Josh Kaplan, former chief investment officer of Drexel University was hired in February 2010 to manage the hedge fund allocation at Ascension Health-Catholic Healthcare Investment Management Company.

Catholic Healthcare Investment Management Company was started in January 2011 to manage the assets of Ascension Health as well as a select number of current and potential outside institutions. CHIMCO is a wholly owned subsidiary of Ascension Health, which is the largest nonprofit healthcare system in the country. CHIMCO manages roughly $20 billion of which $17 billion belongs to Ascension Health. CHIMCO has 20 associates at this time.

Infovest21: What is the role of hedge funds? How does it fit into the portfolio?
Joshua Kaplan: The hedge fund allocation is divided into two categories: absolute return and directional. The absolute return book is designed to demonstrate minimal beta exposure, little correlation to the public markets and generally low relative volatility. This is in contrast to the directional book, which typically exhibits more beta and higher volatility. Practically all of the underlying strategies in the absolute return book are found in the deflation/recession bucket. The strategies in the directional bucket tend to deviate a bit and are mostly classified as growth or inflation investments. Overall, we expect the hedge fund portfolio to possess risk-adjusted performance superior to most of the other asset classes.

Infovest21: What is the asset allocation to hedge funds? How has it changed over the years?
Joshua Kaplan: When I started at Ascension, I inherited a hedge fund allocation of roughly 15 funds that comprised 7.5% of the overall portfolio. The newly created investment policy statement sets a target of 22.5% to hedge funds of which 12.5% belongs to absolute return strategies and 10% to directional. Consequently, there was work that needed to be done to boost the allocation to its target and shape the hedge book according to the strategic blueprint put in place. After nearly two years, the hedge fund allocation is only a couple pieces away from where we originally envisioned it. Today, the portfolio is fully diversified, well positioned going forward and contains high conviction, opportunistic strategies that we strongly believe will add alpha.

Infovest21: Where do you see opportunities and do hedge funds fit in?
Joshua Kaplan: Currently, I am focused on finding a dedicated European distressed strategy as an opportunistic play for the directional bucket. I believe that the crisis in the European Union should lead to several attractive places to allocate. With the banks being forced to recapitalize and required to hold 9% tier one capital, there is going to be an enormous supply of stressed and distressed paper hitting the market. I’m looking for a manager that has the compulsory skill set to be able to source attractive deals and sort through the supply to identify strong investments at distressed prices. Finding a seasoned and successful distressed manager in Europe is very difficult as the region has not had the same history with those cycles that we have had here in the US.

The full interview can be found in the current issue of Investor Focus.

Jordan Foster, who is responsible for marketing and client relationship management for North America and South America at Marshall Wace Asset Management, says that hedge funds have generally become more transparent, often provide holdings (in some form, usually with a lag) to investors, and are now more clear regarding expected return/risk characteristics and value added in terms of alpha and beta.

What institutions want
Institutions are looking for a strategic partnership where they can get your [consultant/fund of funds’] thoughts on financial markets as well as due diligence information, Lukomnik adds.
Both hedge fund managers and funds of funds say institutions are looking for more customization.

“Institutions, recognizing the robust, unique intellectual capital at many hedge funds, are increasingly asking larger hedge fund managers to ‘co-construct’ long-only solutions for them,” says Foster. “These solutions often provide a complement to traditional long-only managers, with the expected effect of improving information ratios of their total portfolio.”

Lukomnik emphasized that manager’s terms and conditions need to line up with the strategy. For example, with a long/short equity fund, there is no need for a three-year lock-up. By contrast, if you’re running an activist strategy, people want a lock-up.
Institutions are also now scrutinizing the manager’s back office as a condition to allocate assets.

Large managers vs small managers…issue of crowded trades
Recent HFR statistics indicate that two-thirds of Q2 2011 asset flow went to hedge fund managers with assets over $5 billion. Speakers at the seminar generally thought that trend would continue as larger managers provide more comfort and less career risk to the institutional investment staff. Lukomnik also pointed out that more extensive operational due diligence must be done on smaller managers than larger managers.

However, institutional investors are trying to find creative ways to gain access to emerging managers as studies show that young, smaller managers outperform.

