Hedge fund strategy: Top-down or bottom-up? What should FOHFs be doing?

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Is manager or strategy selection the key for fund of hedge funds managers?

Commerzbank recently relaunched its multi-strategy fund of hedge funds, where it will be applying a top-down asset allocation strategy within its manager selection process. “The range of hedge fund strategies is now so vast, and many of those are highly dependent on the economic environment,” says Mehraj Mattoo, global head of alternative investment strategies at Commerzbank Corporates and Markets in London. “Particularly so for those where the exposure is directional, such as CTAs or where the hedge fund activity depends on the stage of the economic cycle, such as global macro funds or merger arb funds. Some of the problems the hedge fund industry encountered in May and June of 2006 were where managers and funds of hedge funds partly got the underlying economic assumptions wrong. It is therefore important to have a top-down element in selecting managers. I think most funds of hedge funds would claim to have a top-down approach but not many have made this an integral part of the investment process; this is particularly important for multi-strategy funds of hedge funds. Some are still doing due diligence on a large pool of hedge funds to determine the alpha generators without regard to the broader macro environment.”

Commerzbank has employed a former Federal Reserve economist, Robert Gay, as its consultant strategist, to lead its macro top-down process, and is hiring a number of PhDs from Imperial College London to carry out fundamental and quantitative research to further develop an internal top-down process.

Not everyone, though, is convinced of the value of applying a macro view to manager selection. Aoiffin Devitt, formerly of Cambridge Associates, has recently established a consultancy firm, Clontarf Capital, providing due diligence research and advice on alternative investments. “I believe that it is the manager itself, and not the strategy backdrop, that is responsible for the bulk of hedge fund returns. Admittedly, in some strategies, such as merger arbitrage, fixed-income arbitrage and convertible arbitrage, there is far less dispersion in returns between the top and bottom performers than in areas such as long/short. This suggests that in the former strategies it is difficult for a manager to outperform even if it has an edge, if the strategy is out of favour,” says Devitt.

“However, there is always some dispersion in every strategy, so I believe that it is manager selection, and not strategy selection, that is a real source of value. Calling strategies is notoriously difficult, and it involves essentially a macro call and forecasting based on various economic indicators and a lot of ‘unknowables’. Timing entry and exit into different strategies is also difficult – as was evident with many fund of funds managers who cut their exposure to convertible bonds too late, and then were not invested when the strategy rallied. The same happened to managers who were too early in cutting their exposure to distressed managers, who have actually had quite robust performance over recent years, despite deteriorating fundamentals for the strategy.”

Ability

Devitt adds: “I prefer to invest in a fund of hedge funds’ manager selection ability, and to get comfort that they have built the best ‘all weather portfolio’ of good managers. If these managers are truly top tier and ‘best in class’ they should make money even when the backdrop for their strategy is poor. We see this today with distressed managers – many have large cash piles as dry powder for when the strategy turns and also have selective short credit exposure as protection against a credit event. They thus have inbuilt hedges if there is a credit correction and will be poised to ratchet up exposure as opportunities present. It is far easier for the underlying manager to do this than it is for the fund of funds manager to move capital around once the writing is on the wall for a strategy.”

Barbara Rupf Bee, CEO of HSBC Republic Investments, agrees that a bottom-up process of selecting managers is preferable. “Our manager selection is carried out from a primarily bottom-up perspective. Funds of hedge funds with top-down dominant processes will tend to have a higher turnover as redemptions and subscriptions into funds will be driven not only by the bottom-up due diligence but also by tactical changes from a top-down perspective. This will either result in higher redemption fees or, more generically, limit their effective universe of funds to liquid managers and strategies.”

Mattoo disagrees that turnover will necessarily be higher, “so long as you pick the right manager that fits that particular product in terms of its top-down outlook”.