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 The Hedge Fund Landscape
Our Latest Thinking
The Hedge Fund Landscape
Our Latest Thinking
Table of Contents
Introduction: Industry Seeks Rapid Evolution
2
Managed Accounts: An Evolution
3
The Alternative UCITS Market: The Power
of Perception
6
Hedge Fund Fees: Toward a Fairer Deal
18
Activism: Strategy Overview
22
Improving the FoHF Model
28
Hedge Fund Portfolio Construction:
Key Considerations
30
Into a New Dimension: An Alternative View
of Smart Beta
36
Summary: Hedge Fund Research:
Time and Effort Well Spent
44
The Hedge Fund Landscape: Our Latest Thinking 1
Introduction
Industry Seeks Rapid Evolution Since we began researching hedge fund strategies in the late 1990s,
we have witnessed considerable changes in both the industry and
markets. Economic and financial crises combined with extreme
volatility, and difficult liquidity conditions have challenged the way in
which many investors construct their portfolios. The market extremes
have even caused some to question the viability of a number of
investment approaches.
Despite all this, we have seen robust interest
in, and increasing allocations to, hedge
fund strategies as investors continue to
view them as value-adding components of
portfolios, providing diversity as well as
attractive risk/return propositions. Assets
under management in the hedge fund industry
now exceed US$2.6 trillion as of 2014, and
many expect the industry to continue to grow,
especially as more institutions seek diversity
within their plans.* While this number is open
to debate, one thing is clear: Hedge funds
continue to attract the interest of institutional
investors, and we see a steady flow of assets
into direct hedge fund strategies. The fund-ofhedge-funds (FoHF) model, however, continues
to experience headwinds.
Performance dispersion across hedge fund
strategies remains significant, and while there
have been a number of successful new fund
launches competing against the established
fund managers, many others have failed amid
tough markets and sometimes overinflated
*Sources: HFI, Barclays Capital, Preqin
2 towerswatson.com
expectations of their ability to add value. The
success of any hedge fund portfolio clearly
remains highly dependent on the selection of
skilled managers.
This book aims to provide insights for
institutional investors with direct hedge fund
portfolios or those considering investing
directly in hedge funds. It offers practical
analysis and advice about how to structure
investments as well as information about
the investments themselves. The issues we
address include managed account structures,
the development of alternative Undertaking
for Collective Investment in Transferable
Securities (UCITS) funds, shifts in the fee
model and the growth of more efficient
alternatives to certain hedge fund exposures.
We thank you for your participation in our
ongoing dialogue about these and other
issues, and hope you find this book useful
in your deliberations over the place of hedge
funds in your organization’s portfolio. We
welcome your feedback and comments.
Managed Accounts: An Evolution
Introduction
Our last hedge fund book* outlined the characteristics
of the managed account market, including the
reasons for investor interest, and the advantages
and disadvantages we believed managed accounts
and associated platforms could provide. Managed
account solutions continue to evolve, with the
introduction of new platform providers and services
offered. This thought piece discusses the evolution
that has occurred and how it has altered the options
available to hedge fund investors.
A Quick Refresher
Managed accounts, also referred to as separate
accounts, can be set up by individual clients or
accessed through a managed account platform
(MAP) provider, and can reduce the operational and
administrative burden to the investor. Depending
on the platform and account type, assets may be
comingled with those of other MAP investors.
Historically, our view on managed accounts and
MAPs has been that they provided a solution for a
subset of investors, but that for the main part, the
potential disadvantages outweighed the advantages,
particularly for long-term institutional investors.
Managed accounts and MAPs offered benefits such
as greater transparency and scrutiny of manager
trading activity, improved governance of investment
guidelines and liquidity. However, they also placed
additional operational burdens on the hedge fund
manager (e.g., the need to split trades, use of
different counterparties and possible alternative
investment guidelines) and, consequently, were
often deemed an unattractive way to manage assets
compared with the traditional pooled fund approach.
As a result, we felt managed accounts and MAPs
were subject to adverse selection, with a bias toward
managers either intent on raising assets or those
struggling to do so, accepting the need to tackle
the greater operational burden. In addition, longerterm institutional investors often did not require the
additional liquidity provided by managed accounts.
Often, with less liquid asset classes, the platform
account differed significantly from the underlying
hedge fund strategy and wasn’t focused on the core
skill set of the manager (e.g., liquid credit carve-outs
from event-driven or distressed credit managers).
Our concerns made us cautious about whether
institutional investors would receive sufficient
additional benefits to justify the costs associated
with managed accounts or MAPs.
“Managed
“
account
solutions continue
to evolve, with the
introduction of new
platform providers and
services offered.”
Evolution and Rise of the
Managed Fund
The MAP market is evolving. Many of the established
players in this space were early movers into
comingled managed account services, which were
designed to offer investors a differentiated fund-offund model (i.e., a choice of approved, comingled
accounts from the MAP with enhanced liquidity and
transparency). However, recently, increased interest
from large, sophisticated institutional investors
has grown the demand for greater customization
and segregated, rather than comingled, mandates.
In response, a number of new MAP providers have
entered the market, some of which specialize
solely in these customizable, segregated services.
At the same time, the established players have
expanded their service packages to also include a
customizable, segregated service. As a result, the
MAP market is now more competitive and has a new
product offering, a managed fund.**
*Hedge Fund Investing: Opportunities and Challenges
**For lack of a better, standardized term for this product (segregated fund structure run
by an independent third party), this is what we shall use throughout the remainder of the piece.
The Hedge Fund Landscape: Our Latest Thinking 3
At this point, it is worth defining the key differences
between managed accounts (separate accounts),
managed funds and the other alternative to
investors, the fund of one. A summary of the key
differences is illustrated in the sidebar (page 5).
A managed account is held at the investor’s
custodian, and an investment management
agreement (IMA) is drawn up by the investor to
delegate the investment management of the account
to the manager. Importantly, the investor retains
ownership of the account and the assets within
it, and is responsible for negotiating the required
International Swaps and Derivatives Association
(ISDA) with trading counterparties. Comingled
MAPs are different: The MAP, not the investor, is
responsible for executing the IMA with the manager
and monitoring the account. The assets remain
segregated from the manager, but investors are
pooled together into the same account.
With a fund of one, investors are able to reduce
some of the risks associated with investing in a
pooled account or fund,* but may not benefit from
many of the advantages a managed account can
provide. A fund of one is a separate fund created
by the manager solely for one investor. The terms
of the fund of one are typically similar to that of
the traditional pooled fund run by the manager,
although they can differ by consent of both parties.
Crucially, in such circumstances, the manager
retains ownership of the vehicle and custody of
the assets within it, and may (or may not) offer
better transparency than pooled fund investors
receive. The advantage of a fund of one is that it
does not relinquish too much control or impose
the same administrative burden as a managed
account (counterparties being identical). It offers
the advantage that managers that shy away from
managed accounts may be more open to working
with investors that require such structures, thus
reducing adverse selection bias.
A managed fund is fully customizable, and not
only offers the investor many of the positive
characteristics of a managed account, but also,
if sensibly structured, can reduce the burden on
managers and, therefore, also adverse selection
bias. One simplified way to think of it is as
a separately managed account wrapped in a
fund structure. A separate fund is created by a
MAP provider with delegation of the investment
management of the fund to the manager. In
such circumstances, the MAP provider offers its
capabilities to set up and run a managed fund, but
the investor, in negotiation with the manager, has
full responsibility and discretion to dictate the fund
structure (liquidity, investment guidelines, preferred
counterparties and board of directors, among other
points). The investor also retains full control over
manager selection, rather than having to make a
choice from a list provided by the MAP provider.
The important element to note is that the managed
fund is created and run by the independent MAP
provider, with the investor owning shares in the fund.
The managed fund is also governed by a board of
directors that enforces the IMA. The structure offers
two-way protection to the manager and investor:
•• The manager is protected from investor actions
outside of those agreed on in the IMA — in
a traditional separate account, the client has
ownership and custody of the assets, and could
call for a liquidation of assets, possibly adversely
impacting the prices of the same securities held
in the vehicles operated by the manager. Further,
the manager is protected from unanticipated
withdrawals of capital (and the resulting business
risk), as the managed fund has agreed-on liquidity
terms, with the assets owned by the managed
fund and not the investor.
•• The investor also benefits from independent
custody, valuation and oversight that include a
formal fund board of directors.
*Assuming a separate offshore vehicle is created
“A
“ managed fund is fully customizable, and not only offers
the investor many of the positive characteristics of a managed
account, but also, if sensibly structured, can reduce the burden
on managers and, therefore, also adverse selection bias.”
4 towerswatson.com
What This Means for Hedge Fund
Investments
With the emergence of the managed fund service,
we recognize that a number of our reservations
regarding MAPs may in theory have eased.
In particular, the ability to dictate the structure of the
managed fund enables the investor to more closely
mimic the guidelines, structure and counterparties
of the pooled hedge fund and, thus, make managing
money in such a structure as painless as possible
for the manager. In return, this, coupled with the
ability of the investor to select the manager, should
help alleviate some of the adverse selection bias
that has historically concerned us with comingled
platform accounts. It should be noted, however, that
adverse selection will still persist, as in many cases,
hedge fund managers are likely to resist the use of
managed funds, particularly managers already at or
near capacity. Furthermore, the ability to dictate the
managed fund liquidity also empowers the investor
to avoid a mismatch to the strategy and enables the
manager to run the managed fund in line with its
pooled fund and skill set. At the same time, with the
transfer of responsibility of fund structure from the
platform provider to the investor, the fees charged to
access a customizable, managed fund solution are
typically lower than through the traditional platformcomingled account approach. The reason for this is
because the MAP provider serves to simply provide
the infrastructure to a client that brings a hedge
fund to it, instead of sponsoring the manager for
inclusion on its platform and conducting its own due
diligence.
However, it should be noted that the theoretical
benefits of a managed fund described above are
reliant on the negotiation of terms between the
investor and the fund manager, and the conclusion
of a mutually agreeable and beneficial solution. An
important element to reduce adverse selection bias
is for managers to feel comfortable running such
structures, and therefore, investors may need to
compromise on certain powers typical of managed
accounts (for example, instantaneous liquidity and
termination power), which in practice have been
skewed toward the investor.
In conclusion, while we retain our view that managed
accounts provide an optimal solution only for a
subset of investors, we recognize that managed
funds may provide a wider solution for investors and
hedge fund managers. Such funds may help clients
more appropriately address their unique needs with
lower fees than are typically charged for accessing
a comingled managed account and reduce adverse
selection bias to some extent. That said, we still
retain concerns that adverse selection will not be
eliminated completely and that a traditional pooled
fund may continue to be the optimal implementation
method for many investors.
Definitions
Managed accounts
•• Separate account at a client’s broker with delegation of the
investment management of the fund to the manager
•• Client owns the account and has control of the assets within it
•• Requires the client to set up its own service providers and
counterparty agreements (e.g., ISDA, custodian or administrator) or
access through an account on a platform instead
•• Provides increased transparency, independent oversight and liquidity
(as the client owns the assets)
•• Greater operational burden and client risk to managers results in
fewer managers willing to offer this solution
•• If accessed through a comingled MAP, access fees can be relatively high
Customized managed fund
•• Separate fund is created by a MAP provider with delegation of the
investment management of the fund to the manager
•• The fund owns the assets within it; the client owns shares within
the fund
•• The independent platform provider and board of directors of the fund
provide oversight and enforcement of the fund guidelines (IMA) from
both the manager and the client
•• May provide enhanced transparency (negotiable with manager); does
not necessarily provide better liquidity relative to the pooled fund
•• Client and manager agree on the structure of the fund, which is fully
customizable to address the preferences of the client and concerns
of the manager
•• Platform access fees are lower than under comingled managed
account approach
Fund of one
•• Separate fund is created by the hedge fund manager solely for
one investor
•• Terms typically similar to that of the pooled fund run by the manager,
although can differ by consent of the two parties
•• Manager retains custody of the assets, and there is no independent
oversight
•• Segregation of investor from potential adverse behavior of
coinvestors within the pooled vehicle (redemption pressures)
The Hedge Fund Landscape: Our Latest Thinking 5
The Alternative UCITS Market
The Power of Perception
“UCITS
“
regulations have
progressed through a
number of iterations, with
rules generally updated in
consultation with market
participants, including the
larger asset managers.”
Introduction
Background
The alternative UCITS universe has sprung to life.
What was historically an appealing investment
option for individuals has attracted significant
growth in assets over the past year, including from
European institutional investors.
The key benefits to investing in alternative
UCITS-compliant funds are broadly considered
to be:
Reasons for this demand ranged from a broadly
improved investment appetite to tax incentives, but
were also due to investors seeking protection under
regulatory authorization. We assess the factual
details of these “safety” perceptions and present
the realities that many investors are either ignoring
or unaware of, paying special attention to fees,
liquidity, transparency and regulatory oversight. We
also consider the growth in the number of funds
and question the suitability and attractiveness of
strategies within the UCITS framework, as well
as whether UCITS funds are set to overtake their
offshore counterparts in Europe.
•• Regulatory oversight
•• Greater transparency offered than traditional
hedge funds
•• Frequent liquidity, typically daily or weekly dealing
•• Low minimum investment thresholds
•• Efficient tax treatment in some jurisdictions
The UCITS directives aim to subject open-ended
EU-domiciled funds investing in transferable
securities to the same regulation in every member
state, promoting consistency across the industry.
This regulation has applied to long-only mutual funds
since 1985 but is now also applicable to hedge
funds that wish to register. UCITS regulations have
progressed through a number of iterations, with
rules generally updated in consultation with market
participants, including the larger asset managers.
Key Points
•• By the end of 2013, the alternatives UCITS universe stood at
€160 billion — over 20% growth for the year.
•• In the past year, institutions have become the largest
investors, mostly due to solvency and regulatory requirements,
as well as tax incentives.
•• Private banks and retail distributors remain significant
allocators.
•• A greater range of strategies is available with a deeper pool of
talent, particularly from the U.S.
•• Continual evolution of regulations have occurred in the space,
but oversight measures are light in some cases.
•• We prefer managers to keep to their core skill set and
consider if they are sacrificing their true edge when fitting a
product into a UCITS framework.
6 towerswatson.com
•• A number of funds have already reached capacity and are
closing to further subscriptions.
•• There is a broader range of fee structures than was previously
available.
•• Performance fee structures are suboptimal in most UCITS
funds and are not being given sufficient consideration by
investors.
•• Investor perception of liquidity could pose the greatest risk,
with most funds having the ability to gate.
•• UCITS investing does not directly help in achieving Solvency II
requirements.
•• Deep manager research remains key to assessing the
quality of the strategy implementation, as relying on a wellintentioned regulator’s stamp of approval is not sufficient in
protecting capital.
