The Risk-On, Risk-Off Teeter-Totter: How Managers Adapt

In the September 2013 issue of The Cerulli Edge, the research and consulting firm Cerulli looks at the place of hedge funds within U.S. asset management, in an article aptly titled “Institutions Look to Hedge Funds for Risk Management and Diversification.”

Its kick-off premise is that risk-on and risk-off environments now alternate with dizzying speed, so asset managers in general have to “fortify their product lines with offerings that have appeal in both.”

Managers have had some time to develop their abilities in this line dramatically since 2008. The first half of 2013 was a time of at least cautious optimism, when retail investors wanted some exposure to risk. Thus, for example, during that six month period, emerging markets mutual funds received inflows of $25.8 billion. Since then, the caution has increased and the optimism has frozen up again.

Fortunately, hedge fund products often have low correlations with traditional equity or with fixed income products, and this has become a powerful selling point in the meta-environment of Risk-On, then Risk-Off, the Risk-On again.

Disintermediation
One survival rule might be: it doesn’t pay to be the intermediary! Middlemen get cut out of loops.

There has been a movement of investors of late away from fund-of-funds structures. In part this is the instinct for disintermediation; in part it is a reaction to the Madoff scandal and the scrutiny that has brought to FoFs. Even some of the largest public pension funds, those historically reliant on the intermediation of FoFs, have chosen to invest in hedge funds directly instead. To get their desired diversification and risk management benefits without the extra overlay of fees.

Another survival rule: have a strategy that meets the moment. The article reminds us in particular that the HF world has its roots in long/short equity. “There has been increased interest in global and regionally focused long/short strategies,” it says, “such as those focused on emerging markets or Asia.”

Special situation funds also meet the moment. It is a strategy that generates “ways for skilled managers to use their technical skills and valuation prowess to realize substantial returns for their investors.”

RFP and Database Management
Another point made within the September issue is that managers shouldn’t let the teeter-tooter of investor tastes lead them to miss out on opportunities to compete for mandates. Of course, no manager can compete for every mandate, but Cerulli does offer advice on how to knock on as many doors as is feasible. Thus, one of the articles in the September issue is entitled “RFP and Database Management.”

First, get and stay in the databases! A manager is at risk if it is not represented in one of the key databases, or when the data there is stale, incomplete, or just wrong.

Second, create an effective process. Management’s institutional sales force should be able to “engage directly with prospective clients, identify their needs, and communicate their intelligence to the RFP team….”

Third, have the right partners. “Investment consultants and other third-party database providers are increasingly important partners for asset managers as they seek to secure mandates.” Sometimes managers have outsourced the function of keeping themselves up to date on databases, but have come to rue that decision. “Low-paid analysts in outsourcing centers across the globe are sometimes poorly trained and compensated, and make a high number of input errors.”

Other managers have sought to stay up to date and accurate with the pertinent databases through the adoption of automation, typically eVestment’s Omni. But Omni is high cost. The hope here is that emerging competitors will drive down the costs, making the animation of this function affordable for a wider range of managers.

Cerulli suggests that managers “routinely evaluate which databases they will populate, and which strategies within each database they will maintain.”

Finally, it is also helpful for analysts to understand when they have to do more than provide numbers, when they should include more qualitative data. Wilshire, for example, is a database (cited by several consultant database analysts to whom Cerulli has spoken) that has recently built up the qualitative aspect of its content about managers and strategies.