By: Andrew Saunders, Director, EFX Prime Services, Member, AllAboutAlpha.com Editorial Board

To paraphrase Mark Twain, the reports of the death of fund of funds (FoFs) may have been greatly exaggerated. Recent surveys seem to show a future that – to borrow Ben Bernanke’s phrase now – “unusually uncertain” (see posts here, here, here and here). However, intermediated investment in hedge funds (i.e. funds of funds) look to remain an integral component of the hedge fund investment universe for years to come. Today’s seven questions are for Fabio Savoldelli, CIO, and Rachel S.L. Minard, Partner and Executive MD of Optima Fund Management. Their collective experience can offer some insights into the operations, investment and marketing of the FOF of 2010. Savoldelli has held many CIO positions at large asset management firms including Merrill Lynch Investment Managers, Chase Manhattan Private Bank and Swiss bank. Minard has held business development leadership roles at Corbin Capital and Cadogan Management before recently joining Optima. She is a past recipient of Foundation & Endowment Money Management’s “Non-Profit Marketer of the Year.”

Q1: Rachel, Pension and Investments recently issued a list of the top North American investors in hedge funds/Fund of Funds. The list offered some interesting insights into asset flows and showed that the assets managed by the top 10 FOF had fallen 27% (from ~25 bln to ~18 bln.) What is the future of Fund of Funds? What is your expectation for this trend going forward? What factors will turn it around?

RM: Recent redemptions from HFs and FOFs is a reflection of four factors: 1) the need for cash to cover portfolio liabilities resulting from unexpectedly high 2008 correlations and illiquidity; 2) a need for cash given 2008’s unexpected gates and lock-ups across most portfolios; 3) Issues like Madoff, 2008’s negative performance, headline risks, the unmet promise of “absolute returns” – all forcing investors to question the efficacy and ROI of HF investing; and 4) shifts in asset allocation resulting in consolidation of hedge fund investments.

A longer-than-expected recovery in HF asset flows is the result of a confluence of these factors (which are endemic across almost all asset classes). Coming into 2008, HF investors believed they were well diversified, but ultimately they were not. Where they thought they could be resilient, they ultimately could not be. And where they thought HFs would protect capital, alas, most were unable to.

In the future, we are likely to see a new paradigm of FOFs. The 90’s saw FOFs as an aggregation tool that enabled investors to access top HF talent and a way to outsource research given the time, expertise and resource-constraints of the institution. Starting in early 2001, small or emerging managers were the rage and identifying those “stars of tomorrow” secured a competitive edge for many FOFs. Diversification then was predicated on allocating sub-5% with a melange of HF managers, ideally dampening the losses by spreading out the risk.

Less than a decade ago FOFs were intentionally opaque for fear of relinquishing those small manager names since they believed the special sauce was more in the manager names selected (pedigree) than in needing to understand the investment process used to construct the portfolio.

Then came the mega-launches (TPG Axon, etc.) that delivered access, “first call” privileges and capacity. By 2006, however, global investors in FOFs realized most of the good FOFs held the same top managers. Ninety percent of the world’s HF investments are in the top 200 HFs after all. Moreover, consultants and intermediaries were becoming more sophisticated and could secure access to these managers themselves, requiring FOFs to offer investors more than a Rolodex or a self-proclaimed “proprietary optimization model.”

The ability to clearly articulate a macroeconomic story and a thematic edge, coupled with a talent for expressing those ideas has now become a key success factor. It is no longer enough to simply invest in great managers. One must know why they are there and what investment catalyst, exactly, warrants that conviction. One might rightfully explain how alpha was generated and beta dampened (in terms of style, sector, strategy, commodity, geography, volatility etc.). Investors want to know their fund can withstand volatility shocks and they want their FOF manager to show quantitative proof of this resilience.

By the time 2008 came and went, the largely commoditized FOF industry needed to justify their “fees upon fees”, particularly if their performance suffered, thus counter-acting their self-proclaimed “absolute return” promise. As a result, FOFs are now at an interesting crossroads. Consultants are now constructing portfolios of direct HFs for their clients, disintermediating the FOF business. FOFs which relied on “access” and “capacity” now need to explain “the problem their fund is meant to solve.” In other words, the fund’s specific portfolio objective (liability hedge, alpha generator, inflation hedge, etc.) takes the front seat while performance, once the only factor one cared about, is a shadowy second to process, resilience, transparency and a clear understanding of what and where the innate risks and ROI can be found.

Q2: You have been recognized by institutional investors for your marketing acumen. What does the successful FOF of 2010/2011 look like in terms of marketing and client service?

RM: Let’s first define “successful”. Even if a FOF manager has the highest operational standards, due diligence process, marketing and client service, and it has a solid long-term track record, the hard reality remains: if the firm can’t deliver a return over the long-term that is in line with investment objectives, it has failed to do the job it was hired to do.

