Infovest21 Investor Focus: Consultants discuss RFPs and define “institutional quality” managers

Consultants say search activity in hedge funds has been robust in 2010 and 2011.

“Today, there is still interest in long/short equity and increased interest in absolute return strategies as a substitute for fixed income,” says Greg Dowling, a consultant at Fund Evaluation Group, speaking at Infovest21’s investor morning seminar on RFPs. He is seeing interest in credit managers that have much more of a long/short posture versus the longer biased managers that were popular 18 to 24 months ago. The only exception is Europe where managers with loner biased distressed debt skill sets remain popular. While the type of searches has changed as the market opportunity has changed overall search activity still remains robust, adds Dowling.

Earlier in the year, Towers Watson released a report showing similar findings. Its clients’ hedge fund mandates increased 50% during 2010, bringing the level of mandates back to 2008 levels. Mandates for direct hedge funds now account for 60% of all the hedge funds searches with equity, fixed income and insurance strategies being the most popular.

At the release of the report, Craig Baker, global head of research at Towers Watson, said, “We believe in the ability of highly skilled hedge funds to adapt to a changed environment and generate good performance for our institutional investor clients. We believe that the larger institutional funds will continue to move to investing directly rather than via funds of funds. However, funds of funds can still be an ideal solution for many smaller and governance constrained investors.”

Don Steinbrugge of Agecroft Partners, a consultant and third party marketer to institutional investors, says he is seeing widespread demand from institutional investors for commodity trading advisors which is a dramatic change from their past reluctance to allocate to the strategy. Before 2009, very few pension funds allocated to CTAs. They did not understand how the systematic models worked nor could they evaluate which models were superior. Institutional investors were more comfortable with fundamentally driven strategies that were similar to their long-only managers' investment processes.

After Q4 2008, however, pension funds realized their portfolios were not as diversified as they thought and found their managers to be highly correlated. Meanwhile they saw the Barclays CTA Index up 14% over the same period. This caught their attention and they began to take a closer look at CTAs. Institutions also saw that while some hedge funds were gating or suspending redemptions due to liquidity mismatch, CTAs generally offered monthly liquidity to their investors and accurately valued their portfolios as they tend to trade highly liquid, price transparent futures and currencies.

Defining “Institutional Quality Managers”
In defining what is institutional quality, consultants say they put an emphasis on:

• a historical ability to create excess returns over a benchmark
• a repeatable investment process
• separation of duties
• a strong chief compliance officer
• the people – are the same people in place that created the same track record?
• an articulate valuation policy
• risk management
• liquidity management
• quality of service providers
• business continuity
• the size of the assets relative to the strategy and how the assets have changed

Towers Watson’s Neel Mehta wants to understand how the portfolio managers think as opposed to simply how they have made money in the past. “Once we understand the process, we talk about trade examples, macro views on market, and how these translate into returns.”

Massey Quick says they may select a stock out of the portfolio and ask the manager specifically how the stock was identified, who did the research, what made the manager decide to put the stock in the portfolio, why it was sized the way it was.

The consultants are interested in talking to other team members besides the portfolio manager. “Very often you can get more from meeting the analyst than meeting a portfolio manager. You get a different perspective on the manager. We can talk about process and how the manager has traded on past ideas, how the compensation structure actually motivates the analyst. You also have to meet the chief financial officer, the chief executive officer and understand the business plan of the company,” adds Mehta.

Understand what motivates the manager. Often, large managers don’t want to take on enough risk. Think about wider issues such as the correlation between stock price and assets under management and try to calculate how much money is made by growing assets (inflating the stock price) versus generating revenue from the incentive fee on good performance, observes Mehta.

Character and integrity are also important. Investors remember those managers who closed their funds in 2008 because they didn’t want to pay back the draw downs and reopened under a new name.

On the managed futures front, Steinbrugge advocates hiring CTAs with well built out research teams and seeing how much transparency they give investors into the process. This is because CTA models tend to evolve over time. He suggests looking at managers in the mid sized range i.e. $2 billion to $10 billion as this group is large enough to support a substantive research team but not too large where their alpha may be diluted over a growing asset base.

The above is an excerpt from Infovest21's April issue of Investor Focus. The full issue can be obtained by contacting Infovest21 at 212 686 6440.