“This is an area that our institutional clients continue to be very interested in. Definitions of emerging manager vary – size could range from $500 million to $2 billion,” says Rock Creek Group’s Sherri Rossoff.

Furthermore, as the very large hedge funds reach capacity, investors need to look at the next level of hedge fund manager, said Mihir Meswani, chief portfolio strategist/risk management director at Sandalwood Securities.

One of the implications from relying heavily on larger managers is crowded trades as many managers are investing in the same holdings, says Meswani.
One problem is exiting those trades. “With liquidity only a sometimes thing for the past few years, it’s the exit from crowded trades that has mattered,” says Lukomnik. “If there is liquidity at quarter-end in a trade that has worked, look out. Everyone heads for that exit at the same time, because they’re selling what they can.”
Rossoff points out that smaller managers tend to find investment opportunities that are different from larger managers, which among other characteristics, helps differentiate them.

Evolving role of fund of funds as solution provider
The general consensus was there will always be a role for funds of funds particularly for smaller institutions and family offices that can’t make $50 million allocations.
“The role [of Rock Creek] is more than simply picking managers from a database,” says Rossoff. Funds of funds proactively manage portfolios in terms of top-down positioning to avoid systemic risks and quickly take advantage of new investment opportunities with an experienced team that understands underlying positions as well as the markets generally.

“Funds of funds will increasingly be a solutions provider. Some family offices want to use us as their research arm. Some institutions may ask us to provide a tail risk solution,” adds Meswani.

Differentiated fees, not lower fees
Small institutions are increasingly using hedge fund style mutual funds. Lukomnik points to their strong growth. In 2009, there were 104 hedge fund style mutual funds. Today, there are about 198 – almost double. That represents $163 billion in assets – they are not charging 2/20 fee.
Rossoff points out that while a goal may be to negotiate the best possible fees, she would be cautious about managers dropping their fees too fast and sacrificing their ability to maintain a solid business operation.

Some fee structures that look too good to be true are. For example, a manager who says it has no management fee, just a success fee and “expenses,” could actually be exceptionally expensive if those expenses include salaries and bonuses, says Lukomnik.
There will be pressure for differentiated fees, not necessarily lower fees, says Lukomnik. “The few managers who are good, who are willing to close their funds, will be able to get high fees. Others will not.”

Jordan says, “We (Marshall Wace) have not seen significant fee pressure. I believe that is true for other managers who do not have unlimited capacity. That said, many seem to believe the institutional fee structure will settle somewhere near 1.5%/20 – closer to pre-2000 levels. Some investors have asked for an option to soft-lock assets for two or three years in exchange for a modest fee reduction. I believe this alignment of interests makes sense.”

Foster expects we will see more creative fee proposals, ones that reflect a strategic partnership (more explicit sharing of alpha). “Hedge funds seem to be migrating from a ‘DDQ culture’ (one where hedge funds are more resistant to fluid information exchange with prospective investors) to the ‘RFP culture’ prevalent in the long-only world (where managers are more responsive to detailed questions regarding their investment and operations processes).”

2011 versus 2008
Susan Webb, founder and chief investment officer of Appomattox Advisory, observes a couple of major differences between now and 2008. “First, we’re starting from a lower base of capacity utilization and chances are we will not return to that level. Utilization in the US dropped by 50%. The US has recovered about half of that. We will probably only slowly recover the remainder over the next six years. Second, even though banks haven’t fully restructured, they are in much better shape now than they were in 2008. They can potentially start lending. Credit hasn’t been extended to smaller companies until this last quarter. We will just begin to see the rollover of some of the high yield debt next year.”

Webb believes US pension plans will have to lower their expected returns as its going to be a difficult 10 years. “This realization is currently understood by most plans,” she says.

Rob Picard of Boxtree Capital, a consulting firm, points to another difference between now and 2008. There was a lot of leverage in the system in in 2008. Corporate and consumer is much less leveraged now. The government threw a lot of money in the economy and now corporate America is sitting on a lot of cash. This cash needs to circulate which would be stimulative.

