Perspective on the New Alternative Funds
Investment Quarterly — Fall 2013
October 24, 2013
Investors are displaying an increased appetite for portfolio solutions that offer the potential for diversifying sources of return and lower volatility—a development that has helped drive a transformation of the hedge fund landscape. A variety of '40 Act mutual funds now provide investors with access to an array of hedge fund strategies with lower investment minimums, daily liquidity, greater transparency and more advantageous fee structures than were previously available through the traditional partnership structure.
We recently sat down with David Kupperman and Jeff Majit, portfolio managers of our multi-manager hedge fund strategy mutual fund, to get their perspective on the new mutual funds and the importance of due diligence and careful portfolio construction in the multi-manager context.
Manager Selection is Key
Jeff Majit: Selecting managers and constructing portfolios of hedge fund strategies are where solutions providers can add value. If you look at the data across the universe of hedge fund managers and within specific strategy categories, the spread between top- and bottom-performing managers can be significant. Therefore, manager selection has significant implications on long-term returns. When we evaluate managers, we look at a range of characteristics including, but not limited to, track record, pedigree of the team, investment process, risk management, historical strategy exposures and performance attribution, as well as operational integrity. While no individual element on its own will trigger a decision to invest with a manager, a red flag on any of them can disqualify a manager. A manager that employs too much leverage or a lack of back office infrastructure, for example, could eliminate it from consideration, as could a high Assets Under Management (AUM), if we feel it may impact a manager's investment flexibility.
David Kupperman: Repeatability of a fund's investment process is important as we work to understand the quality of a manager's returns, i.e., how they make money and whether they have the potential to deliver consistency. Fundamental-driven strategies like event driven, long/short and discretionary macro, for example, tend to have processes that can be repeatable, but the factors that make them repeatable will differ depending on the strategy type. For example, when we look at a distressed strategy, one aspect we consider is how the portfolio managers function on a creditor committee. We believe active participation on creditor committees is an important aspect of distressed investing and may put a manager in a better position to deliver returns over time.
Majit: We also emphasize operational due diligence. I think most investors are familiar with the negative headlines some hedge funds have received for fraudulent activity. While those funds represent a very small minority of a universe of roughly 10,000 funds, their failures underscore the importance of analyzing a fund manager's back office and compliance infrastructure. The advent of ‘40 Act alternative funds, with their more stringent oversight, is reducing the operational risk of investing with hedge fund managers.
Kupperman: Having a real compliance process—in writing and in practice—is critical. We've seen hedge fund managers without formal risk management policies and managers who have them but execute them inconsistently. Both are red flags.
Tying Strategies to the Environment
Kupperman: When choosing investments for the portfolio, we look broadly across all types of hedge fund strategies. Certain ones can be more effective in a particular environment. Today, for example, we favor strategies like event-driven investing. The reason: It has been more challenging for companies to grow organically and, consequently, we're witnessing an uptick in corporate activity to increase shareholder value through spin-offs, restructurings or mergers and acquisitions. Long/short equity strategies can also benefit in this environment, especially with correlations dropping from their 2008 – 2009 highs, which has helped stock pickers. We're less sanguine on trend-following strategies at the moment; it's challenging for them to generate returns in a policy-driven environment and returns have suffered in recent years.
While diversification is an important consideration, we believe some multi-manager funds are over diversified. A typical hedge fund manager might have around 50 positions. If you have 10 managers, that's approximately 500 underlying positions. Some multi-manager funds may invest in 30 – 40 hedge funds, which could equate to thousands of underlying positions. We believe it's harder to generate attractive returns with an over-diversified portfolio. Instead, we select managers in whom we have high conviction and we're careful not to over-diversify.
Majit: For us, there are two levels of diversification. David referenced diversification at the portfolio level. At a higher level, we want the portfolio to act as a diversifier for our clients' long-only equity and fixed income exposure. That requires constructing the portfolio in such a way that offers lower exposure to the risk factors inherent in the equity and fixed income markets when investing long only. Certain hedge fund strategies can offer similar volatility characteristics as fixed income yet may be able to better navigate periods of rising rates, for example. Others such as long/short equity offer participation in equity market upside with reduced overall long exposure. Depending on a client's goals and objectives, these can be attractive additions to a broader asset allocation.
Watershed for Accessibility
Kupperman: The advent of '40 Act alternative funds has been a watershed event for the hedge fund industry in terms of increasing accessibility to these strategies, ease of use and oversight. The traditional hedge fund partnership and fee structure became popular 25 to 30 years ago, when there were very few hedge funds chasing available investment opportunities. During that time, arbitrage spreads on investment opportunities were much larger. Now we have at least $2 trillion in hedge fund assets looking for the same opportunities. As a result, spreads have narrowed and managers are finding it more challenging to generate attractive (let alone dramatic) net returns within the traditional 2 and 20 fee structure (representing a management fee of 2% of assets plus an incentive fee of 20% of profits).
Majit: While certain types of strategies will likely always fit better in the traditional hedge fund partnership structure, we anticipate that most, provided they are liquid enough, will see that structure replaced by the '40 Act mutual fund structure. We think the fee structure of these vehicles is more consistent with the current and future investing environment.
Kupperman: We also believe defined contribution plans will be among the most important drivers in the growth of '40 Act alternative funds. Many investors hold the bulk of their investable assets in retirement accounts and many lost money in 2000 and 2008 in part because of more aggressive long-only equity allocations in their retirement portfolios. On the flip side, earlier this year, many retirees' portfolios were hurt by exposure to fixed income in a rising interest rate environment.
The defined contribution industry is looking for ways to provide participants with new, diversifying investment options that can help contribute to steady, smooth growth in their retirement portfolios. To date, that has only happened to a limited degree; but we think within a decade, investment choices could be more comprehensive and that hedge fund strategies will be an important component of that development.
Investing entails risk, including possible loss of principal. For additional information on the principal risks of Neuberger Berman Absolute Return Fund, please see the information on page 11 and the Fund's prospectus, which is available on www.nb.com.