Andrew Clare, chairman of Fathom Financial Consulting and head of asset management at the Cass Business School, said the rapid growth in demand for absolute return strategies could mean investors ignore some of the associated risk.
Investment in hedge funds has grown rapidly since 2000 after the bursting of the technology media and telecoms bubble made the positive returns achieved by these vehicles particularly attractive.
Their success over this period prompted large institutional investors, who were traditionally cautious in their approach, to re-evaluate their positions and look to move money into these types of products, usually through a fund of hedge funds proposition.
The industry has swelled to more than 7,000 funds and Clare (pictured) said it is reaching a point where certain strategies are close to capacity.
“Investing is a zero sum game, meaning that if someone’s making money someone else is losing money,” he said. “I would suggest we’ve probably reached capacity in terms of long/short equity.”
One big problem uncovered by Clare’s research was that performance fees, which are supposed to align the managers’ interests with their investors do not appear to function as they should.
With a 2% annual fee of assets under management, plus 20% of performance based on a high watermark, the expectation is that managers would seek to achieve their targets and control risk to safeguard their fee.
However, managers who are missing their targets have taken on risk to try to boost the short-term performance.
“Returns are much more volatile for managers who are out of the money,” said Clare. “Risk grows relative to their peer-group if they are not achieving top decile returns.”
Somewhat counter-intuitively managers who are top decile relative to their peers tend to reduce risk as they attempt to lock in strong returns along with managers who are out of the money, who are trying to restrain losses.
Those who take on risk tend to be at or around the money want to increase short-term performance to cross the high watermark and start collecting their fee.
Owing to these risks Clare estimated that a fund of funds portfolio needs to contain about 25 funds to mitigate against undiversifiable risk.