Similarities/differences between US and Europe
The big issue in the US and Europe is growth, says Webb. Leverage has funded growth over the past several years but will not be available in the future to do so. “In Europe, the debt is due more to the large pension obligations and misallocated investments. Some managers are calling for a depression in southern Europe. In northern European, like in the US, we are expecting slow growth of about 1.5%-2%,” she says.

Webb points out that Europeans save 15% compared with 5% in the US. While the US has significantly improved its saving rate and reduced each debt burden, individuals still have significant debt overhang. Hopefully, the changes in savings rate will remain at elevated levels.

Picard is negative on Europe. Because the European Union is so different structurally from the US Federal Reserve System, he thinks this will bode well for the US. “The money will flow from Europe to the US. There will be a huge arbitrage from the US perspective. It is hard to get the timing right. How do you make money and survive in that time?”

Webb sees many investors pulling their deposits out of the French banks. France may have to nationalize their banks in order to support Italy and maintain the EU. She predicts that the euro could breakup in two years if a mechanism for orderly exiting of countries is not put in place.

Going forward
Webb adds if they don’t write Greek debt down 10 to 20 cents on the dollar and allow the Greeks to remain within the EU, there will be a massive depression in Greece similar to what happened in the US in the 1930s. “The Greeks, at this current moment in time, cannot support the debt burden by reduction in spending alone. They need a euro bond structure where each country has a certain percentage depending on their GDP and fiscal responsiveness. That will necessitate a political alliance which they still don’t have and a governing and monitoring group to represent the EU,” she says. Picard’s view is that once there is a clog in the system, it takes a while for the whole system to clean itself out. “We are on the road to recovery. There is a lot of frustration in Washington DC, Wall Street and Main Street. The three groups need to agree and clarify the regulations. Once corporate America understands where we’re going regarding regulation, we will see money come back in.”

Picard thinks they’ll get it right shortly. He sees a number of positive factors on the horizon. “The European countries may come to a consensus. It doesn’t happen overnight – it takes time. Washington might start to work together over the next 12 months. And there are some exciting things going on the economy such as developments in technology, pharmaceuticals and energy. These are game changers,” says Picard.

The UCITS III hedge fund industry has grown with lightning speed from about nothing 18 months ago to over 500 UCITS hedge funds today with the pace of expansion accelerating. Estimates are that assets in hedge fund UCITS are about $45-55 billion while Eurekahedge puts assets even higher, closer to $100 billion with close to over 990 funds.

Eurekahedge says UCITS hedge funds account for 7% of total hedge fund assets but attracted 20% of the net inflows in 2010.

UCITS III funds comply with the European Union directive. The acronym stands for Undertakings for Collective Investment in Transferable Securities

The UCITS structure sits very well with institutional portfolios, observes Ballos. “Institutional and family offices investors wanted a regulated, liquid, multi-advisor fund, offered within the UCITS framework, with the added safety of independent risk controls.”

Philippe Dupuy of Alternative Advisors agrees. “UCITS funds offer investors an investment vehicle that satisfies almost all expectations and requirements they’ve been fighting for and struggling to get from offshore unregulated funds – liquidity and transparency.”

The liquidity aspect allows institutional investors to better time their investments according to their macro views, allowing them to tactically allocate.

Dupuy says the nature of the underlying investment is, by definition, more liquid because of strict rules about gating or side-pockets. “Note that side pockets are not allowed in France, allowed only for daily funds in the UK, and negotiated on a case-by-case basis in Luxembourg. In a liquidity crisis, we will get out, though probably not as quickly as anticipated, as gates can be imposed on UCITS funds.”

Bi-monthly liquidity is the minimum requirement but the majority of funds have daily or weekly liquidity.

Chris Rule of Key Asset Management observes that equity long/short is the most developed strategy within the UCITS world. Less liquid strategies such as distressed investing are absent from the UCITS III hedge fund universe and are likely to remain so.

Caution required
Despite the advantages, industry veterans caution investors when looking at new UCITS funds and at UCITS wrapped hedge fund strategies. Not all hedge funds are suitable for the structure. The underlying fund needs to be liquid. Equity long/short and managed futures can fit in a UCITS structure easily while distressed and fixed income arbitrage don’t easily fit.

