Pacific Alternative Asset Management Company (PAAMCO), the US fund of hedge funds manager, recently established a London office to tackle the European market. In this interview Stephen Oxley discusses the key issues faced by European institutions and funds of hedge funds.
At PAAMCO Europe, which obtained FSA registration last month, Oxley is responsible for developing relationships with European institutions and for assisting with European manager research.
Prior to joining PAAMCO, Oxley was a Partner and Senior Investment Consultant at Watson Wyatt LLP in Reigate, UK, where he was responsible for advising institutional clients on all aspects of their investment arrangements. He was also head of the European hedge fund research team.
He is joined in London by Alper Ince, who has relocated from PAAMCO's Californian office to focus on manager research, and Laura Durenard-Brain who has a business and operational management brief.
HW: What is the strategic case for alternatives within European institutional portfolios?
Oxley: Alternative assets are attractive to institutional investors for three main reasons:
1) Diversification of the strategic (long term) asset allocation policy: Pension funds tend to hold bonds as the closest match they have for their known liabilities and have traditionally invested in equities for growth. The shock of the equity bear market has brought home the case for better diversification of growth assets over the long term. Hedge funds are attractive because they offer the potential for equity -like returns with low correlation to equities.
2) Short term downside protection: With the introduction of market-based accounting standards and a move to a more market-value basis for valuing institutional assets and liabilities, any asset that can help protect the downside in the short term is also attractive.
3) Alpha: Institutions have been somewhat starved of alpha in the world of long-only active management. There is strong evidence that investment skill can be accessed through hedge funds. There has been a trend in recent years for institutions to index-manage their core portfolios and overlay high alpha strategies - hedge funds therefore can sit well in the high alpha layer or as a diversifier of the overall benchmark.
HW: How do European institutions access alternative/hedge fund investments?
Oxley: Some have invested directly with individual hedge funds, perhaps because there was an existing relationship on the long only side. Usually these types of investments are limited to one or two strategies such as long-short equity or market neutral equity, but most are choosing the funds of funds route.
A few of the very large institutions are putting together their own diversified portfolios of funds and some are developing core-satellite approaches where they hire one or more funds of funds for their core exposure and also invest directly with single or multi-strategy funds.
Hedge funds behave a lot like individual stocks - there is a good deal of idiosyncratic risk - it therefore makes sense to diversify. Most institutions do not have the resources to identify and monitor the number of managers needed for a diversified portfolio so they select a fund of funds manager to do the work.
Funds of funds also provide a useful buffer between the institution and the managers; they can perform risk management and reporting functions as well as provide strategic advice.
HW: The role of the consultant has come in for criticism by some hedge funds - how do consultants add value to the selection process?
Oxley: I think its unfair to group all consultants together, several consultants in Europe have been in the vanguard in recommending alternative assets to their clients.
Institutions that are governed by trustees or other committee structures tend to be very conservative and can take time to make decisions. The consultant is often caught in the middle and is an easy target for criticism.
Consultants add value by working with their clients on strategic issues, by modelling alternative assets in the asset-liability space, for example, or helping with risk-budgeting. They also conduct research into funds of funds and single manager hedge funds. This is time consuming and expensive - only the largest or more specialist consultants have been successful in gaining a good understanding of the fund of funds universe.
HW: How can an investor judge the performance of a fund of hedge funds?
Oxley: This is difficult because institutions want to know whether their fund of hedge funds is doing a good job or not. They are used to setting performance targets based on market indices. The problem is that as we know, there are no reliable investible hedge fund indices, those that exist are in fact peer groups of managers. Survivorship bias is calculated at between 2-8% per annum depending on the strategy. Funds of hedge fund indices are probably a better indicator of returns because survivorship bias is lower although many of the better funds of funds are not included.
We suggest that clients consider a number of different comparators such as: an absolute return target (eg X% per annum over LIBOR over 3 years), a comparison with maybe a number of different hedge fund indices at the total and individual strategy level and a comparison with a fund of hedge funds index.
Benchmarks and targets should be linked to investment objectives and should include measures of correlation to the existing portfolio, downside risk and a qualitative assessment of the fund of funds manager's due diligence, manager monitoring and reporting.
HW: With funds of hedge funds monitoring increasingly large institutional portfolios, is there a case for monitoring the funds of hedge funds too?
Oxley: Yes, we are very closely monitored by our institutional clients and consultants often play an important role here too. Monitoring should include a good deal of qualitative assessment (changes to people and processes, how the business is developing, conflicts of interest, quality of manager due diligence and risk management).
I think that the kind of performance league tables that you see in the mutual funds world are interesting but dangerous if they are the only monitoring tool being used.
HW: There is a view that the rapid growth of the funds of hedge funds must lead to capacity problems across the market, with more players trawling the same pool of talent - what are the implications for funds of hedge funds and their institutional clients?
Oxley: I would question whether it is the same pool of talent. New hedge funds and hedge fund managers emerge all the time, many of these new managers have pedigrees working with other hedge funds and there continues to be a flow of skilled people from the long-only world and the proprietary trading desks of banks.
We believe that it is going to be increasingly important for funds of funds to identify and access skilled managers early. We have capacity to grow with our existing manager pool and we invest early in managers. The "wall of money" that some predicted would flow from institutions and overwhelm the industry has not materialised.
Institutional investors are investing in hedge funds but my feeling is that it is a steadily increasing flow that will be spread widely of a large number of managers through multiple funds of fund relationships.
Another interesting trend is that hedge funds are becoming more choosy about types of investors, in general they like institutional assets and we have seen cases where closed hedge funds are finding space for institutional assets by removing other clients.
Institutions should be aware, however, that some funds of funds may be growing too rapidly to effectively invest their capital - controlling growth and spending time early on with new managers are critical to success.
HW: What is PAAMCO bringing to the European market?
Oxley: PAAMCO has opened in Europe for two reasons: To continue to find new hedge fund opportunities here and to develop relationships with European institutional investors.
PAAMCO manages some USD 2.7bn in multi-manager hedge fund portfolios over 90% of which is for institutional investors. Half of our client assets are from pension funds. We specialise in creating customised portfolios of hedge funds for these large institutional clients.
We are a partnership and an investment-led organisation - two thirds of our people work in investment management functions.
Our investment methodology is based on a sector specialist approach where each Managing Director has both the responsibility and accountability for specific hedge fund sectors. This means we have high-level, in-depth knowledge of our managers, and particularly broad coverage over many of the newer hedge funds.
In Europe there is a clear trend for large institutions to invest in hedge funds through funds of funds. Our approach and our understanding of institutional investors' needs, will, I believe, appeal to this growing market.
copyright hedgeweek 2003