By Penny Aitken
For some time now there has been a glaring spotlight trained on the funds of funds (FoHF) industry. Such scrutiny is clearly justified in the context of the recent financial crisis, during which many financial institutions were found wanting. However, there comes a point at which constructive criticism, with all its stimulus for positive change, tips over into a destructive force. As Disraeli put it: “How much easier it is to be critical than to be correct.” What start out as useful observations can quickly snowball into a wave of negative sentiment whose momentum can carry perception too far adrift from the evidence.
In the midst of the critical maelstrom, the fact remains that funds of funds have the longest experience in both fund selection and portfolio optimisation. This is evidenced publicly in their track records that often span decades across different market regimes. This historic data is something that is absent in many new entrants and advisory business models, making it hard to assess their relative quality of decision making over a similar period. As competition around cost and type of intermediation grows, there also remains a question that perhaps only time will answer: how low can you go before cost pressures erode the quality and value of service being offered?
It remains likely that there will always be a significant cost to intermediation in a universe that is by default heterogeneous and highly complex. These qualities remain endemic to hedge funds in spite of regulatory attempts at standardisation and transparency. It is a segment that is constantly evolving both intellectually – in terms of strategies and risk – as well as geographically in terms of global scope and jurisdictional diversity. Current shifts in regulatory frameworks may change the types or location of these investment opportunities but they will not disappear. This complexity is not just limited to strategy or risk, but pervades the business models themselves.
Reviewing the statutory documents for a wide range of hedge funds today suggests little has changed in the content and terms post Madoff: the language remains as ambiguous, inaccessible and opaque as ever, arguably even more so in response to the litigious backlash after 2008 and increasing regulatory pressures. Business risks have also escalated with higher start-up costs, break-evens and on-going capital commitments to meet growing compliance and regulatory requirements. All of this complexity comes with a cost of analysis and expertise. Funds of funds have the experience and skills to meet these challenges, but perhaps they have been too slow to seize new opportunities to streamline and adapt their business model.
Today’s broader asset management industry is undergoing a metamorphosis: historic frameworks are being overhauled and the new investment landscape is still emerging and evolving in response. In the face of such pressures coupled with the need to address a critical audience the impetus for change and adaptation has never been greater. Adversity breeds strength and as Churchill stated: “Difficulties mastered are opportunities won.”
So what opportunities can be harnessed by a beleaguered funds of funds industry?
The biggest and most dynamic source of change is surely driven by the technological revolution of the past decades. This has fundamentally altered the way we access, store and respond to information, as well as how we interact and consume. It has had seismic effects on business that continue to ripple across industries and geographies. So are funds of funds really exploiting the true power of technological and computational advances?
The global hedge fund data set has grown larger, longer and broader as strategies have evolved and expanded geographically. This rise in both numbers of funds and diversity in trading approaches has been well documented, but this universe in itself provides a vast richness in data and information both for those that have survived as well as, just as importantly, those that have failed. The level of transparency is also increasing, driven partly by regulatory pressures, so this body of information is expanding and deepening all the time. This provides enormous potential for the deployment of statistical tools and techniques to help manage and filter this information more efficiently and effectively as long as the quality of the data is consistent and the tools are robust and powerful enough. This in itself is no easy task given the general lack of uniformity in standard information available on funds such as strategy labels or asset information. However with the right planning, programming and structure it is possible to start unlocking the information to yield valuable insights contained across multiple market regimes and asset classes.
All this has the ability to empower a deeper, richer understanding of the drivers of hedge fund returns as well as the risks they exhibit over different economic environments. It fosters individuality and creativity of thought by casting off the shackles of industry-imposed constraints such as standard classifications and enables the user to let the numbers speak for themselves. It provides an extensive source of quality data to observe patterns and test hypotheses on hedge funds. It also holds the answers to the questions that continue to be debated:
- Does alpha persist in hedge funds?
- How can you find and evidence it?
- Does it exist in small or large funds or in all strategies?
- What causes it to erode over time and what are the observed risk factors?
- How do you blend this fund to manage associated risks?
- How do you blend this alongside more convent-ional sources of beta and manage systematic risks?
- How can you calibrate a hedge fund allocation for investors with different objectives?
Technological advances have the potential to help unlock a better understanding of hedge funds and the role they should play based on statistically significant evidence rather than supposition or short-term theories.
However, none of this would be possible if the computational power to support and run more diverse and powerful statistical models had not also made huge advances. While hedge funds themselves have been quick to see the potential and have used this to develop powerful broad market models, has this increase in capability been exploited enough by funds of funds?
Not only does this computational progress have repercussions for the range and complexity of analytical techniques to test, develop and understand characteristics of hedge funds more fully but it has implications for business models also. Powerful systems not only provide the ability to innovate and differentiate through research and development on selection and portfolio optimisation techniques, but they also provide the capability to create productivity efficiencies within teams. A well designed and implemented infrastructure has scope, longevity, adaptability and efficiencies of scale against which pure human headcount cannot compete. It also creates a more sustainable, objective asset value for a business, key for its long-term success: a feature highly relevant in an industry likely to see on-going consolidation and mergers.
Powerful and structured systems are also vital to the core activities in investment: analysis leading to decision making and execution. They create an objective, transparent, auditable record of decisions and thought processes that enable learning and improvement. Scientific progress continues to increase our ability to understand our strengths but also our limitations. Most key activities in funds of funds are governed by decisions such as fund selection or portfolio sizing. So the question is how good are we at these decisions and how are we measuring and improving this ability over time? As advances continue to be made into neurological studies we are learning more and more about both our conscious and unconscious biases with much ground still to cover. What we are finding out is that, as Daniel Kahneman states:
“We’re generally overconfident in our opinions and our impressions and judgements.”
Or put another way:
“We don’t see very far in the future, we are very focused on one idea at a time, one problem at a time, and all these are incompatible with rationality as economic theory assumes it.”
This understanding has important ramifications not just for markets but also for how FoHFs manage their internal processes. It suggests a need to create systems that foster a more transparent, scientific approach to decisions that maximises the quality of human judgement based on relevant experience but minimises sources of irrational behaviour or personal bias that may be detrimental.
Technology also holds opportunities for funds of funds in developing relationships with clients. Sophisticated and powerful systems create a more stable long-term platform upon which to undertake a range of fiduciary responsibilities, enabling greater product innovation and activities as well as efficiencies in reporting. They facilitate a more flexible base from which to be able to listen and adapt to changing client demands over time. They can also foster a better working partnership by supplementing investors’ existing expertise by tailoring the powerful statistical tools and techniques to enhance the clarity of their understanding and long-term expectations.
A business should never stand still, and never more so than when the opportunity set around it offers up such a wealth of possibility.
Penny Aitken is partner and head of investment research at FQS Capital, a global multi-asset manager with offices in London and the US.