“Some managers are just surfing the Newcits wave and launching a UCITS even though their core strategy is not transferable, thus moving away from their core competencies,” says Dupuy.

Some strategies are “shoe horned” into a UCITS structure that may not fit well. If so, investor may be buying products that are riskier than they thought. UCITS funds promise liquidity which make it reassuring for investors. A major concern is that the liquidity of some underlying investments may not be sufficient to allow UCITS funds to provide daily liquidity.

A liquidity mismatch may exist between the instruments they invest in and the liquidity they offer investors,” says Dupuy.

Others point out that some managers will change their strategies i.e. reduce leverage or invest in more liquid assets to fit into the UCITS structure.

They argue that negative selection bias exists. Managers who can’t attract assets themselves may rely on big demand for UCITS III funds to attract investors.

Another danger is attracting institutional investors into a retail product as both groups have different objectives. When institutional investors redeem their large investments, it could move prices and hurt smaller retail investors.

Some critics point out that few UCITS hedge funds are larger than $25 million.

Critics also point out that UCITS III hedge funds often underperform hedge funds because of higher fees. UCITS funds tend to have lower margins because of higher operating costs and distribution costs. Operational requirements are higher as daily net asset values are needed rather than monthly.

Eurekahedge statistics show traditional hedge funds outperformed UCITS III hedge funds over the past three years. This is because traditional hedge funds use leverage. Furthermore, event driven and distressed debt that performed well in 2009 are not largely represented in UCITS III funds.

Eurekahedge statistics also show that UCITS III hedge funds performed better than funds of funds.

Argument for UCITS III funds of funds
The argument for the UCITS fund of funds approach is that because there are so many alternative funds either in UCITS, or looking at UCITS, it is difficult to sort out the good from the bad. That makes a very strong case for the multi-advisor fund approach, adds Ballos. The fund of funds as the investment manager is responsible for manager selection, due diligence and asset allocation.

Dupuy adds that a UCITS fund of funds provides a great advantage over the traditional funds of funds. “We can truly act as best-of-breed multi-manager and turn our portfolio around very quickly; something that an offshore funds of funds could not do, having to give sometimes three months’ notice on a quarterly fund. This is valid also for institutional investors.”

“The liquidity and transparency offered by UCITS gives us a lot of flexibility in the way we can manage our portfolio. We can be more opportunistic than a traditional fund of funds would be,” adds Dupuy.

Dupuy points out that the UCITS fund allows the UCITS fund of funds manager and institutional investors the ability to closely monitor what the underlying manager does, the risk he is taking, identify where and why he is making or losing money and enables them to identify style drift, increased liquidity risk, concentration risk, etc.

Outlook
Despite the criticisms and caveats, many are very optimistic about the future of UCITS funds as well as funds of funds. The number of UCITS III funds is expected to skyrocket as tighter regulation of hedge funds occurs globally.

US managers are starting to jump aboard the UCITS trends as it is one way around EU law threatening to freeze US managers out of Europe. York Capital Management’s UCITS fund is up and running while Paulson & Co, Traxis and Peter Schoenfeld Asset Mgt are among those expected to start imminently.

Because EU law requires UCITS managers to be domiciled in the EU, some managers are taking the bank platform route with the likes of Bank of America Merrill Lynch, Deutsche Bank and Morgan Stanley.

“I am convinced that for some strategies, UCITS will replace traditional hedge funds,” Dupuy concludes.

The above is an excerpt from the current issue of Investor Focus which interviews:
• Thanos Ballos of Strategic Investments Group
• Omar Kodmani of the Permal Group
• Philippe Dupuy of Alternative Advisors and
• Chris Rule of Key Asset Management.

Other features include:
Sentiment Indicator: Investors
Overview of UCITS structures
UCITS Indices
Sampling of UCITS funds of funds
Sampling of UCITS platforms
Who’s Who in UCITs

The SEC is proposing that a family office be defined as a firm that:

• Provides investment advice only to family members, certain key employees, charities and trusts established by family members, charities and trusts set up by family members, and entities wholly owned and controlled by family members.