Imagine, for a moment, being an SEC auditor. Your job is to uncover every aspect of a firm and fund’s inefficiencies, potential conflicts, transparency, holes in its investment processes, cracks in its risk management and determining the integrity and credibility of those findings. After that meticulous assessment, the SEC auditor then aggregates those facts, evaluates every facet of a firm’s operational risk and business management functions to ensure what’s claimed to be reality, actually is and can be rightfully proven.

One then hands this report to a trial lawyer who has to take those findings and defend every line item to win over an already skeptical and cynical jury (i.e. an investor or board, who believes everything he/she reads about hedge funds). If the trial lawyer succeeds in persuading the jury to see the merit in hedge fund investing, even with their own money, you have succeeded.

An institutional marketer is never really “selling” – only listening to the needs of the investor, then aggregating proof, substantiating claims, justifying convictions and persuading (again, not “selling”) the jury on a fund or firm. It’s an extraordinarily complex, demanding art.

Q3: How are you addressing the tremendous attention that has been given to managed accounts?

RM: Managed accounts are the natural result of the post-2008, post-Madoff experience and the need for liquidity and transparency by institutions. Managed accounts are increasing in popularity because they offer transparency, “better terms” for liquidity and access to managers many of the commingled funds could simply not provide. We see more and more global institutions considering managed accounts as a remedy for the investment mistakes they made in 2008.

Moreover, institutions everywhere are allocating a nominal portion of their portfolio to cash. Cash has become not just a hedge against all other investments but a safeguard in each portfolio to offset the liabilities they’re still working to unwind. Managed accounts, while arduous to construct, also enable any investor to feel they’re given the “special” treatment that comes with these vehicles. However, some still maintain the concern that customized managed accounts run the risk of being ignored by managers whose main focus is their flagship fund.

Q4: Talk to us about the changing demands of your clients. What questions are they asking? What are the questions they aren’t asking but should?

RM: Interestingly, there are two schools of thought on this. The first is that the demands of hedge fund investors have indeed grown exponentially since 2008, and that their questions are more onerous. The other school of thought is that these questions and demands have remained the same but the expectations placed upon the HF manager to provide quantifiable answers and substantive evidence have increased.

It’s simply not enough for a FoF to have a slick brochure, a pedigreed name and a reputable manager roster and to expect the client to figure out the benefits for themselves. Now each hedge fund manager must work much harder to demonstrate how returns are generated, where risks lie and how each part of the investment process is executed. I sometimes wonder why it took a debacle like 2008 for many managers to realize that perception is not reality – that just because a manager has a large asset base does not make them a great manager.

By being inquisitive and honest, skeptical FoF managers have set a new bar for the global institutional investment market. The FoF manager who asks the tough questions is the one left standing now. Some managers need to stop hiding behind the “anomaly” of 2008 or the various “crises” we’ve faced, embrace the facts and deliver accurate information to their clients. Investors often don’t even need an academic interpretation of how alpha was achieved, but clear evidence that it has been achieved – without compromising investment, operational, business and risk standards.

Q5: Fabio, what are the qualities of a successful hedge fund manager? What qualitative factors/predictive variables does your team look for?

FS: There are some factors that are absolutes, and some “relative factors” that we are willing to view in a greater context. The “absolutes” are non-negotiable – ethics and edge. Without them, there is no point in going forward. The ethics in a fund must be found to be broad and deep. By “broad”, I mean that it must be evident in all employees. We look into the obvious legal and regulatory issues, but we also look at more subtle cues. For example, a glowing reference from ten sources may not outweigh a mediocre reference from one trusted source. “Broad ethics” also means consistency. A portfolio manager who offers monthly liquidity, but has a book that would take far longer to liquidate is either incompetent or ethically lacking. Either way, we would not proceed. The hedge fund universe is rife with examples of funds whose stated ethics are at odds with their actions. Statements and actions must be consistent, or we do not proceed.

“Deep ethics” in an organization means that ethics – and ethical controls – really permeate the organization so that no single unethical employee is in a position to ruin the organization.

In addition, managers must have some “investment edge” they can elucidate – some characteristic that sets them apart. It is a subtle point. That edge need not be narrowly defined; and, unlike ethics, you can have “too much of a good thing”. A tremendous bottom-up stock picker in the healthcare sector, for example, could be at a disadvantage to a solid equity analyst who blends his or her skill with an understanding of the political process. Many skill-sets can create an edge, but every skill can also have a downside if taken to the exclusion of others. It’s a balance of skills that creates the edge. A large part of our own work is dedicated to identifying that “edge”.

From that point on, it becomes more about the sustainability of the process and with it, we evaluate the potential endurance of the edge. We evaluate the research process as well as the quality of research. Is there depth to the team? To the experience? What is the source of alpha? Is it market-timing skill? Sector knowledge? Stock-specific knowledge? One key, yet often-overlooked, factor is the ability to admit and learn from mistakes. You often find that managers who have never been humbled by the market soon are, and that is where the work in assessing the risk controls pays off.

