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It's all about the relationship - Column

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A few weeks ago I participated in a debate on the relative merits of fund of hedge funds (FOHF) versus multi-strategy hedge funds from a single provider.
A few weeks ago I participated in a debate on the relative merits of fund of hedge funds (FOHF) versus multi-strategy hedge funds from a single provider. The latter are only really available from large global investment managers with skills across multiple strategies. It struck me the arguments were very much the same as the relative merits of balanced funds that use multiple specialist managers versus single company balanced funds, which 15 years ago controlled substantial assets. Since then, the manage-the-managers approach has dominated.

The decline of individual manager balanced funds relates to a number of factors, including:

  • Manager risk - this is the risk that a manager will fail to consistently deliver positive active returns. This might be due to loss of key people or the failure of a manager's particular style or investment approach.
  • Few managers have skills across a wide range of asset classes - in the 1980s individual managers offered balanced funds, not because they had a comparative strength across a range of asset classes, but because balanced funds were demanded. Hence, managers that had skills in only one asset class offered balanced funds with all asset classes actively managed, often with poor outcomes.
  • Poor tactical asset allocation (TAA) - the mix of asset classes was actively managed relative to the long-run strategic asset allocation (SAA). This approach involved making a small number of active decisions each year and produced outcomes with little consistency. Often international equities were treated as one asset class, combining more than 20 different equity markets and more than 10 currencies into a single bucket whose composite return was compared to the forecast return of the other asset classes.

The manage-the-managers approach solved many of these problems. Diversifying across managers reduced an investor's exposure to any one manager's risk. Portfolios were constructed to be style-neutral, combining value, growth and core managers to prevent the outcome being unduly affected by whichever style happened to be in or out of favour. The best-of-breed approach meant that, if the investment staff of the fund had skill in selecting underlying managers, the portfolio could be constructed using the best domestic equity managers, the best international equity mangers and so on. Finally, many funds simply stopped making active TAA decisions, believing this too difficult to be done successfully on a consistent basis. This has changed with the emergence of global macro trusts, which make active long-short decisions across multiple asset classes, increasing the number of active decisions and the probability this strategy will add value consistently.

The advantages are significant, but come with two costs. The first is, like FOHFs, there can be a second layer of fees, being the fees of the fund provider that selects and monitors the underlying managers. With FOHFs, these fees are significant. They are typically much less for balanced funds, but can be non-trivial and do vary across fund providers. The second cost is more important and relates to implementation efficiency. The success of a manage-the-managers approach lies with the ability of the fund to consistently select above average underlying managers and then combine their active strategies together efficiently. This is difficult to do. Funds that cannot do this will fail to produce returns consistently higher than the returns available from passive strategies with the same SAA. The proof is in the results and financial advisers and clients should make this comparison when considering balanced funds with active management fees.

Individual managers with skill across a range of asset classes, those who construct style-neutral strategies and those who implement active TAA using global macro trust strategies, have the potential to offer balanced funds without most of the flaws of the funds offered 15 years ago. Individual managers have a distinct advantage in terms of implementation efficiency. They know significantly more about in-house strategies than any external manager can know. Investing across a number of such balanced funds, or using this type of balanced fund as a core manager combined with multiple satellite managers in the specialist asset classes, will control manager risk. The objective of individual manager balanced funds remains exactly the same as that of manage-the-manager funds, that is, to produce returns consistently higher than those available from diversified index funds with the same SAA. Again, the proof will be in the results.

The FOHF versus multi-strategy hedge fund debate has similar conclusions. The latter has greater implementation efficiency and can make sense if the investment manager has skills across a wide range of strategies and good risk controls. The key issue for investors is to control exposure to manager risk.

 

It's all about the relationship - Column
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