The current UCITS IV directive imposes the
requirement for a new Key Investor Information
Document, which discloses risks and investment
objectives in clear language. Versions V and VI are
on their way, with the focus on depositary liability
and eligible assets. Further regulation is also
imposed by the European Securities and Markets
Authority guidelines.
Statistics
The UCITS universe stood at €159.4 billion at the end of 2013, having
grown €25 billion over the year, or 21%, according to Kepler Partners LLP.*
Other databases quote values up to €220 billion. Some of the increase
can be attributed to performance (averaging around 6% to 8% return), but
the majority reflect inflows in investor capital. With regard to how many
alternative UCITS funds these assets are allocated to, various surveys
indicate a range of 600 to 800 existing today. It should be noted that the
asset base is still somewhat concentrated at the top end of the asset
management spectrum by size, with single funds managed by four managers
currently representing €50 billion.
Also very important for hedge funds is the
Alternative Investment Fund Managers Directive
(AIFMD) regulation, which became effective
July 2013. (Note that the AIFMD is focused on
investment managers, while UCITS is aimed at
the fund level.) There are a number of significant
considerations for managers, but the one of most
concern to us here, compared to UCITS funds,
is the marketing ability in Europe. The AIFMD
stipulates that investment decisions need to be
made within the European Economic Area. This can
be challenging for non-European-based investment
managers that do not want to shift key personnel to
the continent from major financial centers such as
New York. The UCITS route allows them to launch
a fund, usually domiciled in Luxembourg or Ireland,
that is then able to be “passported” to various
European jurisdictions.
*
Annual Review: UCITS Review of 2013; English pound converted to euros
within the space, the trend has been that assets
in offshore funds have been stable over the past
couple years, while assets in UCITS funds have risen
rapidly and become a meaningful part of the market,
almost equaling assets from offshore funds.
Prior to 2013, the UCITS market was dominated by
discretionary high-net-worth and retail allocators,
particularly in the U.K. and Germany, where UCITS
returns were taxed more favorably than in offshore
products. Now, for many funds and platforms,
the list of largest investors has been completely
refreshed to continental European corporations and
pension funds.
The hedge fund industry has been improving since
2008 and, very recently, assets in European hedge
funds have returned to their 2007 peak, according
to Eurekahedge. However, taking a closer look
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AuM (USD billions)
AuM (USD billions)
Figure 1. Comparison of assets in UCITS and non-UCITS European hedge funds since 2006
0
Non-UCITS funds (LHS) UCITS III European hedge funds (RHS)
Source: Eurekahedge
Note: Eurekahedge defines European hedge funds as managers with European head offices as well
as non-European-based managers with European mandates.
The Hedge Fund Landscape: Our Latest Thinking 7
UCITS Development: Supply, Demand and the Future
The Three Waves of Supply
A number of UCITS vehicles were eagerly launched
between 2006 and 2008. Many of these were
introduced by the larger European asset managers
that were seeking to access more retail-oriented
European clients.
A pause ensued as the credit crisis and subsequent
redemptions hit the fund industry, with managers
taking time to recover their losses and waiting for a
more stable environment to launch funds.
In 2010, the first draft of the AIFM Directive was
released, and U.S. managers in particular were
faced with the possibility of being blocked from
accessing the European capital base. Consequently,
a number of larger U.S. players entered the market
by launching UCITS funds. Meanwhile in Europe,
many newly established equity managers were
launching their debut funds as UCITS products.
There was another quiet period in new UCITS
launches until more recently, in 2013, when a
number of factors again accelerated the launch of
UCITS funds. New factors were:
•• Substantial assets being raised in the UCITS
universe, which proved that real demand existed
and UCITS was no longer just a promised
opportunity
•• The growth of 40 Act alternative funds made U.S.
hedge funds much more familiar, with highly liquid
offerings
•• These vehicles have been considered a practical
alternative, since UCITS funds are outside the
scope of AIFMD rules
These factors allowed for a significant number of
UCITS-compliant fund launches, not just in Europe
but also from U.S.-based groups, and with a much
greater breadth of managers. The UCITS universe
was once criticized for being filled by mostly
mediocre managers, but that is changing with
what are regarded as higher-quality managers
entering the space.
Heightening Investor Interest
The rapid rise of UCITS assets in 2013 has
continued into 2014, with growth still coming from
continental European private clients and increasingly
from large institutional investors, particularly in the
second quarter of 2013.
To illustrate the scale of interest, many UCITS funds
were closed to further subscriptions in 2013 and
early 2014, as they had grown to full capacity, with
many at US$1 billion to US$2 billion in assets
under management. Moreover, two platforms have
reportedly raised over US$2 billion in a matter of
weeks for two funds this year, one of which was a
new launch. In some cases, UCITS funds have grown
larger than their related offshore funds.
Some of the reasons for the heightened interest
in the institutional world are tax structures and
regulatory/solvency requirements, for example:
•• In Germany, new capital gains taxes implemented
at the end of 2013 made UCITS investing more
attractive.
•• In Spain, aside from lower tax rates when
investing in UCITS versus offshore funds,
investors are encouraged to keep reinvesting
within UCITS products, paying taxes only when
fully redeeming.
“The
“
UCITS universe was once criticized for being filled by
mostly mediocre managers, but that is changing with what are
regarded as higher-quality managers entering the space.”
8 towerswatson.com
•• In Italy, the tax rate of investing in offshore
products was recently raised.
•• Tax transparency is offered by UCITS funds
in a number of jurisdictions, such as the
U.K. and Germany.
•• In some countries, including Italy and Spain,
insurance companies and pension funds have
caps on how much exposure they can have to
nonharmonized alternative funds (which include
offshore, non-UCITS hedge funds) and are
effectively encouraged to invest in UCITS funds.
•• In some countries, insurance companies have
managed to circumvent their capital charge
limitations by investing in more liquid instruments
and vehicles, which UCITS can satisfy.
•• In the dominant high-net-worth market, platforms
in some countries, such as Germany and Italy,
demand daily liquidity, and UCITS have become
popular investment vehicles.
Other reasons can relate to behavioral aspects. For
instance, discretionary managers and high-profile
investors wishing to avoid situations of locked-up
assets in illiquid holdings enjoy the comfort of a
regulatory stamp to protect them against scrutiny,
assured that their decisions were based on the
belief that the funds are subject to higher regulatory
oversight. Even non-European investors, particularly
in Asia, South America and Canada, have been
attracted to the regulated nature of UCITS funds.
Other aspects include the political influences in
Europe, as the spotlight continues to shine on
hedge funds, as well as greater awareness of
environmental and social governance in investing.
“From
“
an investment
perspective, a considerable
number of private banks and
wealth managers have moved
capital from long-only to
long/short strategies, finding
the current environment to
be more favorable to this
type of investing and looking
to execute through UCITS.”
Another significant reason for increased assets is
the broadly improved market sentiment and investor
appetite for alternative funds in general, which is
not necessarily a UCITS-specific phenomenon. From
an investment perspective, a considerable number
of private banks and wealth managers have moved
capital from long-only to long/short strategies,
finding the current environment to be more favorable
to this type of investing and looking to execute
through UCITS.
Similarly, there has been a move by European
institutional investors to reallocate their hedge fund
exposures to more liquid investments via UCITS.
The Hedge Fund Landscape: Our Latest Thinking 9
The popular equity long/short strategy in 2013
was accessed by many investors (that could also
invest offshore) through UCITS structures — indeed,
assets have doubled in equity long/short over the
past year. An observation by managers has been the
positive behavior of relatively subdued flows from
individual investors; that is, they are not subscribing
in, and redeeming out of, funds on a daily/weekly
basis, but holding onto investments for a longer
duration.
It should be highlighted that while some demand
for UCITS funds has been regulatory-driven, the
opposite has also been true where greater solvency
requirements have led to redemptions.
Will All Managers Launch UCITS Funds?
What About AIFMD-Compliant and U.S.
40 Act Funds?
UCITS is not a trend that all hedge fund managers
will follow. First, the strategy must fit within the
required framework. Second, it depends on how
much the manager wants to attract European
investors.
Offshore fund providers argue that many of the
advantages of UCITS funds are also now the norm
in offshore funds. For instance, the appointment of
independent service providers, as well as improved
transparency and corporate governance, are at the
forefront of operations. Regulators in jurisdictions such
as the Cayman Islands have also tightened their grip,
requiring more detailed and timely reporting. Therefore,
there is the argument that operational and investment
risks have somewhat reduced (or at least been
addressed) in offshore vehicles.
10 towerswatson.com
Funds with AIFMD status could appear to be a
competitor for UCITS for being a route to market
in Europe, although the overlap would only be if a
fund strategy is eligible for UCITS. Two aspects a
manager must consider when deciding which route
to opt for are:
•• The currently easier registration of UCITS and
lighter demands on the investment manager from
a business operations perspective
•• The unconstrained investment mandate
allowance of AIFMD, since there are no leverage,
concentration and instrument-type restrictions
with AIFMD
Many of the rules with regard to service providers
and fiduciary duties will be similar for AIFMD and the
new UCITS rules.
In the U.S., a parallel trend taking place is the
notable growth of 40 Act alternative funds in the
past year from both an asset and a number of
offering perspectives, albeit from a lower base.
These are alternative funds that can be packaged
within the format of a mutual fund, largely targeted
for the U.S. retail market. These products do not
generally reflect the more sophisticated hedge
funds they are derived from, unlike alternative
UCITS funds. This is because of the high-liquidity
requirement (daily redemptions) and because of
the lack of a performance fee in most cases, which
means that managers are less inclined to offer the
same level of return target (or performance engine).
The UCITS and 40 Act phenomena have recently
merged in the form of a new opportunity for
platforms and asset managers to offer a new breed
of multi-manager products. These are UCITScompliant funds that allocate “sleeves” to external
investment managers that sub-advise on managed
accounts. Given the multi-managed account
structure, the flexibility of these products is low
relative to, for example, fund of funds, since it takes
time to set up managed accounts, and in most
cases, commitments are made to the managers for
minimum asset levels. Nonetheless, the low cost,
liquidity and risk aggregation ability (given the
transparency into the managed accounts) will no
doubt be appealing to some investors, and we
expect there to be product proliferation in this
space.
“UCITS
“
is not a trend that all hedge
fund managers will follow. First, the
strategy must fit within the required
framework. Second, it depends on
how much the manager wants to
attract European investors.”
The Hedge Fund Landscape: Our Latest Thinking 11
UCITS Strategies and the Importance of Manager Research
“We
“ believe that deep
manager research
remains imperative
to assessing the
quality of the strategy
implementation, beyond
the simple reliance on
the regulatory stamp.”
Over the past six years, the market has become
more educated; managers are more practiced in
managing a portfolio within the UCITS framework,
and investors have become more comfortable
with the strategies and returns relative to offshore
vehicles.
A corollary to a growing number of funds has been
a greater number of strategies being represented.
UCITS platforms have commented on their strong
pipeline of high-quality managers with funds due to
be launched in 2014, across a range of strategies.
Nonetheless, one must be wary of the proliferation
of new launches, which may test the robustness
of the UCITS framework. We have been mindful
of the following when comparing UCITS funds to
unconstrained offshore vehicles:
•• We have a preference for managers to stick to
their core skill set. Has the edge of the manager
been lost in excluding elements to meet the
UCITS rules? This is most pertinent to macro,
managed futures and credit managers,
among others.
•• If there is a tracking error in the performance of
the two vehicles, can the manager truly blame the
framework restrictions, or is there an allocation
policy issue? Does the mindset of the manager,
used to more unconstrained investing, mean that
the offshore vehicles are preferred over UCITS?
This tends to be an issue with multistrategy and
event-driven funds.
•• How liquid is the segment of the universe traded
during crises, and how abnormal is the behavior of
asset classes and sectors within this space? For
instance, in 2008, contrary to expectation, shortdated Investment Grade Developed Market bonds
were the least liquid across the developed market
spectrum, as they were the most leveraged and
were heavily sold.
•• How much leverage is embedded in the
derivatives used to execute the short exposure
(for example, in CFDs and swaps)?
•• Are tight risk management controls in place to
avoid UCITS rule breaches and rapid de-risking?
We are also increasingly seeing unconstrained
portfolios being offered in a UCITS format via
portfolio-level swaps. We are cautious of the extent
to which some of these are adhering to the spirit
of UCITS regulation, where the implied intent is to
sidestep the rules.
We believe that deep manager research remains
imperative to assessing the quality of the strategy
implementation, beyond the simple reliance on the
regulatory stamp.
High-Level UCITS Investment Rules
Below are a few of the investment restrictions enforced on UCITS funds
that do not apply to offshore funds.
•• Ability to invest in defined eligible assets — in the case of long/short
strategies, the strategy manager would purchase market-listed
investments for the long portion of the portfolio, but physical shorting
must be avoided, so shorts can be achieved through buying CFDs,
swaps or options
•• Concentration limits
•• Leverage limits
•• Value-at-risk (VaR) limits
•• There are further rules on the allowed net exposure and counterparty
risk exposure
•• Investment in non-eligible assets (for example, commodities, property
and private equity) is generally not permitted, but exposure can be gained
through derivatives, and there are rules regarding implementation through
swaps and valuation policies
Note that funds can opt for different sets of risk reporting rules depending on their risk profile
(the sophistication of the instruments employed).
12 towerswatson.com
Figure 2. Our views on individual strategies
Strategy
UCITS suitability
Equity long/short
•• Most natural fit for the liquidity and instrument-type restrictions of the framework, as long as the portfolios
meet the UCITS-imposed concentration levels
•• Dominates the space: 30% to 40% of the UCITS universe by number of funds
•• Broad selection in European space and increasingly in U.S.