Q6: Okay then, share some insight into the investment process? How many funds in your database? Watch list? Portfolios? How do funds migrate into the portfolio?

FS: We adhere to a very disciplined investment process. When Rachel and I began working in the hedge fund world, you could probably host a cocktail party for most of the major managers in a Manhattan restaurant. Now, there are two realities: (1) there are about 7,700 hedge funds, and (2) it is our view that a large percentage of them are not very good.

In absolute terms, however, the number of talented managers who have left the long-only world, proprietary trading desks or other hedge funds has never been greater, and a process is needed to separate the gold from the dross. Our own process for doing this has three major steps and can be characterized as “survival of the fittest”, I guess.

Leveraging our internal network of experienced hedge fund investors is a crucial aspect of the first step. A simple write-up is submitted for consideration first to the Manager Selection Committee, and secondly to all senior members of the firm. With all of the funds out there, we want to be sure to focus our resources on the highest-probability candidates. The purpose of the first step is to enable the entire firm to review a fund and share any experience(s) regarding the manager, or someone who knows them. Reactions can range from being enthusiastic (e.g., “I knew him when he was at some predecessor fund and was great”) to scathing (e.g., “Don’t waste your time,” or “Over my dead body.”). As of now, we have over 700 funds in Stage One.

Stage Two is a thorough, in-person process of due diligence during which time we use our proprietary due diligence questionnaire as the basis for our analysis. We generally prefer to have two analysts present at meetings to witness not only managers’ replies but also their body language. This way, the two analysts can compare their ‘feel’ for the manager. The completed work is presented to the Manger Selection Committee, which openly and freely debates the fund’s merits (and flaws). Dissent is not only encouraged but expected, and it usually surfaces.

In all my years doing this, I cannot think of one fund that went through the process without a ‘bring back’: some point, some question, some open issue that gave another analyst pause. The sector analysts will return to the fund with these follow-up questions and then return to committee again with answers and clarifications. This happens again and again until the fund is passed or halted and assigned an NCI rating (“No Current Interest”).

Analysts are not compensated based on the number of funds introduced. We do not believe in the “one fund a month” quota commonly seen in the industry. We only want the highest-conviction managers to make it through the system. We currently have over 300 funds at Stage Two.

At Stage Three, the analysis process graduates from the Research Department and moves on to being reviewed by the independent Risk Team. With a separate line of reporting (to the CFO, not CIO) and a different compensation structure, they are not influenced by the passion an analyst may feel for a new, exciting fund. They have an independent veto over all potential – and current – allocations. They will have about 60 funds under consideration at any given time. In the end, there are about 80 funds on the bench (passed but not invested) and 115 funds to which we currently have allocations.

Q7: I’m curious to know if your approach to portfolio construction has changed in the last 10 years? Does your multi-strategy product look largely similar in terms of strategy allocation from 10 years ago or has it changed? If so, how?

FS: We are great believers in the importance of adding value at both the allocation and portfolio manager selection levels. Part of the overall role of a Fund of Funds manager is to tilt the portfolio to allocations that afford the greatest opportunity. The asset allocation and portfolio construction processes are journeys, not “destinations”; you never arrive at the perfect asset allocation, and there are always additions to the process that can be considered as additive to performance. This is a “dial, not jump” strategy – we do not sling the portfolio around, but the movement can be striking over time.

Every quarter, we congregate as a team to generate a firm-level view looking nine months forward. We begin by examining economic fundamentals and projecting key factors – from global equity markets to rates and currencies. Based on this assessment, we derive an outlook for various strategies (i.e., event-driven or global macro). At that point, every analyst reviews every one of their respective funds, ranking them from 1 to 5 to indicate their outlook over the next nine months and to evaluate long-term skill. Each quarter, these rankings are reviewed and compared to the various funds’ actual performances.

The strategy selection process is analogous to equity analysis in that we consider how the sector will perform, whereas the individual manager ratings are analogous to individual stock selection. Once the views are constructed, we have a guideline for how we wish to monitor the funds and portfolios.

While maintaining VAR as a component of our toolbox, we moved much more to sector and position-level exposure analysis to guard against excessive concentration and the risk of manager “group think”.

“Bonus” Question: The alternative asset management industry is becoming more competitive as new entrants and more institutional marketing efforts counteract the negative headlines of 2008. Where do you see your biggest competitive pressure and your greatest opportunity?

RM: Our biggest competitors are essentially everyone: institutional investors who want to manage their own portfolios without the partner-guidance of an advisor; consultants who have been constructing FOF portfolios for years and winning new mandates from the very clients they’ve been hired to advise; multi-strategy HFs who believe diversification is the safeguard their clients could use right now; and other FOFs who are trying to capture market share across all facets of the industry.