In a recent magazine article, the person responsible for adding funds to a major master trust was quoted as saying that they were “wary of selecting fund-of-hedge-funds partly because of the limited liquidity, but also because they doubted whether a financial planner would be able to explain the investment strategy to a client”.
Such sentiments seem common and may go some way to explain the relatively subdued acceptance of hedge funds as part of retail investors’ portfolios in recent years, despite the strong case and the poor performance of more conventional assets.
However, such comments deserve greater scrutiny. Are they legitimate reasons for excluding such investments from master trusts and client portfolios?
Essentially the essence of this comment is that hedge funds (and specifically fund of hedge funds) should not be in investors’ portfolios because firstly they are less liquid, and secondly, advisers (and presumably investors) don’t understand or cannot explain the underlying investment strategy used in fund of hedge funds.
The first point, illiquidity, needs to be divided into two elements. The first is the liquidity needs of the investor and the second is the liquidity needs of the master trust itself.
While investors obviously prefer high liquidity compared to low, there is no fundamental investment reason why long-term investors need to have their entire portfolio in liquid assets. In fact, investors have become somewhat spoilt in having daily liquidity across most assets.
While a significant liquid component almost always makes sense for most clients, particularly in the retirement/draw down stage, most investors could easily get by with lower levels of liquidity in as much as one-quarter or even more of their portfolios.
In fact, there are sound reasons why investors should want some less liquid assets in their portfolio. After all, other things being equal, they should expect a higher return from less liquid assets. In today’s environment where high returns will continue to be hard to come by, any additional higher return from illiquid assets may become a vital element of portfolios.
Indeed, low liquidity is one reason that some hedge fund strategies (such as distressed debt) and ultimately fund of hedge funds can provide higher, non-correlated returns. In essence, part of a hedge fund’s return derives from it participating in and therefore providing some liquidity to certain illiquid markets.
Having said that, the monthly or quarterly liquidity on most fund of hedge funds is hardly overly constraining, particularly compared to other illiquid assets such as private equity or direct property.
The true problem with liquidity seems to be at the administration platform and not the investor level.
Some master funds seem unable to cope with the delayed pricing and extended redemptions that are characteristic of most fund of hedge funds.
Interestingly, some other master trusts do not seem to have this problem and wrap accounts, in particular, seem to have been better able to include some of these investments.
If some of the larger master trusts continue to adopt the view that hedge funds or other alternative investments are “too hard” they risk becoming seen as obsolete investment solutions.
Furthermore, if it is administration simplicity that is driving what is ending up in client portfolios, we as an industry need to ask whether we are really looking after clients’ best interests.
The second point suggests precluding investment in fund of hedge funds because advisers don’t understand the underlying strategies and could not explain them to clients. Presumably this assumes that clients want to know the intricacies of the hedge fund strategies explained to them. I doubt whether this is the case. Clients need to trust the advice and investment provider. Isn’t this why they ask for advice in the first place?
I don’t think even planners need to understand the intricacies of individual hedge fund strategies and managers for them to feel comfortable including them as part of portfolios, although it is vital that they understand the broad nature and rationale for them. How well, for example, do advisers really understand why an equity fund manager is buying or selling a particular company or what companies make up the portfolio?
In any case, the key element in assessing a fund of hedge funds from a research perspective is judging the ability of the manager to allocate to hedge fund strategies and managers. That is, does the manager have the skills and ability to understand and assess which strategies will do well in the expected investment environment and to judge which managers are good at actually implementing their strategy?
In practice a good fund of hedge funds will consist of people who have strong experience with some of the actual strategies. This may mean they come from a trading or fund management background themselves. This is what you pay a fund of hedge fund manager for. If we have to wait until researchers, advisers and clients fully understand how to assess all the individual underlying hedge fund strategies and managers before anyone allocates money to them, I expect we will be waiting a long time.
After all, you don’t assess an equity manager by independently analysing the fundamentals behind each of their individual stock holdings at a point in time.
Of course, you can assess a fund’s holdings (or some of them) over time and attempt to understand why a particular stock is held. In the same way researchers looking at fund of hedge funds need to broadly understand the strategies used, and to gain an understanding of some of the managers to assess whether the fund of hedge funds is doing what they say.
The hedge fund world is a very complex one. While a researcher should be able to understand the basic operation of most hedge fund strategies, it is another level to actually understand what makes an individual hedge fund manager good at its particular strategy. This requires specialist skills that a quality fund of hedge funds will have. The fact that a researcher or planner does not have the skills to understand individual strategies should therefore not preclude them from recommending fund of hedge funds.
Finally, some commentators have suggested recently that the good times for hedge funds (if they existed) are over. Since they failed to raise significant amounts of funds in the past two years of equity bear markets, they have missed their chance since markets must recover now. I think this view may turn out to be wrong on two counts.
Firstly, well-run diversified fund of hedge funds will always have a role for modest risk and defensive portfolios in good and bad markets. The perception that hedge funds only belong in high-risk portfolios is one of the greatest mistakes many commentators make.
Secondly, who can be sure that the bear market in equities is over, or that a period of sideways markets and overall poor returns for an extended period is not possible?
Hedge funds exist not as a fad, but because the dynamic of the hedge fund industry allow and encourage them to exit. These dynamics suggest more, not less hedge funds and boutiques in the future and a greater allocation by many investors.
Those conveniently ignoring these dynamics and sticking only with mainstream managers and assets will increasingly be tested. Adopting a ‘set and forget’ approach to mainstream managers and assets has always had limitations, but this has never been so obvious as now. The recent problems of several large brand name managers and the departure of key people from leading investment teams have demonstrated that simply trusting size, brand and mainstream investments in such a fickle industry is a flawed strategy.
It seems that some in the industry are hoping that hedge funds, or at least the perceived need for them, will go away over time. They are seen as too hard from an administration angle or just too difficult to understand. Such thinking shows a poor understanding of the dynamics of the investment management industry, the nature of markets and the ultimate risk/return needs of investors.
Master trusts, advisers and investors need much better reasons to ignore hedge funds then they have come up with to date.