•• Track records show there is very little tracking error between unconstrained offshore equity funds and their
mirrored UCITS versions
Event-driven
•• Usually liquid portfolio, but concentration levels can be limiting
•• Tend to be equity-heavy portfolios
•• Investment terms should match the investment horizon as much as possible
•• Unsuitable for activist-type strategies, which would suffer from a potentially unstable capital base
Credit
•• Simple liquid corporate credit is suitable; both developed market investment grade and high yield
•• Many non-vanilla instruments are either too complex or too illiquid for UCITS rules
•• UCITS VaR limits are not restrictive (highly unlikely for the portfolios to reach the levels stipulated)
•• Structured credit is unsuitable; distressed is largely not suitable (on liquidity grounds)
•• One danger of credit is the nonlinear nature of liquidity in the markets — liquidity is based on demand
and not on the size or term of the bond
Macro
•• Choices are limited in the space
•• Most liquid instruments with low leverage can fit the framework
•• Interest rates and FX are the most likely candidates
•• Concentration levels can be a limitation
•• Complex derivatives are unsuitable
•• Cannot trade commodity futures
•• May miss the trade structuring skill of managers as a result
•• Poor recent performance of traditional macro funds has dampened demand
Managed futures (CTA)
•• CTA strategies have been limited due to the inability to trade commodity futures
•• Funds and platforms have devised various ways to replicate CTAs into UCITS models, but few have
been successful
•• Increasing UCITS regulatory scrutiny is likely to cause a move to AIFMD registration
Multistrategy
•• Liquidity, concentration and instrument constraints
•• Tend to be mostly equity portfolios with an ability to invest in other instruments in a limited manner
•• UCITS versions of unconstrained multistrategy funds have usually removed some of the less liquid credit
exposure and reduced position sizes of concentrated holdings
•• Difficulty to ascertain the effectiveness of the allocation policy with regard to managing an unrestricted
offshore product alongside a UCITS product, also difficult to assess the flexibility afforded by the
differences in the portfolio in treating the products with a different mindset (performance drags can always
be blamed on framework restrictions)
Smart beta
•• Very liquid portfolios with mostly daily-dealing funds
•• Combining strategies that are not widely available from traditional UCITS products such as reinsurance,
momentum and currency carry
Multi-asset
•• Liquid portfolios
•• Illiquid (unlisted) asset classes unsuitable
•• Limitations on investing in other funds
Risk parity
•• Liquid portfolios, mostly passive futures strategies
•• Leverage and commodity futures restrictions apply
The Hedge Fund Landscape: Our Latest Thinking 13
Common Perceptions of UCITS Funds
Lower-Quality Product
“The
“
recent growth in
managers electing to
offer UCITS products
has broadened investor
choice, potentially
increasing the quality of
some available options.”
Some strategies do not, and should not, fit the
UCITS model, and those that are being forced into
such structures result in suboptimal outcomes. The
recent growth in managers electing to offer UCITS
products has broadened investor choice, potentially
increasing the quality of some available options.
The view that some UCITS products are lower quality
may be drawn from their inferior returns, which may
be a result of higher costs and fees. We seek to
understand the manager’s true skill and if it is able
to be translated into UCITS.
Highly Regulated
UCITS regulations continue to be updated as
lessons in implementation are learned along the
way. Regulators assess funds in detail before
allowing them to obtain their UCITS licenses.
Detailed explanations and justifications of fund
investment policies are demanded, and the
registration process can be drawn out (usually taking
much longer than for most offshore jurisdictions).
Once set up and in motion, UCITS funds report their
positions to the relevant regulators semiannually via
their auditors. Leverage is also reported.
The regulator has the power to fine and charge the
investment managers if any significant deviations or
breaches occur.
We recognize that there are some shortfalls with
the regulatory framework. The portfolios presented
are snapshots on a lagged basis, and are therefore
less relevant and perhaps misrepresentative of
the typical profile. They also show actual holdings
and not economic exposures, so some factors can
be hidden, for instance, by the use of swaps. In
terms of adhering to rules on an ongoing basis,
these can be breached passively or actively. For
example, a passive breach may occur if a stock
price rises rapidly, meaning that a fund exceeds
the concentration limit. In this case, the regulator
is satisfied by timely reporting of the issue and
rectification within a matter of days. An active
breach is more serious and must be rectified by
the fund immediately, refunding the investors of
any expense incurred and informing the regulator
through the auditor. While there is a possibility
that a manager could hide this, the independent
administrator custodian would be able to flag the
issue to the regulator under their responsibilities
within the relevant jurisdictions.
Can UCITS Funds Help to Address Solvency II Requirements?
UCITS funds can address Solvency I requirements, but Solvency II can be more difficult, as the
regulation requires transparency through to the underlying positions and loss limitation. (Some
managers will provide snapshots of portfolios with a lag, while others provide no transparency.) For
clients seeking full transparency, the most effective means of investing in hedge funds remains
through managed accounts, but this is not a path generally open for small allocations. Another route
for adherence is through the application of swaps, notes or other derivatives around the fund products
that currently meet regulatory approval, although the experience with those instruments in 2008
remains a significant hurdle for some investors.
14 towerswatson.com
Highly Liquid
Liquidity is possibly the greatest danger of UCITS
funds. The actual liquidity of the funds may be
tested in an extreme market shock. Daily and weekly
dealing funds will be a challenge for investors
placing redemptions at arguably the worst time to be
liquidating a portfolio. This measure is not required
to be regularly reported but could potentially be a
problem in the future.
A strategy particularly prone to a liquidity drift is
credit, where managers could creep into instruments
that become less liquid. This would not be picked up
until the audit and requires close monitoring.
A feature that many investors do not concentrate on
is the ability for UCITS funds to gate and suspend
redemptions, a concept prevalent in offshore hedge
funds but in this case taken from the long-only
UCITS practices. Gates usually range from 5% to
30% at the fund level (as opposed to investor level).
However, depending on the jurisdiction, there are
generally limits on how long the fund can suspend
redemptions — usually two or three dealing dates.
UCITS rules do require that portfolios are managed
to meet reasonable redemptions. While this is
a rule, the interpretation of “reasonable” can be
relatively wide. Side-pocketing is also not explicitly
ruled out in UCITS directives.
High Transparency
The Key Investor Information Document required
of funds certainly aids in highlighting risks that
may be borne by an investor in a more simplified
format. Given the liquid nature of UCITS portfolios,
managers are broadly willing to provide transparency
on their entire portfolios, but not necessarily any
more so than offshore managers, particularly
given pronounced investor demands post-2008.
When a manager runs a UCITS fund alongside a
similar offshore product, it would be mindful of
treating investors fairly, so again, transparency is
not necessarily enhanced in the UCITS format.
Clearly, less liquid strategies or those where there
is limited transparency during certain periods (such
as when building large positions in activism) would
not be eligible for UCITS due to the instruments
and concentration levels employed. From that
standpoint, the UCITS rules filter out the less
transparent strategies, but do not necessarily offer
better transparency in the universe that remains.
“A
“ feature that many investors
do not concentrate on
is the ability for UCITS
funds to gate and suspend
redemptions, a concept
prevalent in offshore hedge
funds but in this case being
taken from the long-only
UCITS practices.”
The Hedge Fund Landscape: Our Latest Thinking 15
Fees
UCITS institutional share classes tend to charge
management fees comprised of a 1% to 2% base
fee and a 0% to 20% participation rate, with the
terms evenly distributed across these ranges.
There are a number of additional cost considerations
when comparing UCITS funds to relevant offshore
hedge funds. The most significant additional
expenses in UCITS funds relate to administrative
and statutory services:
•• Fund accounting, custody and transfer agency
costs can be comparable to offshore funds,
particularly at larger asset levels, but at lower
levels, can generally be 20 bps to 25 bps higher
per annum due to the greater frequency of
operations such as portfolio valuations and cash
transfers.
•• Statutory/cross-border costs can be significant
legal and tax burdens (which are not incurred
by offshore hedge funds since they are sold on
private placements). These can amount to an
extra 15 bps to 20 bps.
•• Where relevant, local jurisdiction transaction
taxes (for example, in Luxembourg) can also be
significant.
The above three are included within a total expense
ratio calculation, which also takes account of base
fees. Platforms and providers have different revenue
streams, but usually their distribution fees are taken
out of the management fee, and while not disclosed
to investors, can be 60 bps to 100 bps. Platforms
may also charge for other structuring offerings, such
as additional portfolio swaps.
Beyond the above factors, managers and investors
have to consider whether greater liquidity and
greater regulatory oversight would warrant higher
fees for UCITS investors. There has been a
significant shift in the viewpoints, from certainly
higher fees a few years ago to a much wider
perspective today. Some of the arguments, related
to offshore structures are presented below.
“UCITS funds should charge more”
•• Charges are calculated in order to not penalize
offshore investors that are tied in for longer to
avoid cannibalizing offshore funds.
•• There has been evidence of disgruntled investors
redeeming from offshore products where UCITS
funds have equivalent fees, but this is not as
common as might be expected.
“UCITS funds should charge the same”
•• One UCITS platform recently publicly announced
it did not believe investors should pay more for
liquidity if the portfolio can adhere to daily or
weekly dealing, and if the vehicles with different
liquidity are separated.
•• Managers prefer to have a UCITS product in order
to protect themselves against losing European
investors, rather than worry about cannibalization.
“UCITS funds should charge less”
•• In the case where the strategy has been watered
down, for instance, with a lower leverage or
narrower remit, this strategy adaptation has been
used either where the full portfolio is not UCITScompliant or to justify a need for different fees.
“Beyond
“
the above factors, managers
and investors have to consider whether
greater liquidity and greater regulatory
oversight would warrant higher fees for
UCITS investors.”
16 towerswatson.com
So, while in the past, UCITS funds tended to be
more expensive, warding off many fee-sensitive
institutional investors, offerings are changing
as managers recognize the need to attract larger
European-based investors. Examples of options
tendered beyond institutional share classes include:
Understanding the impact of performance fees on
UCITS funds is important, and while solutions for
fair calculations can be administratively burdensome
where the number of investors are high and flows
are very frequent, some attention needs to be taken
in this area.
•• Lower-fee, early-bird share classes for a limited
capacity in new launches
•• Step-down management fees as assets rise
•• Rebates through side letters (these are permitted
in UCITS, contrary to popular belief)
•• Application of hurdle rates — at some point, the
UCITS fund can become cheaper than the offshore
•• Our view on fees remains guided by the impact
on alpha share: Net of fees, we believe investors
should be left with the bulk of alpha generated
Further Fee Considerations
Focus on Performance Fees
Conclusion
For completeness, we should also discuss one
of the limitations of UCITS investing: The majority of
UCITS funds accrue a performance fee at the shareclass level, rather than at the investor level. This
means that an investor below its high-water mark
may continue to pay performance fees, even though
losses are being recovered. Various methodologies
are prevalent in calculating the performance fee,
some being performance across the average number
of shares in issue, average performance across the
full number of shares, or daily accrual including asset
debits and credit. Other methods also exist, but none
of the smoothing methods are perfect, and net asset
values are in some way or another impacted by asset
inflows and outflows. In some cases, these can work
in favor of the manager and, other times, the investor
(for instance, where investors can avoid paying any
performance fees by trading in and out of a fund as
it attains its blended high-water mark). Hedge fundlike series accounting or equalization principles are
also not applied to UCITS funds, largely due to their
previously retail nature. Nonetheless, this has not
been an area where investors have spent much time.
In many ways, UCITS directives have promoted
processes and principles that have considerably
improved practices in the hedge fund industry,
iteratively improving the governance to address real
investor issues. As such, the UCITS market has
sprung to life and is likely to grow further, with the
impression of safety being increasingly alluring for
certain regulators and institutional investors. In a
world of heightening demand for protection, this
framework seemingly fits all requirements.
Some managers have applied swing pricing or
antidilution levies to protect investors in the
funds when there are notable subscriptions and
redemptions, which add trading costs. It is important
to consider how the managers are adjusting for
these measures, as there is usually very little
transparency around the methods employed, which
can be quite punitive.
Nonetheless, the practicalities of adhering have
meant that divisions have occurred between actual
UCITS fund propositions and what investors believe
they are getting. As such, caution and pragmatism
must be applied in transparency, liquidity and fee
expectations. Regulators should also be aware
of the realities of both framework limitations and
of strong incentives to drive capital into a limited
capacity space. We would emphasize the importance
of deep manager research before selecting UCITS
funds for investment, as we believe that reliance
on a well-intentioned regulatory stamp alone is
insufficient to protect capital.
More recently, some funds and platforms have
been looking to improve the issue. For example,
some are crystallizing fees earlier than annually
to prevent any “free rides.” However, quarterly and
annual performance fees pose their own conflicts of
alignment. A few managers have also been offering
institutional investors zero-fee share classes with
regular invoicing, which can be tailored.
The Hedge Fund Landscape: Our Latest Thinking 17
Hedge Fund Fees: Toward a Fairer Deal
A Changing Dynamic
A. Types of Hedge Fund Fee Structure
For a number of years, supply-and-demand
dynamics worked in favor of hedge fund managers.
Limited capacity led to rising hedge fund fees, and
structures evolved with provisions that skewed
the alignment of interests between investors and
managers. Fee and fund term negotiations were
limited, and many managers hid behind most-favored
nation clauses, which were originally designed to
protect investors but became an excuse not to offer
concessions.
Hedge fund fees usually consist of:
The events of 2008 and the subsequent pressures
faced by many hedge funds led to a reevaluation of
the value added by hedge funds and the way this is
shared with investors. The terms offered by many
managers, as well as the traditional 2 + 20 fee
model, came under scrutiny. Investors providing
sizable allocations with a long-term investment
horizon found themselves in a position of
considerable negotiating power.
We believe skilled managers should be rewarded for
alpha. We do not believe that cheaper is better, but
we do think the combination of the hedge fund’s fee
and portfolio exposures (gross, net and beta) should
be structured to allow for a more reasonable alpha
split between the manager and end investor. Given
that investors place 100% of their capital at risk, we
view a two-thirds to one-third split of alpha between
investors and managers, respectively, as an ideal
division.
Here, we examine the structure of hedge fund fees
and terms, and how these have evolved since the
financial crisis. We believe that both are equally
important in achieving a structure that better aligns
the interests of funds with investors.
18 towerswatson.com
•• An annual management fee
•• A performance, or incentive, fee
We believe structures that are well aligned
should include:
•• Management fees that properly reflect the
position of the business
•• Appropriate hurdle rates
•• Non-resetting high-water marks (known as a
loss carry-forward provision)
•• Extension of the performance fee
calculation period
•• Clawback provisions
•• Reasonable pass-through expenses
Hedge fund managers should be compensated
for their skill (alpha) and not for delivering
market returns (beta). The separation of alpha
and beta is complex, but in our view worth analyzing
in detail. In the context of constructing appropriate
fee structures for hedge fund managers, we base
our estimates on assumptions of expected alpha
generation per 100% of gross exposure. This is
married with the forward-looking estimate of gross
and net exposures of the fund to calculate a gross
alpha expectation. Total fees payable are then
assessed as a proportion of total gross alpha. We
have a target level of about 30% to 40% of this
alpha being paid to the manager.
Annual management fees
The management fee — often set at 2% of assets
— provides the manager with revenue to cover the
operating costs of the firm. In some large funds,
the management fees may form a significant part of
the manager’s profit. We would prefer to see annual
management fees aligned with the operating costs
of the firm, leaving the performance fee for employee
bonuses. Over the past few years, we have seen
a material reduction in the management fees our
clients pay, resulting from both direct negotiations
with hedge fund managers as well as the inclusion
of alternative beta solutions in our client portfolios.
We would ideally prefer to see tiered management
fee structures (on a sliding scale), given that a firm’s
operating costs do not normally increase in line
with assets under management. We do, however,
recognize that there are some strategies where alpha
generation is reliant on growth in research resources
or significant ongoing technology investments.
Performance, or incentive, fees
Performance fees are usually calculated
as a percentage of the fund’s profits net of
management fees. The performance fee is
generally used to pay staff bonuses and equity
holders. Typically, hedge funds charge 20% of
returns as a performance fee, payable annually.