• Is wholly owned and controlled by family members

• Does not hold itself out to the public as an investment adviser.

Historically, family offices have not been required to register with the SEC under the Advisors Act because of an exemption provided to investment advisers with fewer than 15 clients. The Dodd-Frank Act removes that exemption, enabling the SEC to regulate hedge fund and other private fund advisers, but includes a new provision requiring the SEC to define family offices in order to exempt them from regulation under the Advisers Act.

Public comments on the proposed definition should be received by the SEC by November 18, 2010. The Dodd Frank Act becomes effective on July 21, 2011.

The SEC has been charged with adopting a definition that is consistent with the SEC interpretation in prior exemptive orders.

Because multi-family offices serve more than the lineal descendants of a single individual, multi- family offices with more than 15 clients are not expected to qualify for the “family office” exemption and are likely going to need to register as investment advisers with the SEC or their home state depending on the amount of assets under management. As SEC-registered investment advisers, multi-family offices will have to adhere to the same requirements as other investment managers, including, for example, the requirement to appoint a chief compliance officer and to have written compliance policies and procedures.

Industry observers estimate approximately 2500 to 3000 family offices exist in the US, managing in total over $1.2 trillion in assets. Generally, family offices have at least $100 million in investable assets.

Views on hedge funds
Family offices, which had scaled back their hedge fund investments during the financial crisis and who were angered by gates and frozen redemptions, are slowly investing again. In the aftermath of the Ponzi schemes and fraud cases, they have concerns about the safety of their assets and investment portfolios.

As a result, many family offices are reassessing their portfolio construction, asset allocation and risk management policies.

Based on the family office interviews in the current issue of Infovest21‘s Investor Focus, we see families are allocating a higher percentage of their portfolio to liquid assets and are accepting lower returns. Some are investing a higher percentage in gold.

Families are also spending more time doing thorough due diligence on topics such as liquidity, lock-ups, side pockets, fees and terms. Due diligence has become more sophisticated. Some conduct identity, background and reputational due diligence as well as operational due diligence. Manager’s controls, procedures and counterparty relationships are assessed. Some family offices have instituted on-site compliance efforts where they test and independently verify practices. Monitoring is occurring at regular intervals.

Some family offices are reexamining portfolio construction and emphasizing risk management. In particular, some are examining tail risk hedging.

The issues contains interviews with:
*RIJO Investments
*Consolidated Investment Group
*Nine Thirty Capital

Other features include:
*Family office and tail risk hedging
*Family office regulatory update
*Sampling of Who’s WHo in Family Offices
*Quarterly Sentiment Indicator: Managers

Christine Jurinich, partner and member of the investment committee at Offit Capital Advisors,points out “In 2008, there were some specific strategies or even an outlier of a manager in a specific style that preserved capital in 2008 through a combination of hedging, managing exposures tactically or security selection. We have found that there are talented hedge fund managers, some in Europe, for example, that were in strategies such as long/short equity, volatility or fixed income that just did a better job than funds in the tri-state area. We believe that some of these, as well as some funds in Asia, South America and Europe can diversify the return stream, although clearly in 2008 Asian exposurein particular had large losses and was very long biased. That being said, there are long/short equity funds that also were down slightly to positive in 2008 also outside the tri-state area that are off the radar, that diversify the return stream and don’t own APPL for example, which is what we are looking for.”

Another New York family office points out that they are focusing on Asia and emerging managers. “We are taking a broader view on where investment opportunities are and are not just focused in the US.”

Another reason for looking abroad is that some US families feel vulnerable to the US dollar and dollar returns. “US based investors are concerned about the US dollar as a store of value, even with positive nominal returns, value of these dollars could erode over time. So non-dollar investments offer the opportunities for real gains that are derived from the currency and the underlying asset exposure,” observes Jurinich.

Anthony Gordon of the Gordon Family Office says he is looking for a healthy dose (20-30%) of multi-currency cash allocations in the Group of 10 and emerging markets. “Investing across borders is the way to go today.” He is keen on Brazil, Russia, India and China and other countries who supply the large economies of Korea, Mexico, Indonesia, Nigeria, South Africa, Vietnam and Australia. Not only because of their “higher potential growth but also the assessment of the sheer amount of work currently required to restore confidence in the US financial and political system.”

