says Manning. It recently formed a partnership with a New York research firm called Atrato Advisors, a startup formed by a team out of Deutsche Bank, to help develop a series of direct opportunities for clients of more significant wealth (upward of $50 million).  

Still, Preqin found a significant number of institutions plan to continue their fund-of-funds investments despite extra fees. Respondents cited diversification benefits, access to certain managers that would otherwise be out of reach and lack of internal resources to vet individual managers and create a diversified portfolio.

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