We believe historical performance fee structures do
not sufficiently align manager and investor interests
— managers share profits, but there is often no
mechanism for them to share losses, so there
is an incentive to take excessive risk rather than
targeting high, long-term returns. Structures that
contain hurdles, high-water marks and those that
defer fees with the ability to claw back in the event
of subsequent drawdowns are preferable. Where an
investment vehicle is set up to liquidate a portfolio,
we would prefer to see no performance fees charged.
Hurdle rates
The use of a hurdle rate signifies that a manager
will not charge a performance fee until performance
exceeds a predetermined target. Using a hurdle
encourages a hedge fund manager to provide a
higher return than a traditional — usually lowerrisk — investment.
A manager may employ a “soft” hurdle, where
fees are charged on all returns if the hurdle rate
is cleared. Others use a “hard” hurdle, where fees
are only payable on returns above the hurdle rate.
We prefer fee structures that include appropriate
hurdle rates. These should reflect the level of
net market exposure of the fund, although in
practical terms, this is sometimes difficult to
implement. A hurdle based on a risk-free rate
can be more workable.
High-water marks
A high-water mark can be applied to the calculation
of the performance fees to limit the fees payable.
It prevents a manager from taking a performance
fee on the same level of gains more than once and
means that a manager will only receive performance
fees when an investment is worth more than its
previous highest value. Should the value of an
investment decline, the fund must bring it back
above the previous highest value before it can
charge further performance fees.
Some managers make use of modified high-water
marks such as an amortizing high-water mark, which
spreads any losses over the longer term, enabling the
manager to earn at least some of the performance
fees in the current period. With a resetting high-water
mark, any losses are erased after a defined period of
time has elapsed, meaning managers can charge fees
again before reaching the previous peak value.
We prefer the use of traditional non-resetting highwater marks to ensure performance fees are not
paid on the same investment gains more than once.
However, we acknowledge that a period of earning no
performance fees can put tremendous pressure on
a manager’s business. This could lead to difficulties
in retaining talented investment professionals, and
create an incentive to close the fund and simply start
another one. A well-structured, modified high-water
mark provides managers with the resources to reward
their best-performing staff and enable them to stay in
business. An example of this type of structure might be
a reduced performance fee until 250% of losses have
been recovered. Our fee analysis shows that, in many
cases, the comparative cost to investors is negligible.
“A
“ well-structured,
modified high-water mark
provides managers with the
resources to reward their
best-performing staff and
enable them to stay
in business.”
Extending the performance fee
calculation period
The shorter the period over which performance
fees are calculated and paid to managers, the more
the fee terms are skewed in the manager’s favor.
Consider a situation where the performance fee
is calculated and paid quarterly: If the manager
delivers a strong first quarter and three subsequent
periods of underperformance, the manager would
still be paid a performance fee (at the end of the
first quarter) despite underperforming over the
course of the year. The investor nurses a loss for the
year, while the manager enjoys a performance fee.
In seeking to extend the performance fee calculation
period with managers, we aim to reduce the
optionality of the performance fee to a more balanced
structure, aligning the payment profiles of managers
and investors during both positive and negative
return periods.
Clawback provisions
This provision allows investors to claw back
performance fees charged in previous periods if
performance subsequently reverses. It links the fee
to longer-term performance, not a single year, and
means that fees are paid on average performance
over a longer period (of two to five years) or at the
end of a lockup period.
The Hedge Fund Landscape: Our Latest Thinking 19
Negotiating fee discounts
“Hedge
“
funds historically
have offered less
transparency than
traditional asset managers,
principally to retain any
perceived informational
and analytical advantage.”
On the face of it, lower fees are preferable, given
that they translate directly into higher net returns.
However, investors should be aware that negotiating
a disproportionately low management fee may
compromise the manager’s ability to execute its
strategy effectively. In addition, if an investorspecific fee is meaningfully lower than that of
other accounts, the manager’s incentive structure
may be distorted with respect to the allocation of
investments. A fee structure that is far below market
levels may also hamper the manager’s ability to
retain key investment professionals.
We believe that the terms offered by a hedge fund
manager are of equal importance to fees in aligning
the interests of the manager with the investor, as we
examine in Figure 3.
Below is an explanation of each of these terms and
our views on how each could be negotiated between
the investor and the manager.
Transparency
Hedge funds historically have offered less transparency
than traditional asset managers, principally to retain
any perceived informational and analytical advantage.
This has contributed to a reputation of secrecy. While
we have some sympathy with this, the dynamic of the
industry has changed, and managers must increasingly
respect the fiduciary reporting requirements of
institutional investors and their advisors.
The majority of hedge funds will now enter into
detailed discussions of the risks assumed and
significant positions within a fund, yet some
continue to offer limited transparency.
We insist on an appropriate level of transparency
in researching and monitoring hedge fund managers.
This can be in the form of access to key investment
professionals as well as portfolio transparency. Most
managers are willing to offer performance transparency
but some are reluctant to offer full position data,
which they consider to be a trade secret. To improve
transparency and monitor risk more effectively, we
use a third-party risk analytics provider that accesses
portfolio information via the administrator. This allows
an independent verification of holding and analysis of
the portfolio risk: Exposure, sensitivities and underlying
instruments used can all be tracked, and combinations
of managers can be modeled.
B. The Terms Offered by Hedge
Fund Managers
The main terms described in a hedge fund
contract are:
•• Transparency
•• Liquidity
•• Gates
•• Side pockets
•• Key-man clauses
•• Initial lock periods
Figure 3. Terms
Strategy
Manager 1 Multistrategy
Fixed-income
Manager 2
hedge fund
Macro hedge
Manager 3
fund
Equity long/
Manager 4 short hedge
fund
20 towerswatson.com
InvestorEarly redemption
level
fees
Liquidity gate
Hurdle
Terms
Notice
period
Lockup
period
Original
terms
45 days
2 years + 1
NA
full quarter
Annual
No
Negotiated
90 days
terms
3 years
hard
NA
3 years
Original
terms
1 year soft
3%
Negotiated 180
terms
days
2 years
hard
Original
terms
Fee per annum
High-water
mark
Base Performance
No
1-year
loss carry
forward
2.0%
20%
No
3-month
T-bills
Yes
1.5%
20% (back-ended)
Quarterly
25% per
quarter
No
Yes
2.0%
20%
NA
Quarterly
25% per
quarter
LIBOR 6%
Yes
cap
1.0%
15%
3 years
hard lock
NA
Annual
No
No
Yes
2.0%
20%
Negotiated
90 days
terms
3 years
rolling soft
lock
5% if redeemed
on first
anniversary + any
differential with
Annual
the fee structure
of the other share
class
No
LIBOR
Yes
1.5%
15% (back-ended)
Original
terms
30 days
1 year hard NA
Quarterly NA
NA
Yes
1.5%
20%
Negotiated
30 days
terms
1 year soft 4%
Quarterly NA
NA
Yes
1.0%
15%
90 days
90 days
Liquidity
Initial lock periods
Hedge funds typically offer monthly, quarterly or annual
liquidity, and ask investors to serve a minimum period
of notice for redemptions, normally ranging from 30
to 180 days. We believe the key concern here is that
the liquidity of the fund reflects the inherent liquidity of
the underlying portfolio. In addition, we insist that the
majority of redemption penalties be paid into the fund
rather than to the manager.
Initial lock periods can exist for a number of valid
reasons, most notably for newer funds, allowing time
for the manager to build up the portfolio, particularly
for a strategy that is relatively illiquid. Additionally,
managers may try to attract longer-term investors that
believe in and are committed to the strategy, or to
secure better terms from their counterparties.
Gates
Gates exist to provide stability to the portfolio in the
event of a large number of redemptions at one time.
These can be applied to each investor or to the fund
as a whole. Investor-level gates can help to mitigate
the “prisoner’s dilemma” of preemptive redemption
requests being placed, as was witnessed in late 2008.
However, fund-level gates, when applied judiciously, can
act as valuable guards to investors’ interests, ensuring
they are not left with the most illiquid assets. However,
a manager should first seek to match the liquidity
terms of the fund with the portfolio assets, rather than
rely on gates to protect the fund.
Side pockets
Some funds have side-pocket provisions that allow
them to segregate certain illiquid assets. Sidepocket assets cannot be redeemed by investors in
the same way as others. In most cases, it would be
disadvantageous to investors to liquidate the assets
before a particular date or development.
We believe that side pockets do serve a valuable
function as long as the legal documentation is clear
on how they are structured and there is monitoring
transparency. They should not be used by managers
as a way to segregate poorly performing assets and
improve the performance of the fund, nor should
fees be charged on them for indefinite time periods,
particularly if investors have expressed their desire
to redeem.
Key-man clauses
Hedge funds typically have key individuals who
are critical to the management of the hedge fund
strategy or business. Where a fund is heavily reliant
on key individuals, and where the fund does not
offer clients ready liquidity, we strongly favor the
use of key-man provisions, which ensure that critical
personnel remain in place, and in the event of
death, incapacity or resignation, allow investors to
exit the fund. Other clauses could relate to minimum
coinvestment levels or material changes in firm
ownership. Such provisions might include early
redemption rights that loosen lockup periods and
waive investor fees, or grant investors voting rights.
We believe the lock term should be reasonable and,
critically, that past the lock expiry, liquidity terms are
aligned with the portfolio of assets.
Holdbacks
Some funds return 100% of the proceeds from
redemptions to investors within days of the redemption
date. Others hold back 5% to 10% until a year-end
audit has been completed. For an investor redeeming
in January, an audit holdback could mean that funds
will not be returned for more than 15 months.
We would prefer to see a reduction in the use of
holdbacks, particularly for funds with liquid and
tradable securities. In the case of harder-to-price,
more illiquid strategies, there may be a stronger
case for holdbacks.
“We
“ believe that the fees
and terms offered by a
hedge fund manager are
of equal importance in
Active negotiation of fees and terms
aligning the interests of
We believe that the fees and terms offered by a
hedge fund manager are of equal importance in
aligning the interests of the manager with investors.
Since the financial crisis, we have been actively
involved in negotiating and designing appropriate
structures for our clients. Additionally, to encourage
transparency, our entire list of favored managers has
been migrated onto a third-party risk management
platform.
the manager with the
investors.”
We remain mindful that the fee concessions offered
by managers will often come at the cost of reduced
liquidity (generally an initial lockup period), so we
seek a balance when constructing portfolios of
direct hedge funds. An extended lock in a liquid
equity long/short strategy, for example, is harder
to justify in the context of an overall portfolio that
displays a significant degree of illiquidity.
Alignment of interests strengthens industry
Alpha is a scarce commodity, and we expect
to reward managers that are able to produce it
consistently. Those rewards had become skewed,
but since the events of 2008, managers are more
responsive to engaging in discussions with investors
on fees and terms. Many have moved toward
structures that better align the interests of investors
and managers, and this has been crucial to the
revival and growth of the industry.
The Hedge Fund Landscape: Our Latest Thinking 21
Activism: Strategy Overview
“The
“
extent of activism
can range from a longonly investment manager
simply voting its shares
at a company’s annual
general meeting (proxy
voting), through to a
private equity manager
taking control of
companies to effect very
direct change.”
In activism, investors use their ownership stake to
influence the way a company is managed. These
investors address a wide range of aspects, including
the choice of management in the underlying
company or the policies they employ.
The extent of activism can range from a long-only
investment manager simply voting its shares at a
company’s annual general meeting (proxy voting),
through to a private equity manager taking control
of companies to effect very direct change. There are
varying degrees of activism in between that can be
classified broadly into two groups:
•• There are active managers — including long-only
and hedge fund managers — whose investment
in a company is driven primarily by a view on
valuation rather than their intention to effect
change per se. These managers will, from time to
time, engage more actively with the management
teams of companies they own in situations where
they believe management is not maximizing value
in some material way. Direct engagement with
underlying companies is a secondary driver.
•• There are active managers — very often
structured as hedge funds — whose added value
proposition is much more driven by an activist
stance and where the investments they make
will be heavily predicated on their view that they
can successfully effect change that will increase
returns to shareholders. Direct engagement with
underlying companies is a primary driver.
Here we focus mainly on the latter group of
managers, as well as give our views on the
prevailing opportunity set for the activist style of
investment.
22 towerswatson.com
Approaches to Engagement
Activist shareholders use their stake in a company
to apply pressure on that company’s management.
The goals of activist shareholders range from
financial (seeking the increase of shareholder value
through changes in corporate policy, financing
structure, cost cutting and so on) to nonfinancial
(for example, disinvestment from particular
countries, adoption of environmentally friendly
policies and so on).
There are various ways an activist investor can
influence companies, such as engaging with company
management directly, gaining representation
on the company’s board of directors, publicity
campaigns, proposing shareholder resolutions,
discussions with large shareholders, litigation and
proxy battles, or participation on remuneration/
nominating committees. The success of the approach
will often be determined by how successfully the
activist engages with management and the extent
of the influence that can be brought to bear to
make changes happen in practice. Also important
is the content of any change and its likelihood of
succeeding. Content can cover operational changes
to the business (such as disposal of part of the
business, with reinvestment elsewhere), improved
cost management, financial changes (for example,
to balance sheet composition) or communication (for
instance, better communication of corporate strategy
with the market).
Activists will usually seek to identify an undervalued
company through deep fundamental analysis,
together with a detailed understanding of market
dynamics, governance structures and operational
capabilities. For this reason, it is common to
observe a number of activist teams with a
management consulting background and/or
private equity or banking experience. Beyond this,
the ability to engage with company management
to share not only the assessment of why there
is underperformance, but also to convince it to
implement the required change, demands very
specific skill sets, and it is here one typically sees
the distinction between collaborative approaches
and those that are more hostile and aggressive.
It is the subtleties of the way activists engage, their
reputational leverage and the credibility of their content
that will distinguish successful activist investors.
Approach Preference
Towers Watson prefers the more collaborative form
of activism, where the manager seeks to engage
(often very robustly) with company management
behind the scenes. Discussions are focused on
the implementation of structural changes within a
company to improve operating margins over time
or that lead to a business structure that is better
rationalized by the market, resulting in higher
valuation multiples. Often the target companies
are established franchises that have undergone
a period of poor management and share price
underperformance: As a result, the entry point itself
will offer some element of downside protection.
Typically, this style of activist is more income
statement-focused on the views and methods of
improving the operational efficiency of companies
over time.
This contrasts with more balance sheet-focused
approaches that tend to rely more heavily on the
use of leverage to generate return. Such approaches
also tend to be more aggressive in style, involving
activities such as the use of proxy fights, public
discussions on a company or its management’s
failings, and generally adopting a more adversarial
relationship with company management. This
carries the disadvantage that investors with the
activist manager can be inferred to hold the same
adversarial, and in some cases controversial, view
of a particular company or its management.