He adds that quantitative easing by the Federal Reserve may do little to spur consumer demand unless unemployment and poverty is reduced.

Excerpts from
Infovest21‘s September Investor Focus.

Investors should look at the seeder’s experience – that is the key factor, says Robert Discolo of PineBridge Investments. “You need people who’ve been doing this for a long time and during different cycles. They have to have a lot of relationships and experience. Due diligence of emerging managers is very different from due diligence on regular funds because you have limited data to work with.”

He says investors should also look at prior seeds’ experience and performance. Investors also need to look at the worse-case scenarios – how many problems and how many blow-ups have there been. Also look at risk controls the seeders have in place and how they monitor it.

Seeders provide their IRR which is a construct from the private equity world. It is an indicator of the investor’s economic return; it is based on cash flow. “…if a seeder gives money to a manager and then pulls it back after three or four years, the seeder still has a revenue share. The IRR can’t go down because there is no money at risk. The additional increases in IRR are based on the profit share for each individual manager,” adds Discolo.

Another veteran seeder suggests that other metrics be examined besides IRR such as gross return, net return, cumulative draw down, the amount of assets distributed, unrealized value and total value. Fee income is another important metric which reflects the manager’s ability to gather assets i.e. distributions relative to paid-in capital.

Institutions and seeding
Institutions are increasingly looking at seeding arrangements.
In the summer of 2010, Rock Creek won a mandate from New York State Common Retirement Fund to manage the first installment of the pension’s new emerging manager program. Rock Creek is playing a key role in developing the emerging manager hedge fund portfolio, focusing on newer firms, firms with assets totaling less than $500 million, and women- and minority-owned fund management companies.

At that time, the $132.6 billion pension fund has about $5 billion committed to emerging managers. Of that, about $2 billion was in private equities and $3 billion in public equities. The pension is now developing a similar program in its real estate portfolio.

Other pensions with emerging manager programs include New York City Retirement System, California State Teachers Retirement System and California Public Employees’ Retirement System.

As of September 30, 2010, CalPERS had $1.3 billion in its MDP programs, close to $600 million in the emerging manager funds of funds program (which is part of the external manager program via FIS and Leading Edge), about $539 million in the fund of emerging hedge fund program (which is part of the Risk Managed Absolute Returns Strategies program). In the latter program, CalPERS had about $143 million with PAAMCO’s fund of emerging funds, $201 million with Rock Creek fund of emerging funds and $194 million with 47 Degrees North.

CalPERS’ Performance – Emerging Manager Fund of Funds
FIS Group
Inception date: Feb 2008
AUM $M: $269
YTD Return(%):0.87
Last 1 Year Return(%): 2.08
Last 3 Year Return (%): N/A
Since Inception Return (%): -0.11

Leading Edge Investment Advisors

Inception Date: March 2008
AUM $M: $298
YTD Return (%): -0.63
Last 1 Year Return (%): 0.76
Last 3 Year Return (%): N/A
Since Inception Return (%): -0.70

Source: CalPERS Global Equity Program Review, Oct 18, 2010

Excerpt from just-released Infovest21 Investor Focus

 Keith Meister is being seeded with $250 million by Soros Fund Management. Meister, who had been principal executive officer and vice chairman of Icahn Enterprises, will take an activist approach. He has served on a number of boards including Federal Mogul Corp and Motorola.

 Patrick Wolff, a managing director at Clarium Capital, is starting Grand Master Capital Management with the first hedge fund launch scheduled for January 1. The fund will focus on a macro-informed long/short equity strategy. Clarium’s Peter Thiel is seeding the firm with $50 million that will be committed for three years.

 Brummer & Partners has seeded former Millennium Management portfolio manager Scott Collison who is starting Orvent Asset Management in Singapore. The event driven fund will start in January with about $150 million in seed capital from Brummer.

 Investcorp and Ballast Capital Management have formed a strategic partnership. Ballast, which specializes in long/short equity, is joining Investcorp’s single manager platform. Ballast is led by Robert Kaynor, chief investment officer, and Ryan O’Sullivan, president. At launch, Ballast will have eight people on its team. Kaynor and two other team members, Mason Stark and Joanna Wald, had previously worked together at Ramius LLC.

