Hedge Funds: Not your momma's home cooking

Leighton Strader - Virginia Ventures, LLC

At the end of 2007 there were more than 1000 reporting hedge fund of funds (FOF). About 43% of these are located in the U.S. More than 50% of these FOF have less than $50mm in assets under management, but only a few FOF's portfolios have assets over $1Bln. At the same time there are more than 8000 registered hedge fund managers around the globe. If you apply a $100mm asset under management minimum screen to the hedge fund group, you eliminate more than 70% of the direct managers. These individual managers employ more than 20 different strategies ranging from the sanguine and more traditional long/short equity to highly complex and "secret" black box strategies conceived by former NASA and/or MIT math-types.

In this maze of hedged vehicles and strategies lie opportunities and prospective risks. The potential cauldron of achievable recipes that can be created with these vehicles is limitless. It is this conundrum that many plans face - how best to mix the proper strategies to most effectively accomplish investment goals to complement or augment existing portfolio needs. Moreover, how will the investment strategies of this sector be implemented within portfolio guidelines?

It has been suggested that plans without sufficient internal staff (and/or knowledge) to monitor individual hedge funds, be fiduciarily wise and initially seek fund of funds managers with resident skills in these matters. We could not agree more!

In 18 years of hedge fund (and FOF) observation, ownership and association, there are certain truths that have evidenced themselves. First, hedge funds, like many slices of life are good in their proper proportion - too much is not a good thing, and too little is ineffective. An initial 5% to 10% allocation to hedge funds (in any form) for the uninitiated is plenty to taste the effect without the potential hangover. Second, the wise course of action to initiate allocation to this sector is the fund of funds route. The reasons for this are very basic. As cited in an article by Ken Phillips of RCG Capital Partners (Insights, Winter 2002-2003), "good fund of funds managers have knowledge of the manager universe, practice specific due diligence and monitoring processes, and have honed an allocation methodology." And, we would add, with reasonable skill have been able to produce 8-12% net returns with 3-4% standard deviation over the past 10 years.

Third, selection of a consultant to investigate your hedge fund impulses can be challenging. In our observation, there are many consultants still ramping up their knowledge of hedge funds. The hedge fund industry has burgeoned only of late, and entry by traditional consultant institutions is even more recent. Many consulting firms are forced to get up to speed and learn hedge fund "institutional history" on the fly as a result of this groundswell. It is important to put your consultant through the paces on hedge funds to ensure and confirm their knowledge.

Herein are some criteria to examine in the pursuit of the right FOF. Keep in mind FOF's vary in their return profiles, in their alpha and beta components, in their r-square and in their standard deviation, as do other types of managers. There is a wide dispersion between FOF's, so the ability to achieve the desired results may rest with one or more fund allocations.

In addition to track record and other obvious statistical readings, there are some not so obvious issues that must be considered in choosing a FOF manager. The more crucial ones are:

• Fund Capacity - how large can the FOF grow without sacrificing manager and capital mobility?
• Fund Growth Velocity - how fast can the funds grow and employ capital efficiently in the marketplace?
• Stability of Capital - what is the client mix of the FOF and what liquidation issues might it present?
• Fund Sector Concentration - is there a potential for security concentration over more than one sector? Do different managers have the ability to traffic in similar securities?
• Leverage - Fund Level - is there any leverage at the fund level? Does the fund manager have the right to use derivatives? What is the FOF's history of leverage usage?
• Transparency - what is the frequency and amount at the fund level? Sector leverage and security exposures vary by strategy, and the FOF should establish a monthly minimum exposure report for a client.
• Number of Managers - are there "impacted managers" (managers who have been with the FOF so long it is difficult to fire them in bad times)? What is the criteria for releasing managers - has it been exercised? Are there too many managers thereby potentially creating a dilutive effect on returns?
• Turnover of Managers - What is the manager turnover ratio - in representative years 10-15% is common.
• Style Classification - is the FOF truly a multi-strategy fund or is it tracking other sector(s)? This refers to sector issues. FOFs can be "tilted" to short bias, equity sector biases, market neutral bias, directional or to a host of arbitrage biases. These are not bad biases, as long as they are obvious, disclosed and deliver the desired effect on your portfolio.

When examining a FOF, understanding the methodology used in manager due diligence and monitoring is crucial to understanding the FOF process. There are more than 30 variables on which underlying managers can be judged. The key variables are: management's hedge fund experience, product capacity, leverage (absolute and variance), diversification rules, short selling discipline, portfolio management contract/employment terms, prime broker practices, investment process repeatability, visibility and straightforwardness, firm growth and product growth plans, and overall liquidation ability and timing.

Many dismiss looking at the underlying managers in a FOF, just like some people don't want to look under the hood when buying a car. Our advice: ask questions, kick tires, raise the hood. Make the FOF manager (and/or the consultant) detail, through example, the manager selection process, and get answers to these pertinent issues.

Parting advice: Begin your marketable alternatives (hedge fund) program via a FOF. Learn about strategies, learn about managers. After a while you'll be more comfortable and possibly ready to hire your own managers directly. Chances are your consultant/advisor will be better informed too. Like all else, there's no substitute for a little firsthand education.