Irrespective of style, an activist is seeking to effect
change in a company’s management with the end
result of value accretion for all shareholders
and/or subsequent repricing upward to reflect the
improved structure. Whether the approach is hostile
(proxy fights and replacement of boards) or friendly,
the end goal is to unlock value. The duration of
investment and opportunity can be a multiyear
period with little recourse to interim liquidity, hence
it is very important that an investor in an activist
fund is satisfied that the activist offers sufficient
demonstrable skill to justify an allocation. Further,
activist hedge funds may have more restrictive
liquidity provisions than their fundamental long/
short equity or long-only peers, since their underlying
investments require a longer holding period due to
the time it takes for them to work with company
management to implement their plan. As large
stakes in target companies are held, it should also
be noted that exiting positions can have regulatory
restrictions or execution challenges.
We have observed that the more collaborative
activist approaches seeking to work with, rather
than against, incumbent management tend to have
an easier route to effecting positive change, though
by its very nature, activism is highly idiosyncratic and
situation-specific.
This idiosyncratic nature is also observed in exit
routes from positions that can range anywhere
from a simple share sale to an industry buyer,
to divestment of underlying businesses and
subsequent cash distribution, share repurchase or
corporate structure change, particularly increased
or special dividends. The fact that there is no one
method of exit allows inherent flexibility to the
strategy (levers to pull). Also, by investing in publicly
listed securities, there is always recourse to selling
at an established and identifiable market price. This
latter option also applies to being patient in waiting
for an entry price rather than being restricted to what
is for sale, which is often quoted as an advantage
over the private equity approach.
“We
“ have observed that
the more collaborative
activist approaches
seeking to work with,
rather than against,
incumbent management
tend to have an easier
route to effecting
positive change.”
The Activist’s Ability to Effect Change
The corporate governance landscape has changed
over recent decades, with more focus on company
management to increase returns to shareholders.
This can be achieved in a number of ways depending
on the business a company is involved in, its
ability to earn greater returns via improved capital
management or operational management, or indeed
running the business with the focus on generating
cash rather than growth and returning this cash to
shareholders.
We believe this greater focus on shareholder
returns provides a tailwind to activism, as there
is a greater awareness of management’s broader
responsibilities, including shareholders and the
media in general. This results in a greater openness
to engagement around a particular shareholder’s
viewpoint and changes that can be made to improve
returns, particularly where this investor has a track
record of adding value for all shareholders.
The Hedge Fund Landscape: Our Latest Thinking 23
Of course, there will always be scope for genuine
differences in views between investors and
management. For example, one opportunity for
difference might be over the time horizon. One
investor could have the objective of effecting change
within a company that will result in a near-term
increase in share price and an opportunity to exit
for a quick profit. These are often characterized
in the more balance sheet-driven approaches. An
alternative “buy and hold” shareholder may take a
longer-term view, waiting for management to make
decisions that will result in longer-term, better
returns on capital. This tends to be a feature of
the more operationally focused, income statementdriven approaches.
Company management can react differently to the
presence of an activist investor on its shareholder
register. Some might view this as having a strategic
consulting partner who has substantial experience,
is effectively providing free beneficial advice, and
whose interests are aligned with management and
other shareholders. This contrasts with employing
an investment bank or management consultant
(at significant cost), which are arguably more
incentivized to give advice that will maximize fees
(such as making an acquisition). In practice, the
initial reaction of company management is often far
more defensive.
The real nuance of an activist’s skills lies in the
ability to persuade company management to be in
the former camp and truly engage with the proposed
value-enhancement views. This is where we believe
the current environment is much more conducive
to engagement than, say, 10 to 20 years ago. The
personality and charisma of the activist investor is a
more pronounced success factor as a result.
Credibility and influence
An attractive element to investors of activism is its
simplicity and transparency. This belies the skills
applied by an activist to effect change, often going
no further than the confines of the boardroom.
That only a few investment decisions are taken
by an activist means the approach is highly pathdependent, in the sense that a successful company
management interaction and investment outcome
often lead to a positive reference point for the
following investment. The culmination of this is a
“rainmaker” reputation, where the market tends to
react positively to an activist disclosing, actual or
rumored, its involvement in a company.
A number of activists seek to be the largest
shareholder in a target company in order to have the
greatest influence over change. An important feature
that we have observed with successful activists has
been their ability to influence other shareholders
— often the large, passive managers — that invest
alongside them such that, in aggregate, a significant
influence on company management can be exerted
over and above the activist’s own shareholding. (It
is unusual for more than one activist to be involved
in a firm, though there have been some recent
examples.) In some cases, independent shareholder
advisors have also had influence over the outcome
of an activist’s investment.
“The
“
real nuance of an activist’s skills lies in the
ability to persuade company management to be in
the former camp and truly engage with the proposed
value-enhancement views.”
24 towerswatson.com
Size and capacity
As with asset managers in general, activists
range in size and capacity limitations from small
to mid-cap specialists managing limited amounts,
typically US$2 billion assets under management
(AUM) or less, through to more than US$10 billion.
Often the latter can target a larger company with
more capital: We have observed that this has been
one of the drivers of the more prevalent, recent
introduction of relative performance fees, as this
allows investors to allocate to activists as part
of their (typically larger) equity rather than
hedge fund allocation. The activist benefits from
greater influence as a result of capital available
for investment with company management, and both
ultimately benefit from the prospective improved
return on capital. An extension of this size argument
can be seen in the use of coinvestments in specific
situations to focus capital raising in high-conviction
ideas. By definition, this requires a specific
marketing effort by the manager.
Other Considerations
Portfolio profile, fees and liquidity
Activism is rarely a quickly implemented strategy,
and activist managers value stability in their asset
base in order to have a solid footing with which to
continue their engagement with their underlying
companies. As a result, investors are often asked
to commit to capital locks, with one-, three- and fiveyear periods (in some cases, rolling) common. Some
managers will offer quarterly liquidity, although
capacity in such share classes tends to be limited
by managers and is subject to higher fees.
Activist managers are generally bracketed as hedge
funds but, in practice, make very limited, if any, use
of leverage and limited to no use of short exposure.
As such, both the gross and net exposure will vary
close to 100%, akin to a long-only manager, although
hedge fund fee structures are commonly applied: a
base fee generally ranging from 1.5% to 2.5% and
absolute performance fees of 15% to 20%.
In these situations, we strongly prefer to see the
performance fee calculated and paid at the end of the
lock period so that this incentive is kept at risk during
the period that investors cannot access their capital.
We are seeing an increased adoption of relative
performance fee structures. We view these positively,
as they address the market beta element of a
manager’s return profile.
Portfolios are typically very concentrated: Five to
10 core positions are not uncommon, with a tail of
smaller toehold positions that are fundamentally
attractive, but where the engagement process with
company management is at an earlier stage.
As noted earlier, activists tend to make little use
of shorting. Where this is applied, it is typically
achieved through index exposure or broad baskets
of securities as hedging around corresponding core
positions. We would not ascribe a significant alphagenerative assumption to this blunt style of shorting
— core long alpha is what is being accessed with an
activist manager.
Our return-driver approach to portfolio construction
is more conducive to including the strategy since
Towers Watson is able to work with clients to
decouple component risk premiums, which are
generally equity beta plus alpha, and then include
them in their overall asset allocation by adjusting
allocations with significant equity beta elsewhere.
The significant equity beta of the strategy can create
challenges for funds of hedge fund or dedicated
hedge fund portfolio advisors where oversight of a
broader asset allocation framework is not part of
their mandate, as this equity beta often conflicts
with typical return objectives. The advent of relative
performance fee structures also supports the case
for an allocation within a long-only active equity layer.
Risk factors
•• Concentration issues: Portfolios tend to
be concentrated and highly idiosyncratic, meaning
that there will be a “lumpy” return profile with
single individual positions capable of causing
significant decay in performance should there
be obstacles encountered in the engagement
process.
•• Liquidity: What is the exit route? Given the size
of the position and the public awareness of the
position, is it easy to liquidate at a fair price?
•• Related to this point, it is possible for an activist
to be treated as an insider in a position, thereby
restricting their ability to trade in certain windows,
such as around earnings announcements.
The Hedge Fund Landscape: Our Latest Thinking 25
•• The experience and expertise of the activist in
the regulatory domiciles affecting its underlying
investments, for example, local rules relating to
how shareholders engage with each other — in
other words, there is a risk of a group of large
shareholders becoming a “concert partner,”
when they can be forced to bid for a company.
•• A high level of key man risk, given the specific
nature of the engagement process and its
transparency via public markets (positions being
reported in quarterly Form 13F/13D submissions
in the U.S., financial press and so forth): The latter
can create headline risks that some investors are
not comfortable being associated with.
•• The associated risks of a failed attempt in a core
position can have a potentially deleterious effect
on a manager’s reputation and credibility for
subsequent investments.
Versus private equity, long-only, replication
We note that activist managers operate within
the public equity markets, with the transfer of
positions to private ownership a relatively rare
occurrence and, in a number of cases, prevented
by fund documentation. As such, the activist
investment teams are inherently reliant on imperfect
information (relayed via public markets rather than
as a private owner of a business), and they also
have to implement their strategy in the full view
of public markets, which can lead to near-term
volatility of share prices as the market assimilates
developments. A private equity manager has the
benefit of being able to implement change away
from this public forum.
“By
“ investing in public markets,
activists can often overlap in positions
with long-term ‘buy and hold’
long-only managers that can often
benefit as a result of the work by
activist managers.”
26 towerswatson.com
A criticism leveled at private equity managers is
that they can face a limited opportunity set, with the
resultant risk that this can lead to overpaying, and in
those instances, driving attractive returns becomes
very difficult even with the full range of activist tools
available. Comparatively, there may also be greater
recourse to the use of leverage by some private
equity managers than a more income statementfocused activist that is striving for a gradual
improvement in company operating margins. It
should be noted that not all private equity managers
place a heavy reliance on leverage, and in a number
of instances, they have a principal focus on adding
value via operational and strategic improvement.
The attraction of shareholder activism lies in its low
capital requirement compared to similar approaches
to unlocking value by private equity managers —
that is, a fairly small stake (less than 10% of
outstanding shares) may be enough to launch a
successful campaign. In comparison, a full takeover
bid is typically a much more costly and difficult
undertaking.
By investing in public markets, activists can often
overlap in positions with long-term “buy and hold”
long-only managers that can often benefit as a result
of the work by activist managers. The advantage to
an investor is that this is often achieved at a low
fee rate (typically less than a 1% flat fee) and in a
liquid comingled fund or managed account format.
These managers, however, tend to run comparatively
more diversified portfolios, so the benefit of this
work is not quite as pronounced in return terms,
plus the long-only manager is not in control of the
engagement process with the company concerned.
We view this as a key characteristic of activism.
That said, with the requirement in the U.S. for asset
managers over US$100 million to report their long
equity holdings and for disclosure of stakes of over
5% of a firm by a fund with activist intentions (Form
13F/13D filings), this data source is increasingly
mined as a source of activist alternative beta by
index providers at comparatively lower fees and
greater liquidity than offered directly by activist
managers. By definition, these approaches are
“coattail” and reactive, although the low-turnover
nature of activist portfolios does lend itself to this
type of approach, and if one can marry a lower alpha
expectation to lower fees and improved liquidity, it
becomes a potentially attractive portfolio allocation,
principally as it can incorporate the views of a
range of managers rather than one in particular.
However, certain activist managers will be more
successful than others, and so, indirectly, manager
due diligence and selection remains an important
ingredient to success. Further, a significant amount
of value is often realized from the appreciation of
a company’s stock when the news of an activist’s
involvement becomes public. Investing based on
lagged public filings would not capture this.
What Would Constitute a Less
Compelling Environment for Activism?
There are some factors that we believe would make
activism a less compelling investment approach.
Some examples of these are as follows:
•• Significant change in corporate governance/
regulatory environment impacting shareholder
participation
•• Evidence of persistent allocation to cash within a
portfolio (signalling a weak opportunity set)
•• Significant decline in corporate M&A activity
•• Significant increase in market volatility — should
the volatility persist, it could erode the willingness
of companies to undertake many of the actions
that activists suggest, as high-volatility regimes
are often associated with company management
uncertainty, increasing financing rates/spreads
and a decrease in M&A activity
What Does Towers Watson Look For in
a Good Activist Manager?
•• An investment team with company management
experience, often management consultancy or
private equity backgrounds
•• Evidence through their detailed fundamental
research of a strong knowledge of the underlying
businesses in which they are invested and why
their proposed value enhancement strategies
make sense
•• Demonstrable reasons why they will have the
credibility to influence company management:
Path dependency is important — prior success in
investments and continued positive relationships
with prior company management as well as other
shareholders that often act as references
•• Awareness of risks — selection of entry point
is important
•• Appropriate fund terms — a liquidity structure that
supports the process as well as a fee structure
that ideally addresses the often significant net
market exposure
Conclusion
We believe that the backdrop for activist investing
is benefiting from significant tailwinds, and that the
strategy is one where manager alpha can be more
tangible and identifiable than other hedge fund
strategies. Investors do need to factor into their
decision whether to invest the significant equity
beta that is inherent in the strategy, as well as
their ability to accommodate a level of illiquidity.
However, the portfolio benefits of a highly active
and concentrated approach can make a significant
contribution at the aggregate portfolio level, be this
either as part of a hedge fund allocation or broader
equity long-only layer.
The Hedge Fund Landscape: Our Latest Thinking 27
Improving the FoHF Model “The
“
genesis of today’s
issues dates back to the
1990s, when the hedge
fund industry was much
smaller and more opaque
than it is today, and
institutional investors
started to consider hedge
funds as a good addition
to their portfolios.”
Over the years, we have frequently discussed the
flaws of FoHFs and continue to welcome discussion.
While some of the best-in-class FoHFs recognized
and addressed some of these flaws, the vast
majority of offerings remain suboptimal. This is true
of mainstream, diversified, multistrategy pooled
FoHFs and even the separate accounts offered by
some of these organizations. In addition, many
pooled FoHFs that claim to be niche or specialist
often still have the majority of their portfolios
invested in relatively mainstream hedge fund
strategies.
The genesis of today’s issues dates back to the
1990s, when the hedge fund industry was much
smaller and more opaque than it is today, and
institutional investors started to consider hedge
funds as a good addition to their portfolios. FoHFs
were then created to offer preferential access to the
alpha — the very best hedge funds could produce.
At the time, the alpha produced by the wider hedge
fund industry was also substantial because it had
a first-mover advantage, and the industry was much
smaller and dominated by truly skilled investment
professionals.
As the hedge fund industry has grown and matured,
the majority of FoHFs have failed to adapt to reflect
the new reality where they produce less alpha, and
institutional investors have more ready access.