The Universities Superannuation Scheme, one of UK’s largest pension plans which has over £30 billion in assets, is considering investing in a seeding fund, reports Financial News. It is currently looking at a number of choices and a decision is expected in early 2011.

USS will have co-investment rights with the seeding fund and also participate on the advisory board of the hedge fund(s) in which the seeding fund invests. The UK scheme will use the stakes to implement improved governance of the hedge fund(s) in which the seeding fund invests, aiming to make a positive impact on the industry and to benefit all investors.

Luke Dixon, the portfolio manager for absolute return strategies at USS, told Financial News that the allocation to the seeded fund would be larger than that made to traditional hedge funds.

At the end of March 2010, USS’ absolute return strategies amounted to £607 million ($977 million), considerably higher than £245 million ($395 million) in March 2009, according to the 2010 annual report. Since then, USS has revealed that the hedge fund portfolio has climbed to £950 million ($1.53 billion) with 15 managers.

A number of new incubators are in the works. For example, The Harvest Fund was formed in early 2010 to develop and manage a private special situation investment platform. The private equity-like structure provides growth capital to promising newly independent hedge firms run by pedigreed teams with expertise and capabilities to build institutional caliber firms. A first closing is planned for early 2011. The fund expects to make five to six allocations over the following 12 to 18 months.

Harvest Fund is an affiliate of Moody Aldrich Partners, a privately held investment firm founded in 1988. Moody Aldrich Partners is owned by Eli Kent, William Moody, Amory Aldrich, Eyk Van Otterloo, Jeremy Grantham and Michael Pierre. MAP manages equity investment strategies for large investors through separate accounts. Eli Kent and Chris Kelley are co-founders and managing partners of Harvest Fund.

Wilshire Associates is assisting with key aspects of the platform including investment manager and operational due diligence, risk management, separate account platform services and distribution support.

Eli Kent says, “Our platform is structured to be flexible and highly scalable in order to offer co-investment opportunities to our larger clients and to potentially partner with the right institution and/or strategic partner to accelerate growth.”

Additional information on seeding in the hedge fund community is available in Infovest21’s just-released issue of Investor Focus. The issue contains interviews with Weston Capital Management, Alternative Asset Managers and Stride Capital. Samplings are provided of hedge funds seeded in 2010 and a Who’s Who of Tiger Seeds.

MassPRIM recently decided that about $500 million of the $3.5 billion allocated to funds of funds will now be diverted to direct allocations in hedge funds. A reassessment will take place by year-end 2011 and the pension will decide whether more should be allocated to hedge funds directly.

MassPRIM says the move will prevent manager overlap, provide transparency and save about $4.2 million in fees. It paid about $30 million in fees to funds of funds. Transparency was also an issue for MassPRIM as it didn’t immediately know the extent of its exposure to Level Global when the hedge fund was raided by the FBI in November 2010. MassPRIM’s funds of funds – K2 Advisors, Rock Creek and Grosvenor Capital – had each allocated to Level Global with $24.7 million, $13.3 million and $10.7 million respectively. Arden Asset Management had invested $11.6 million with Diamondback Capital Management, which was another firm raided by the FBI in November.

Lois Peltz, president of Infovest21, points out that performance is another reason the large US public pension funds are increasingly allocating directly to hedge funds. “The average hedge fund outperformed funds of funds in six of the seven past years. The largest differentials occurred in 2009 and 2010,” she said.

At Infovest21 ’s Investor Seminar on Pension Underfunding and Its Implications for Hedge Funds/Funds of Funds,” Don Steinbrugge, chairman of Agecroft Partners, pointed out that over a certain mandate size – perhaps $100 million – pensions will eventually directly allocate to a manager rather than use a fund of funds. “Most of the pensions that have gone direct had done so recently. Approximately 80% have done so in the past three years,” he adds.

A number of surveys support this trend toward direct investing.

