Three Keys to Success in Fund-of-Funds
Ask a successful realtor what the three keys to success in the real estate business are and they will say, “Location; Location and Location.” We argue in this note that successful fund-of-funds (FoF) will be those that follow a similar credo and focus on, “Allocation; Allocation and Allocation.” In the context of managing FoFs, the three key allocation decisions are the decision to (a) strategically allocate various hedge fund styles; (b) tactically allocate across hedge fund styles; and (c) dynamically allocate to individual managers. At the end of the day, the activity where most FoFs are currently spending their time, namely manager selection, will end up being a mug’s game as there is little that is proprietary in manager selection. However, getting the three allocation decisions right can carry a fair deal of proprietary knowledge and therefore returns for which clients should be glad to pay an additional layer of fees. A recent research piece by Van Hedge Advisors suggests that most FoFs have not contributed returns from allocation, though they are not specific about which allocation decision they are talking about – strategic or tactical. Combining the two into one number masks the quality of decision making by a FoF. We briefly discuss these below and address some challenges for each and how innovative FoFs will work around these challenges.
Depending on whether the FoF is designed to be single or multi-strategy, this decision can be either very easy or very complex. The difficulty with setting a strategic asset allocation (SAA) in the context of a FoF is that this is not an area where there has been meaningful developments in the theory as opposed to the well-developed science of setting an SAA for a pension fund. While a pension fund exists to defease a liability and hence an asset-liability approach is appropriate, a FoF is an investment vehicle and an SAA is meant to demonstrate how good investment staff are at structuring the product. The typical approach of doing a mean-variance analysis to establish an SAA suffers from the problem that in these investments variance may not be a good measure of risk and hence most innovative funds set SAAs subject to some kind of drawdown minimization constraint. However, given the challenges that we describe in the section on the tactical asset allocation, establishing either a static SAA or a dynamic SAA will be the predominant contributor to returns. Many FoFs develop an SAA in the context of their product offering – e.g., low volatility or high volatility, but clients should probe deeper into what the SAA is, how was it arrived at and what is the process for changing the SAA and what factors go into such decisions.
This is a more contentious issue and the author’s experience in talking to a range of FoFs has been very revealing. While many FoFs tell clients that they follow a top-down and bottom-up approach, what constitutes top-down or tactical style allocation decisions seems very arbitrary and extremely qualitative. The range extends from FoFs who do not do this at all, to those who claim they are conservative and hence stick close to the SAA (however, this could be a very risky strategy if certain styles are not doing well), to others who have done extensive factor analysis and have not formalized these analyses into intelligent style allocation strategies. Given the difference in performance of styles in a calendar year, tactical style allocation can add meaningful returns. What many FoFs would argue is that they are prevented from doing tactical style allocation because of liquidity constraints, which implies that those FoFs that have internal managers (e.g. a number of investment banks have seeded funds under their umbrella and can move capital around quite freely with these captive funds) and hence the ability to navigate could translate into better returns, if appropriately utilized. Alternatively, new financial products will need to be developed (e.g., swaps or structured notes) that allow FoFs to go long and short basic styles. If such an evolution takes place, innovative funds will allocate a certain portion of their funds to implementing such activities.
Many FoFs that either do not do style allocation currently or have never researched the same are apt to suggest that these activities do not add value. However, in a typical FoF portfolio, this is a decision that is effectively owned by the CIO and hence cannot be relegated to the “did not try and hence will disregard” box. Under the broad theme of tactical style allocation, authors such as Michael Howell have argued that hedge fund style performance can be predicted by evaluating market and credit risk and the author has tested these ideas with some success. The more important aspect of this set of decisions is that it constitutes good governance as the FoF is now managing the beta as opposed to holding a static policy – a recent paper by Dr. Woody Brock demonstrates the critical importance of such decisions (i.e. if the SAA includes assets that are not highly correlated, then the CIO is accepting that these assets will not all perform in synch, and therefore the logical conclusion is to try to underweight assets out of favor and vice-versa). However, the key to making effective style allocation decisions will boil down to a disciplined process to make three key decisions periodically; namely, (i) what to do – overweight or underweight a style; (ii) when to do it – based on levels of certain indicators or factors; and (iii) how much to do – should the overweight be by 1 per cent or 3 per cent.
Even more contentious is the proposition that at the next tier of decision-making it is not only important to select good managers, but also know how much money to give them. Most products used by FoFs typically do simple evaluations of individual managers and do not give any insight into the more difficult question of how much to give each manager and when. Once again, FoFs would argue that good managers do not like monies taken away (though they are quite happy to receive inflows) and that access would be cut off to the FoF that moves cash around. Implicitly, the FoFs are making a trade-off between the ability to add value through dynamic manager allocations and the contribution of illiquid managers. Clients should ask for a proof statement that such an investment policy is justified, but one would expect that over time, liquidity would be less of a constraint as more managers enter the business. Just as in the pension fund world, a staff member would be admonished for leaving cash lying around with a deep value manager, when deep value is not in play, FoFs should be compensated for having a good sense of when their respective managers are in play or not as that is part of the typical RFP/due diligence questionnaire and should be followed up with action.
With increasing competition in FoFs and new funds springing up daily, there will be a weaning of the good from the bad. Innovative FoFs will be those that get three key decisions right: Allocation, Allocation, and Allocation. This should translate into better returns for which clients should be glad to pay for. Getting these decisions right will also lead to even more impressive drawdowns, but the challenge for the industry will be to develop products that allow FoFs to manage around liquidity constraints. Those that focus solely on manager selection, may find that they are on the wrong end of client selection.