Persistent weaknesses include:
Poorly aligned fees. The absolute level of FoHF fees
remains too high, on both a pooled and a separate
account basis. Although fees have slowly declined,
in our view, there is still a long way to go. The
problem is that the FoHF industry has an inflated
28 towerswatson.com
cost structure that can be supported only on the
old fee model. It is clear that the new fee model
is considerably lower, and in that scenario, most
cannot survive.
Performance fees should also be much better
aligned with investors’ interests. In particular,
they should be based only on true alpha creation,
not total return. Most performance fees are
not designed in this way and therefore actually
encourage some misalignments (more so than a
basic ad valorem fee).
FoHFs should also consider ways to avoid assetgathering incentives over time, for example, by
setting strict capacity levels in advance.
High underlying manager fees. Through better
negotiations with managers and, in particular,
the use of well-designed hedge fund smart beta
products, it should be possible to attain an average
fee far lower than the typical fees found within even
the best FoHFs. Of course, one should never choose
a manager on the basis of fees alone: The net alpha
(net of both fees and beta) is key. So FoHFs should
make more use of fee-modeling tools and their
relationships with underlying managers to ensure
that the proportion of forward-looking true alpha
being paid in fees is appropriate for each hedge
fund as well as at the total FoHF level.
Correlation. Correlation with equity and credit beta
is generally higher in FoHFs than most institutional
clients would like. Unless fee structures change
radically, FoHFs should rarely include significantly
net-long long/short equity and credit hedge funds,
as most investors would be better served getting
this exposure via their long-only managers. Of
course, that is not something an FoHF can do,
hence, correlation persists.
Overdiversification. The number of managers in a
portfolio should be more limited than is typically
the case to ensure that it remains a focused fund
while still running the appropriate risk levels. At the
moment, most FoHFs are overdiversified and have
stayed open too long, having not set limits on the
number of funds and/or diversification at the outset.
Asset/liability mismatch. Many FoHFs have
historically offered greater liquidity to clients than
they actually have in the underlying funds, which can
cause huge problems if clients start redeeming at
the same time. While many FoHFs have improved
on this, they are still generally not very flexible on
redemption. For example, dilution levies are unusual,
and FoHFs do not typically make it possible to pay
redeeming clients in units rather than cash where
there are any remaining locks.
Transparency and risk monitoring. Only the very
best FoHFs get holdings-based risk analyses
done on all of their underlying funds. More direct
managers should put their portfolios on proprietary
or established third-party platforms, allowing
the production of a combined total portfolio risk
analysis, which would be far more transparent.
Change Is Needed
A number of traditional FoHFs have transitioned
into hedge fund solution providers, offering a range
of services across customized, opportunistic and
advisory-style mandates. This has introduced
additional competition into the marketplace,
which can only be a good thing for the end client.
Others have looked to address some of the areas
of concern, but most have not, and overall fees
remain far too high. To put this in perspective,
an institutional client investing in a typical FoHF
achieving a net return of cash plus 5% per annum
would likely be paying fees of close to 5% per
annum. This is not acceptable. Change is needed.
“A
“ number of traditional FoHFs have
transitioned into hedge fund solution providers,
offering a range of services across customized,
opportunistic and advisory-style mandates.”
The Hedge Fund Landscape: Our Latest Thinking 29
Hedge Fund Portfolio Construction
Key Considerations
“It
“ is paramount to have
a dedicated and wellresourced hedge fund
research team to conduct
the bottom-up manager
due diligence.”
The process of constructing a hedge fund portfolio
is both an art and a science. While the flexibility
managers have allows them the possibility of
generating alpha, it also means that selecting the
appropriate managers necessitates expert analysis
and judgment. Our goal in this section is to focus
on hedge fund portfolio construction, with less of
an emphasis on how to identify the best managers
through due diligence.* Below, we discuss what we
believe are several of the ingredients for success.
Manager Universe
A universe of high-conviction hedge funds across
a variety of strategies is the starting point for any
hedge fund portfolio. It is paramount to have a
dedicated and well-resourced hedge fund research
team to conduct the bottom-up manager due
diligence. Our experience in building and managing
portfolios for clients supports the belief that hedge
fund manager selection insight comes only through
primary research.
In addition to investment due diligence, conducting
operational due diligence prior to approving a
manager may identify important risks. Operational
due diligence is the part of the process where the
hedge fund business is reviewed to assess whether
the proper controls, resources and procedures are in
place to adequately support investment and trading
activities.
Finally, an analysis of a hedge fund manager should
include a review of the manager’s capacity (i.e.,
whether the manager with its management style is
able to take in additional assets without impeding
its ability to invest). Even region-specific constraints
such as the ability of a manager to take ERISAclassified assets may need to be examined.
Guidelines and Constraints
The starting point for constructing a hedge fund
portfolio from this universe of high-conviction
managers is establishing appropriate investment
guidelines and constraints. Often, these will be
client-specific, expressing risk tolerances and
preferences framed by overall portfolio objectives
that typically include:
•• Return and volatility targets. For example, a
typical target return for a diversified hedge fund
portfolio might be LIBOR + 4% to 6% annualized,
with annualized volatility of 4% to 8%.
•• Strategy allocations. Investors may want to limit
their allocations to certain strategies or weight
others higher.
•• Exposure guidelines. Such guidelines are put in
place to minimize the risk of capturing market
exposures that are redundant with other parts of
a portfolio. Often, investors are sensitive to equity,
credit or other risk premiums across their asset
allocation and look to hedge funds as a source of
diversified returns.
•• Liquidity guidelines. Investors will have different
tolerances for liquidity and will typically express
this with reference to proportions of the portfolio
that either need to be realizable in a specified
period of time, or a maximum proportion that can
be locked up for a given period of time, or both.
•• Maximum percentage allocations to any one
manager to mitigate manager-specific risk. This
can be based on a simple percentage of capital
allocated or on the downside risk of the manager.
•• Drawdown or stress period management. It is
informative to see how the portfolio would have
behaved in prior stress periods, as well as to
make projections on how it could behave in future
periods, making certain assumptions.
*For additional content related to our views on hedge fund fees, terms, alpha assessment and other interesting topics, please reference our
book: Hedge Fund Investing — Opportunities and Challenges, available at towerswatson.com.
30 towerswatson.com
•• FX hedging policy and choice-of-fund share
class. For instance, while most hedge funds offer
U.S.-dollar share classes, for clients outside the
U.S., it may be important to have a share class
denominated in their home currencies.
While these hedge fund portfolio constraints are
fairly common, there are still many others that are
possible.
Diversity Versus Dilution
There is a balance between achieving diversity in a
hedge fund portfolio and having too many managers
in the portfolio so that it dilutes any meaningful
benefit from strong manager selection reflected in
returns. We would argue that overdiversification
(dilution) is one of the most common mistakes that
investors make when building a hedge fund portfolio,
adding complexity while debasing conviction.
How prevalent is hedge-fund-of-fund dilution today?
And what are the implications for investors? Today,
most hedge funds of funds have 30 to 50 (or
more) managers, resulting in alpha being diluted
or diversified away, eroding opportunity for the
investor. Consider Figure 4, which shows Towers
Watson’s highest-rated hedge fund managers. It
is clear that the reduction in risk by adding the
next manager is indistinguishable well before
reaching a 30-manager portfolio. There are other
factors in addition to volatility reduction, such as
the liquidity of the portfolio and achieving the right
strategy allocation at a higher level, that have to be
considered when justifying a higher manager count.
But we would argue that a portfolio of more than 20
to 25 managers begins to look more like an index
— making it increasingly difficult in our minds to
justify high fees. Finally, the added complexity of a
large manager lineup makes it more difficult to stay
on top of each manager in the portfolio and creates
governance challenges that are unnecessary if the
portfolio is constructed appropriately.
Complementary Strategy, Style and
Manager Allocations
Diversification across strategies and styles, and
low pairwise correlations between managers should
ideally lead to a portfolio that exhibits low volatility
and beta while still generating alpha. A hypothetical
portfolio will help us illustrate how powerful this
diversification effect can be in a hedge fund portfolio.
Importantly, the primary goals of this portfolio include
low annualized volatility and low beta to equity
markets. Where the client already has a significant
public equity allocation, the ability of the portfolio to
serve as a diversifier is just as important as its ability
to generate returns.
Strategy Allocations
As illustrated in Figure 5, the portfolio is allocated
across several broad strategies. It was built with
a higher allocation to diversifying strategies such
as macro and statistical arbitrage, which tend to
exhibit less volatility and beta than more directional
strategies such as equity long/short. A sizable
allocation to “smart beta” managers was included
— these funds are structured to capture many of the
diversifying characteristics of hedge funds, but at a
fraction of the cost.*
Figure 4. Benefits of hedge fund manager diversification
16%
14%
12%
Where additional managers have
minimal impact in reducing volatility
10%
8%
6%
4%
2%
0%
0
10
20
30
40
50
Number of managers
Figure 5. Strategy allocation for the hypothetical portfolio
Proposed hedge fund strategy breakdown
11%
17%
11%
15%
9%
9%
11%
18%
17% Credit long/short
15% Equity long/
short directional
11% Multistrategy
18% Discretionary macro
9% Systematic macro
9% Smart beta — CTA
11% Smart beta —
Reinsurance
11% Equity long/shortstatistical arbitrage
*For more details on Towers Watson’s smart beta thoughts and capabilities, please contact your Towers Watson representative for a copy of
Understanding Smart Beta, August 2013.
The Hedge Fund Landscape: Our Latest Thinking 31
Manager Allocations and Relationships
“While
“
diverse strategy
allocations are important,
it is just as important
to make sure that the
underlying managers are
generally uncorrelated in
order to achieve the type of
portfolio volatility profile
(i.e., low volatility with
downside protection) that
most institutional clients
demand.”
equities based on a statistical approach that
focuses on the relationship between securities over
time and the propensity of the relationships to mean
revert, and has a low correlation with each of the
other equity long/short managers in the portfolio
(0.0 and –0.1). Further, the manager maintains a
book that is neutral to equity market beta and also
exhibits a return profile that can be complementary
(i.e., uncorrelated) with other strategies — for
instance, the manager’s correlation with the overall
portfolio is among the lowest, at 0.10.
While diverse strategy allocations are important, it
is just as important to make sure that the underlying
managers are generally uncorrelated in order to
achieve the type of portfolio volatility profile (i.e.,
low volatility with downside protection) that most
institutional clients demand. One way is by allocating
to managers that have different styles, even if they
trade the same broad strategy classification. To
illustrate, consider a few examples in Figure 6 and
the references within.
Macro-managers can deliver returns that are
uncorrelated with major markets and often
post positive returns during challenging market
environments as other strategies suffer (e.g., many
were positive in 2008). This diversifying element
and the potential to offer downside protection were
therefore important considerations in constructing
the portfolio. In addition, the macro-allocation
deliberately included three managers that had
historically low pairwise correlations due to their
style differences. Manager seven is discretionary
and focuses almost entirely on trading Asian interest
rate, foreign exchange and equity markets. Manager
eight is also discretionary and focuses entirely
on G7 interest rate trading. Finally, manager nine
is systematic (i.e., rule-based and model-driven)
and trades across a variety of markets and asset
classes. While a core competency of each manager
is to formulate macroeconomic views across
countries and markets, and then express these
views through investments, managers are still quite
diversified by region, asset class and style.
Managers one and two are each credit long/short
managers. However, despite trading in the same
markets (i.e., credit spreads and related securities),
the correlation between the two is fairly low, at only
0.30. This is because they each have very different
styles. Manager one is a bottom-up, fundamental
manager that does deep analysis and research on
individual companies, and also does a fair amount
of investing in Asia. The other manager is tradingfocused, tends to run a fund that is market-neutral
to spreads and rates, and is focused on short-term
technical factors and trading spreads between
developed-market debt securities.
Managers three and four are traditional equity
long/short managers that take a fundamental
approach to stock selection, taking long positions
in companies they think will appreciate and short
positions in companies they believe are overvalued.
While these two managers exhibit a low correlation
with each other (in this case, 0.10), a third equityfocused manager exhibits the same characteristics
as well as broader benefits. Manager 11 trades
Figure 6. Examples of allocation by manager style
Correlation
to total
portfolio
1.Credit l/s manager (7%)
0.5
2.Credit l/s manager (9%)
0.2
3.Equity l/s manager (6%)
0.4
4.Equity l/s manager (9%)
0.4
5.Smart beta — Reinsurance (11%)
0.1
6.Multistrategy manager (11%)
0.5
7.Discretionary macro-manager (7%)
0.5
8.Discretionary macro-manager (11%)
0.2
9.Systematic macro-manager (9%)
0.6
10.Smart beta — CTA (9%)
0.5
11.Equity l/s manager — Statistical arb. (11%)
0.1
32 towerswatson.com
Pairwise correlations
1
2
3
4
5
6
7
8
9
#
11
0.3
–.01
0.2
0.0
0.2
0.2
0.1
0.1
0.1
–.01
0.1
0.1
0.0
0.3
0.0
–0.1
0.2
–0.1
0.1
0.1
0.0
0.4
0.0
0.0
0.1
–0.1
0.0
–0.2
0.2
0.2
–0.1
0.2
0.1
–.01
0.1
–0.4
0.0
0.1
0.2
–.01
0.1
–0.1
0.2
0.0
0.2
0.1
0.2
0.1
0.1
0.3
0.2
0.2
A
C
0.6
0.0
–0.2
B
B
Factor-Based Projections and
Stress Testing
Volatility and Correlation Stress Testing
While back-tested returns are certainly useful for
understanding the historical characteristics of a
given manager’s portfolio, they are still historic data.
This understanding of history, supplemented by
transparency and applied to current asset classes,
regions, sectors and, in many cases, individual
securities that are held by managers, allows for
forward-looking analysis and scenario testing.
Rather than simply relying on the historical returns
of the underlying managers, in this important
stage of the process, we map the exposures of
each of the underlying managers (e.g., equity,
credit, rate, currency, commodity) and attempt
to project how the portfolio would have behaved
in previous environments given each manager’s
current positioning, as illustrated in Figure 7.* This
allows an investor to formulate expectations of the
future sensitivity of the portfolio to similar stressevent scenarios, as well as material up and down
movements in asset classes.
Additionally, a considerable amount of quantitative
and qualitative effort is employed to project what
each manager’s potential downside is based on its
volatility profile and, critically, to stress-perceived
correlation benefits of each manager that were
considered and discussed earlier. This part of
the process helps us understand whether there
is too much reliance on our perception of worstcase scenarios or the correlation benefits of each
manager, especially since during extreme stress
environments, volatility levels can significantly
exceed normal levels, and correlations can
dramatically increase as risk assets sell off in
tandem.
“While
“
back-tested returns
are certainly useful
for understanding the
historical characteristics
of a given manager’s
portfolio, they are still
historical data.”
For example, we consider the historical volatility
of each manager and the loss implied by a twostandard-deviation move. Then our dedicated hedge
fund research professionals, in conjunction with our
portfolio construction specialists, will assign a left-tail
multiplier to this volatility projection. The multiplier
can range from between one and five, and reflects our
Figure 7. Projecting portfolio behavior in previous environments
3
2
4
3
Bull market move
Bear market move
2
2
1
1
1
0
0
–1
–1
10% shock to
commodity prices
30% shock to credit
spread
100 bp shock to
interest rates
–2
–2
10% shock to US$
exchange rate
Credit seize 2009
2007 subprime
markets
TMT bubble
bursting
September 11
attacks
1998 Russian
financial crisis
1997 Asian
financial crisis
–3
10% shock to
equity markets
–1
–2
Note: A bull market move is a favorable shift for a particular market; a bear market move is a negative
shift for a particular market.
.
Non-dollar-denominated funds might still show a currency stress test in US$s.
For illustrative purposes only — returns are not meant to represent an actual client portfolio.
*A third-party risk aggregator is utilized to assist in the calculations.
The Hedge Fund Landscape: Our Latest Thinking 33
belief about how vulnerable a manager is to market
shocks, particularly those that impact asset classes
where the manager is exposed. Position-concentration
levels, leverage and the liquidity of the markets in
which the manager trades are all examples of things
we consider when arriving at a multiplier. Figure 8
illustrates how these figures are used to calculate
the portfolio’s returns in stress environments. As
illustrated, in our opinion, the worst-case scenario
is the very unlikely chance that all managers are
perfectly correlated during a stress scenario and that
each experiences its maximum projected loss — the
result, as one would expect, is considerably worse
than the historical two-standard-deviation portfolio
return.
Figure 8 shows hypothetical expected portfolio
losses using the following volatility-based loss
estimates:
•• Two-standard-deviation event — historical. Based
on the realized volatility of past returns for each of
the underlying managers
•• Two-standard-deviation event — projected.
Based on the estimated forward-looking volatility
of returns for each of the underlying managers
•• Two-standard-deviation event — historical, lefttail adjusted. Based on the realized volatility of
returns for each of the underlying managers, with
a left-tail multiplier applied to each manager’s
historical volatility
•• Two-standard-deviation event — projected,
left-tail adjusted. Based on the estimated
forward-looking volatility of returns for each of
the underlying managers, with a left-tail multiplier
applied to each manager’s historical volatility
While this exercise has a number of uses, perhaps
its most important use is to determine the
differences in stress-environment returns and their
sensitivities to things such as correlation. This also
applies on a time-series basis, where changes in
these metrics over time can signal an overreliance
on assumed correlation benefits or volatility
assumptions.
Back-Tested Returns
In combining the universe of appropriate managers
with the guidelines, principles, risk analysis and
judgment noted in this article, the portfolio manager
will determine an initial portfolio that is expected
to meet a client’s objectives. A review of how this
aggregate portfolio would have behaved historically
is then a valuable analysis, all while overlaying
the analysis with qualitative judgment to account
for things that are not easily measured (manager
conviction, among other factors) before the final
portfolio is determined.
Figure 8. Hypothetical portfolio losses based on various loss estimates
Estimated loss
Two-standarddeviation event
•• Historical
Two-standarddeviation event
•• Projected
Two-standarddeviation event
•• Historical
•• Left-tail adjusted
Two-standarddeviation event
•• Projected
•• Left-tail adjusted
–5.0%
–6.3%
–15.4%
–19.5%
Assuming manager correlations = 0.5
–10.5%
–11.7%
–32.7%
–36.2%
Assuming manager correlations = 1
–14.2%
–15.8%
–42.7%
–48.5%
Using historic manager correlations
For illustrative purposes only — returns are not meant to represent an actual client portfolio.
“In
“ combining the universe of appropriate managers with the
guidelines, principles, risk analysis and judgement noted in this
article, the portfolio manager will determine an initial portfolio
that is expected to meet a client’s objectives.”
34 towerswatson.com
Figure 9. The return profile of our hypothetical portfolio
The result is a portfolio with low beta, volatility and downside protection. It is designed to be a complement to existing asset allocation.
Volatility versus benchmark (HFRI FOF) is lower despite an 11-manager portfolio versus hundreds.
Returns (%)
Month
QTD
Return pa (%)
1 year
3 year
Best and worst
month SI
SI*
Volatility
(%) SI
Sharpe
Ratio SI
Beta SI
Max (%)
drawdown
Recovery
(months)
Portfolio
1.02
2.97
7.74
5.51
7.53
2.61
–2.21
3.30
2.04
—
–3.40
Objective
0.36
1.08
4.46
4.46
4.88
—
—
—
—
—
—
2
Benchmark
1.00
3.46
4.88
2.13
–0.22
3.32
–6.54
6.22
–0.16
0.24
–20.11
52
Equities
1.88
6.63
11.19
7.81
1.14
11.49
–19.91
21.31
0.02
0.05
–51.73
50**
High Yield
0.88
2.83
10.12
5.85
6.68
12.60
–16.53
15.53
0.38
0.04
–37.68
13
—
**
Notes: Equity is MSCI AC Global; High Yield is Merrill Lynch US High Yield Master II.
*SI means since inception of the portfolio (April 1, 2008).
**Indicates the recovery is ongoing
For illustrative purposes only — returns are not meant to represent an actual client portfolio.
In Figure 9, we consider the return profile of the
hypothetical portfolio that was discussed above and
develop back-tested returns for a period spanning
several years. Generally, the goals, as specified at
the outset of this exercise, were achieved over this
period:
•• The portfolio would have exhibited lower volatility
than equity or credit markets, as well as the
benchmark Hedge Fund Research Inc., HedgeFund-of-Funds Index (HFRI FOF), despite having
allocations to only 11 underlying managers
versus hundreds (on a look-through basis) in the
benchmark.
•• Further, the portfolio’s beta to equity and credit
markets would have been quite low.
•• Finally, during periods of market declines and
stress, the portfolio would have managed to
preserve capital with minimal drawdowns.
Finally, once a portfolio is implemented, there
should be a formal, ongoing process for review in
which many of the same considerations discussed
above are again vetted. This ongoing review process
is critical since a less-than-robust process and
ongoing resource commitment can lead to materially
negative outcomes, given the flexibility that
hedge funds may have to deviate from previously
understood parameters.
Both Art and Science
The process of constructing a hedge fund portfolio is
both an art and a science, and can be very iterative
in nature before the final portfolio is eventually
implemented. We hope this section illustrates many
of the tasks inherent in building an appropriate
hedge fund portfolio for a client’s unique situation.
Controls and Ongoing Monitoring
Critical to the process is the control environment,
which we believe is enhanced by including
experienced professionals in the approval process
who are not exclusively focused on hedge funds
to bring additional high-level objectivity. These
professionals serve as independent and objective
client advocates. The goal at this stage of the
process is to incorporate a healthy dose of
skepticism about underlying managers in the
portfolio and their allocations so that a relationship
with a manager, or bias toward a manager or
strategy, doesn’t cloud judgment.
The Hedge Fund Landscape: Our Latest Thinking 35
Into a New Dimension
An Alternative View of Smart Beta
The investment landscape is changing. Smart beta,*
a concept gaining significant investor interest, is
a term we use to cover a broad spectrum of ideas
that challenge the traditional black-and-white split
between alpha and beta. We believe this is good
news for investors. In this section, we:
“While
“
many of the ideas
have been around for
years, there has been little
interest in using a broader
beta set to construct
portfolios, in part because
good implementation
options were not
available.”
•• Show that some of what was once called alpha
can, in fact, be captured as beta
•• Develop a broader framework for thinking about
returns, adding an implementation strategy
dimension to the traditional asset class definition
•• Examine the diversification properties of some
of the new — or so-called “alternative” — betas
that come from this broader framework
•• Consider implications for alpha and beta
While many of the ideas have been around for
years, there has been little interest in using a
broader beta set to construct portfolios, in part
because good implementation options were not
available. We believe this is changing.
Therefore, we think that investors should:
•• Consider allocating directly to these new betas
because they have low correlation to equity and
credit markets
•• Consider the beta exposures embedded in active
mandates and the appropriateness of the fees
they are paying for these exposures
*See appendix for the bulk beta/smart beta/alpha continuum.
36 towerswatson.com
The Alpha/Beta Debate Has a
Long and Evolving History
Prior to modern portfolio theory, there was no easy
way to understand performance — investors could
ascribe returns only to manager skill or perhaps
luck. However, investors realized their portfolio
returns were linked — to a large degree — to a
common driver, namely, the performance of the stock
market as a whole. The development of the Capital
Asset Pricing Model (CAPM) and indexation led to
a new way to understand performance: The market
(as described by a capitalization-weighted index) was
beta, and excess return was active management,
or alpha. The idea of market capitalization indexing
in other major markets such as government and
corporate bonds also took hold.
Even in the early days of the CAPM, academics had
identified groups of equity securities with certain
characteristics — such as value, low volatility
and momentum — that offered returns not easily
explained by the simple market model. These groups
of securities could be described and captured
systematically.1, 2
Some ‘Pure Alpha’ Is Captured by Beta
The most recent chapter in the debate relates to
research on active managers, in particular, hedge
fund/returns — once considered the ultimate
expression of pure alpha investing. In fact, many
studies show that a significant proportion of
aggregate hedge fund returns can be explained
by beta.
To illustrate this point, in Figure 10, we show
cumulative returns for hedge funds (as represented
by the Hedge Fund Research Inc. Composite Index)3
and a combination of beta investments. The thesis
is simple: While individual funds may exhibit pure
alpha, hedge funds, as a whole, pick up some
common sources of return. This is particularly true
for a broad collection of hedge funds, such as those
represented by an index.
As can be seen, the majority of hedge fund returns
have been captured over this period by betas. Hedge
funds did outperform modestly, despite the zero-sum
game of active management and high fees. On a
risk-adjusted basis, however, returns for the hedge
fund index and the beta combination are similar.
Figure 10. Illustrative cumulative return
250
200
150
100
50
0
c.
De
96
c.
De
97
c.
De
98
c.
De
99
c.
De
00
c.
De
01
02 . 03 . 04 . 05 . 06 . 07 . 08 . 09 . 10 . 11 . 12 . 13
c
c
c.
c
c
c
c
c
c
c
c
c
De
De
De
De
De
De
De
De
De
De
De
De
Hedge Fund Composite Index Beta combination
Return over cash % per annum
Risk (standard deviation) %
Risk-adjusted return
Hedge Fund
Composite Index
Beta combination
5.1
7.4
.69
4.3
5.9
.73
This analysis and the performance figures are backward-looking and intended to illustrate the portion
of net hedge fund returns that can be captured by various market betas. The beta combination figures
do not represent an actual portfolio return. Results of an actual portfolio invested in this way would
vary depending on the timing of transactions, fees and other factors. Products designed to access the
strategies utilized may not have been available to investors for all or part of the time span covered here.
The hypothetical beta combination being used for comparison is shown gross of fees.
The Hedge Fund Landscape: Our Latest Thinking 37
Figure 11 shows the beta allocations broken down
for each of the main HFRI categories. As well as
bulk betas such as equities and credit, we add
alternative strategies such as value or momentum.
The allocations are intuitive. For example, long/
short equity strategies have a greater exposure to
equity market beta, whereas fixed income relative
value strategies pick up bond and credit beta.
Similarly, macro hedge funds include an exposure
to momentum (trend) following strategies. The
Figure 11. Beta allocations matched to hedge fund strategies
exposure to the volatility premium across most
categories is likely to come from the typical lefttailed pattern of hedge fund returns.
We can also assess the importance of beta by
looking at return patterns. Figure 12 shows the
percentage of monthly hedge fund returns that can
be explained by beta — a highly significant 84%
for the broad HFRI index. Differences by strategy
are again intuitive — higher for equity long/short
(more equity exposure) and lower for macro (more
idiosyncratic strategies). Figure 13 shows that the
finding is also remarkably consistent over time.
100%
Figure 12. Percentage of hedge fund returns
explained by beta combination*
90%
80%
70%
HFRI strategy
Percentage
Relative value
64%
40%
Equity I/s
84%
30%
Event
67%
Macro
48%
Composite index
84%
60%
50%
20%
10%
0%
Relative value
Equity l/s
Event
Macro
Composite
index
Alternative beta
Carry Vol. premium Momentum Equity value Equity size
Bulk beta
Credit spread Gov bonds EM equity spread DM equity spread
Figure 13. Percentage of hedge fund returns (HFRI composite) explained by
beta combination — Rolling three years
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec.
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
38 towerswatson.com
*R^2 measure from monthly regression of returns — See appendix
Visually, the drawdown chart of Figure 14 also
shows the closeness of fit: The dips appear at
the same time and, broadly, to the same extent.
Finally, we offer a note of caution. Our intention
is not to replicate hedge fund returns per se or
to demonstrate that alpha has disappeared. The
analysis is backward-looking and the betas fitted
with hindsight.
It should also be acknowledged that active
managers have been responsible for identifying
many of the strategies that are now being
commoditized as beta. Nevertheless, the analysis
does present some interesting issues for active
management going forward (as discussed later).
A Broader Framework for Beta — Into
a New Dimension
To date, beta has been synonymous with asset
classes and indices. An asset class groups together
securities with similar characteristics, for example,
equities or bonds. Once defined for inclusion in an
index, the securities are generally buy and hold,
changing little over time.
As can be seen from Figure 10 (page 37), we include
examples of betas that do not fit into a traditional
definition. At this stage, it is worth setting out a
broader perspective on beta, although we shy away
from a precise definition:
•• The securities capture a premium for exposure to
common sources of risk or return.
•• The process has low fees and costs.
•• Manager skill is primarily used for access
(sourcing or selecting securities) and good
implementation.
The majority of passive assets globally are in
equities and bonds. Because these are simple,
cheap and liquid, we refer to them as “bulk beta.”
However, under our broader description, we can
extend bulk beta in two main ways:
•• Implementation strategies. Here we refer to a
strategy of owning or tilting toward securities
with specific characteristics, and not holding (or
shorting) those without.4, 5 Examples are carry
(own higher-yielding securities) or momentum (buy
securities that have recently appreciated). The
idea also includes thematic investing — owning
assets with characteristics that should benefit
from a long-term investment horizon.
•• Extending asset classes to nontraditional areas
such as currency or commodities. We also
include strategies that are derived from an asset
class. For example, the volatility strategy captures
a premium for unanticipated volatility in an asset
class, rather than returns from the asset class.
“It
“ should also be
acknowledged that active
managers have been
responsible for identifying
many of the strategies
that are now being
commoditized as beta.”
•• Defined processes are applied to select a group of
securities with common characteristics. Simplicity
and transparency are preferable.
Figure 14. Drawdown chart
0%
–5%
–10%
–15%
–20%
–25%
Dec. Dec. Dec. Dec.
96 97 98
99
Dec.
00
Hedge Fund Composite Index
Dec. Dec. Dec. Dec.
01
02
03 04
Dec. Dec. Dec.
05
06 07
Dec. Dec.
08
09
Dec. Dec. Dec. Dec.
10
11
12
13
Beta combination
The Hedge Fund Landscape: Our Latest Thinking 39
An interesting perspective can be gained by
considering this broader beta set in two dimensions
(Figure 15). Going down the table, we extend our
asset class universe to diversifying areas such
as currency, commodities and volatility. (We omit
others for brevity.) Across the table, we extend
beta to implementation strategies, separated into
systematic and thematic ideas.
to generate positive returns over time. We discuss
alpha a little later within a broader context of skill.
All Very Interesting, but Why Bother?
As with most things in investment, risk and return
are key considerations. A striking feature of these
new betas is that they have great diversification
properties, both between themselves and —
perhaps more importantly — to traditional asset
classes.6 To illustrate this, Figure 16 shows
correlations for pairs of betas. As can be seen,
correlations are highest in traditional markets such
as equities and credit.
The broader set of betas is not theoretical. The ticks
in the table refer to betas where we have found good
solutions to implement and continue to investigate
new ones.
We can also fit traditional alpha neatly into this
framework. We would characterize alpha as
discretionary processes to select markets/securities
Figure 15. Broader opportunity set
Systematic
Implementation strategies
— Examples
Return drivers
Asset classes
Equity
Equities
Term/inflation
Bonds
Credit
Bonds
Currency
Currency
Insurance
Volatility 
Commodities 
Carry
Thematic
Momentum Value








EM
Deleveraging




Alpha
Stock
selection
Market
(beta)
selection

Bulk beta Alternative beta Alpha
Figure 7. More diversification from alternative betas
Correlation
Equities vs. credit
Equities vs. value
Carry vs. momentum
Equities vs. volatility premium
Best = lowest
Worst = highest
0.33
0.86
–0.72
0.65
–0.40
0.38
–0.10
0.68
Average
0.59
–0.22
0.03
0.22
Rolling three-year correlations from December 1996 to December 2013
40 towerswatson.com
Some Implementable Solutions
Not all things that can be called beta will necessarily
generate positive returns. Our approach is to
consider the following questions:
•• Rationale — What economic risks or behavioral
effects are we capturing, and why should they
exist?
•• Evidence — What academic or other evidence is
there? Do we have out-of-sample tests? Can we
independently substantiate the findings?
•• Beliefs — What do we believe about the world
going forward? Will it be different from the past?
We have been researching smart beta strategies
for a number of years, often working with the
investment community to develop new products from
scratch. Figure 17 summarizes the performance
characteristics of an implementable alternative beta
portfolio shown in Figure 18 and compares it to
hedge funds (HFRI index).
Figure 17. Illustrative performance summary
HFRI index
Average return % per annum
Standard deviation %
Max drawdown %
Equity beta
% of returns explained by alternative
beta portfolio
Alpha and Skill — The Role of
the Investor
This broader beta framework adds a space between
bulk beta and alpha. The terms “alpha” and “skill”
are often used synonymously, and investors have
often outsourced alpha generation to specialist
44
This hypothetical alternative beta portfolio analysis is shown net of estimated fees. Please
see appendix for fee assumptions and additional information.
This analysis and performance summary are backward-looking and intended to illustrate the
portion of hedge fund returns that can be attributed to various market betas. The figures do
not represent an actual portfolio return. Results of an actual portfolio invested in this way
would vary depending on the timing of transactions, fees and other factors. Products designed
to access the strategies utilized may not have been available to investors for all or part of the
time span covered here.
Figure 18. Example alternative beta portfolio
7.5%
12.5%
7.5%
17.5%
As Figure 17 shows, this alternative beta mix would
have performed well, especially after adjusting for
risk. Sensitivity (measured by beta) to traditional
asset classes such as equities has been low. Note
also that the alternative betas do in fact explain
some of the hedge fund returns, although not by
design, confirming the presence of alternative beta
in hedge fund returns.
5.4
4.4
–12
0.1
December 1996 to December 2012
The portfolio features:
•• Strategies using long and short positions,
where relevant, which result in low exposures to
traditional markets (and therefore low correlation
by design)
•• Strategies that can be accessed cost-effectively
elsewhere are avoided, for example, equity value
can be accessed cheaply in long-only mandates
with equity smart betas
•• The allocation that uses portfolio construction
principles, scaling for risk (including tail risk) and
diversity; we do not try to replicate hedge fund
returns, per se, with either individual strategies
or a combination
•• Low management fees relative to existing
methods of access (say, 50 bps per annum versus
a 2 + 20 hedge fund fee scale)
5.1
7.4
–23
0.4
Alternative
beta portfolio
12.5%
25%
17.5%
12.5%
7.5%
12.5%
17.5%
25%
17.5%
7.5%
Emerging market currency
FX carry
Multi-asset carry
Volatility premium
Reinsurance
Momentum
Commodities
fund managers. However, we think there is an
opportunity for investors to capture new sources
of returns — as beta — by applying governance
or skill in a broader sense.
It is fair to say that these ideas require more
time and expertise to understand and manage
than traditional asset classes. Some of them
are, in part, based on behavioral or structural
explanations and therefore require investor
beliefs about the rationale and sustainability of
returns. We might also argue for a complexity
premium, available to investors that have or can
develop appropriate governance. The additional
governance may be a barrier for some investors,
particularly those with predominantly simple
passive portfolios.
“The
“
terms ‘alpha’ and
‘skill’ are often used
synonymously, and
investors have often
outsourced alpha
generation to specialist
fund managers.”
Some of the ideas have limited capacity or
cyclical return patterns, and their effectiveness
may diminish over time. Similarly, over time, new
strategies will emerge that can be commoditized
as beta. So monitoring and selection of betas is
very important — a form of alpha in itself.
The Hedge Fund Landscape: Our Latest Thinking 41
•• Manager selection is key. While this seems
obvious, there may be a presumption that hedge
fund managers are an above-average bunch, and
therefore, the usual zero-sum game argument
does not apply. While this may be true before
fees, it is harder to justify net of fees. As shown
earlier, we saw some additional return from hedge
funds, but the argument is finely balanced.
•• Overdiversified hedge fund strategies risk moving
to industry-average returns and therefore closer to
the returns that can be captured with beta. This is
exacerbated when FoHFs are used.
Compared to alpha, the governance emphasis is
shifted toward understanding, constructing and
managing beta allocations rather than manager
monitoring and evaluation. From a clear sheet
of paper, we would argue that this broader beta
framework entails more up-front governance, but less
ongoing governance than alpha. Investors can, of
course, have both beta and alpha, and indeed, this is
what we would advocate, where governance allows.
Implications for Alpha
In this section, we make a case that some of what
has been labeled alpha can be captured as beta.
This is good news, as beta is (or should be) cheaper
than alpha. We are not suggesting that alpha is
not worth pursuing; genuine alpha is a source of
uncorrelated returns and therefore much valued for
portfolios.
However, there are some implications for active
management, particularly for hedge funds:
•• Investors should consider the fees being paid for
alpha, bearing in mind that some could, in fact,
be beta. There is nothing wrong with including
beta in an active mandate, providing that fees are
appropriate. To help with this, we consider fees as
a share of alpha.
“Overdiversified
“
hedge fund
strategies risk moving to
industry-average returns, and
therefore, closer to the returns
that can be captured with
beta.”
In Summary
In Figure 19, we draw together the key messages from this paper.
The development of smart beta challenges the traditional split
between alpha and beta, building a space between them. This
creates an opportunity for investors that have or want to develop
the skills to capture these sources of return.
While many of the ideas have been around for years, there has
been little interest in using a broader beta set to construct
portfolios, in part because good implementation options were
not available. We believe this is changing.
Figure 19. The traditional split between alpha and beta
Beta
Alpha
Old definition
•• Returns from passive market capitalization exposure in
traditional markets
•• Returns from active management
New definition
•• Returns from broader set of asset classes and strategies
that are exposed to common risk (or other) factors
•• Returns that cannot be explained by exposure to
common risk factors
So what?
•• Can be considered in a broader framework
•• Investor skill needed
•• Some of what was alpha is beta
Portfolio implications
•• Understand beta exposures
•• Beliefs in new betas: Risk and return properties
•• Consider appropriate exposure to betas (portfolio
construction) and method of access
•• Pay appropriate fees for alpha
•• Consider overall contribution to return from beta
and alpha sources
•• Focus on true alpha generators
42 towerswatson.com
Into a New Dimension: An Alternative View of Smart Beta
Appendix
Bulk Beta, Smart Beta and Alpha
•• Bulk beta — Traditional market cap
passive investment in core asset classes
such as equities and bonds. Bulk beta
should be simple and liquid.
•• Smart beta — Strategies that move
away from market cap indexation in
traditional asset classes. We therefore
include nontraditional asset classes and
systematic processes to capture common
sources of risk or return. We divide smart
beta strategies into three areas:
•• Diversifying. Alternative asset classes
that have low correlation with traditional
markets
•• Systematic. Strategies that capture new
risk premiums or exploit inefficiencies in
market cap investing
•• Thematic. Capturing mispricing
opportunities by being a long-term investor
As far as is practical, strategies should
be beta-like in nature — simple, low cost,
transparent and so on.
•• Alpha — Discretionary process to select
securities and/or markets. Alpha cannot
be explained by either bulk or smart beta.
Beta and Hedge Fund
Regression Results
•• Data from December 1996 to December
2013
•• Sources: HFRI, FTSE, MSCI, Merrill Lynch,
AQR, Ken French, Bloomberg, Towers Watson
•• Beta strategies used:
•• Developed-market equities: U.S.
equities
•• Emerging-market equity spread:
Emerging-market equities less global
equities
•• Government bonds: U.S. government
bonds
•• Credit spread: U.S. high-yield bonds less
U.S. government bonds
•• Equity size: Fama-French U.S. size factor
•• Equity value: Fama-French U.S. value
factor
•• Momentum: Multi-asset trend following
strategy based on prior 12 months’
performance
•• Volatility premium: Short volatility
strategy on the S&P 500 index
•• Carry: FX carry strategy represented by
1.8*FTSE FRB10 index
R^2 is a statistical measure giving the
percentage of monthly return variation that
can be explained by a given strategy. In
this section, we show the percentage of
the variation in hedge fund returns that
can be explained by a combination of beta
strategies, with the allocations shown in
Figure 11.
The beta allocations depend somewhat on
the way in which strategies are defined, as
well as the time period used. Nevertheless,
the broad conclusions in this paper are valid.
Illustrative Performance
Summary Fee Assumptions
•• Beta strategy returns being analyzed are
a combination of manager back-tests,
indices and live data.
•• A 3.5% per annum penalty has been
applied to manager back-tests and index
returns as a broad deduction to account
for fees, expenses, trading costs and
survivorship bias.
•• Where manager live data were used, the
data are net of fees.
•• An additional 40 bps per annum was
deducted across all strategies to simulate
an investment advisory fee.
Endnotes
1. Many of the alternatively weighted equity strategies capture common betas such as value and small cap. See for example, “The Surprising ‘Alpha’ from Malkiel’s
Monkey and Upside-Down Strategies,” Arnott, Hsu, Kalesnik and Tindall, Journal of Portfolio Management, summer 2013.
2. Within equity stock selection, these risk premiums are often referred to as “style premia.” The ideas come from work by Fama-French (value and small cap),
Jegadeesh-Titman and later, Carhart (momentum) and are not new. The work on style premia has largely been used to understand and attribute active equity
manager performance, rather than to consider the merits of the premium on a stand-alone basis. In part, this reflects controversy over the sources of return and
dominance of thinking around the efficient market hypothesis.
3. The HFRI Fund Weighted Composite Index is a global, equal-weighted index of over 2,000 single-manager funds that report to the HFR database. Constituent
funds report monthly, net of all fees, performance in U.S. dollars and have a minimum of US$50 million under management or a 12-month track record of active
performance. The HFRI Fund Weighted Composite Index does not include funds of hedge funds.
4. The selection of desirable assets could be at the country or sector level, rather than individual security level (e.g., weighting equities toward lower-cost countries or
sectors). In other asset classes, this makes more sense (country selection for government bonds) or is the only choice (there are no securities in FX).
5. It is possible to isolate the pure risk premium by constructing long and short portfolios — holding securities with desirable characteristics and shorting those with
undesirable characteristics, balancing holdings in such a way as to remove or significantly reduce the underlying market risk. This approach is often used in academia,
for example, with the Fama-French value and small capitalization factors for equities. In practical terms, the cost of doing this needs to be carefully considered.
Implementation with liquid futures markets makes the approach more cost effective. For stock-selection strategies, long/short strategies are less cost effective.
Access to premiums can be achieved in long-only portfolios by tilting toward desirable characteristics, depending on the exposures to the premium needed.
6. This does not guarantee future diversity. We are aware of the potential for correlation and downside risks, depending on the specific strategy being considered.
The Hedge Fund Landscape: Our Latest Thinking 43
Summary
Hedge Fund Research: Time and Effort Well Spent
We hope the information and analysis in this book will be helpful
to you in your future deliberations over hedge fund allocations.
We have demonstrated that there is no single way to invest in hedge
funds, no single strategy that suits all investors and that there are a
lot of considerations to take into account when doing so.
Alpha opportunities do exist, even as volumes
in many markets rise, and we believe investing
time and resources in identifying these
opportunities and formulating the right way
of accessing them will be amply rewarded.
Equally, there are strategies that provide
decorrelated returns with indices that do not
necessarily require investors to invest in hedge
funds and pay hedge fund fees.
44 towerswatson.com
Towers Watson has considerable expertise in
this area and for years has helped clients to
navigate their way through the issues. But we
recognize there are no right or wrong answers
and that this book forms part of an ongoing
dialogue about the options available. In that
respect, as in others, we look forward to your
feedback and comments.
Please note:
This document was prepared for general information
purposes only and should not be considered a substitute
for specific professional advice. In particular, its contents
are not intended by Towers Watson to be construed as
the provision of investment, legal, accounting, tax or other
professional advice or recommendations of any kind, or
to form the basis of any decision to do or to refrain from
doing anything. As such, this document should not be
relied upon for investment or other financial decisions,
and no such decisions should be made on the basis
of its contents without seeking specific advice. This
document is based on information available to Towers
Watson at the date of issue and takes no account of
subsequent developments after that date. In addition,
past performance is not indicative of future results. In
producing this document, Towers Watson has relied upon
the accuracy and completeness of certain data and
information obtained from third parties. This document
may not be reproduced or distributed to any other party,
whether in whole or in part, without Towers Watson’s
prior written permission, except as may be required by
law. In the absence of its express written permission to
the contrary, Towers Watson and its affiliates, and their
respective directors, officers and employees, accept no
responsibility and will not be liable for any consequences
howsoever arising from any use of or reliance on the
contents of this document, including any opinions
expressed herein.
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