• A Pensions & Investments survey found the largest institutional allocations’ direct investment in hedge funds increased 75.6% to $77.8 billion through September 2010. In comparison, investing via funds of funds increased 20.8% to $31.9 billion.
• Cliffwater’s survey found 49% of the US systems invest directly in hedge funds while 33% only invest through funds of funds. Another 18% of the systems do both – invest directly in hedge funds and through funds of funds.

On an asset weighted basis, 64% of hedge fund investments are invested directly and 36% through funds of funds.

Funds of funds take a more solutions-based approach
Yet, most industry observers say funds of funds serve a function and are here to stay. Their role, however, is changing.

“Many funds of funds aren’t adapting; many are in denial. Some won’t negotiate fees or do separate accounts. The Darwinian approach may take form – and in some ways already has – where it’s not the strong that survive but the adaptable. The entrepreneurs who, while sticking to their knitting, are constantly evaluating the most effective and efficient methods for delivering the information, for aggregating the data and providing insight on how alpha was generated, how beta was mitigated and the investment instruments appropriate to those decisions,” said Rachel Minard, executive managing director at Optima Fund Management at the Infovest21 Pension Underfunding Seminar.

Most effective are those funds of funds which are changing their business model to accommodate the new institutional obligation of the partnership.

Some funds of funds are taking a more solutions-based approach i.e. developing advisory businesses. Those funds of funds say they find themselves competing against consultants, specialist consultants, wealth managers and multi-strategy funds.

“Some of the better consultants are looking holistically at their investors’ portfolios to determine which hedge funds are appropriate versus just hiring a product. People aren’t selling products anymore – they’re selling solutions-oriented programs. That is why many hedge fund specialist consultants are getting so much business now: they empower the institution by their selecting which funds meet the investors’ risk and return targets, keeping the discretion squarely with the fiduciary but having this large trough by which to evaluate and cross-reference hedge fund options against their existing holdings,” adds Minard.

“Everything is holistic. You’re not looking just at their [investors’] alternatives but also their by-laws, cash balances, obligatory monies due to shareholders or endowments. Look at every facet and focus on liquidity, capacity, transparency,” says Minard

Various institutional investors are hiring funds of funds for various functions. Some want them to do asset allocation studies while others are looking for risk management. Some want them to identify the most appropriate managers, vet them, set up investment guidelines, do reporting and monitoring.

Some funds of funds are finding themselves moving into the subadvisory business as some pensions are looking for a fund of funds that can facilitate knowledge transfer so the pension may eventually take on the internal management of the hedge fund program.

“Today, there is still interest in long/short equity and increased interest in absolute return strategies as a substitute for fixed income,” says Greg Dowling, a consultant at Fund Evaluation Group, speaking at Infovest21’s investor morning seminar on RFPs. He is seeing interest in credit managers that have much more of a long/short posture versus the longer biased managers that were popular 18 to 24 months ago. The only exception is Europe where managers with loner biased distressed debt skill sets remain popular. While the type of searches has changed as the market opportunity has changed overall search activity still remains robust, adds Dowling.

Earlier in the year, Towers Watson released a report showing similar findings. Its clients’ hedge fund mandates increased 50% during 2010, bringing the level of mandates back to 2008 levels. Mandates for direct hedge funds now account for 60% of all the hedge funds searches with equity, fixed income and insurance strategies being the most popular.

At the release of the report, Craig Baker, global head of research at Towers Watson, said, “We believe in the ability of highly skilled hedge funds to adapt to a changed environment and generate good performance for our institutional investor clients. We believe that the larger institutional funds will continue to move to investing directly rather than via funds of funds. However, funds of funds can still be an ideal solution for many smaller and governance constrained investors.”

Don Steinbrugge of Agecroft Partners, a consultant and third party marketer to institutional investors, says he is seeing widespread demand from institutional investors for commodity trading advisors which is a dramatic change from their past reluctance to allocate to the strategy. Before 2009, very few pension funds allocated to CTAs. They did not understand how the systematic models worked nor could they evaluate which models were superior. Institutional investors were more comfortable with fundamentally driven strategies that were similar to their long-only managers’ investment processes.

After Q4 2008, however, pension funds realized their portfolios were not as diversified as they thought and found their managers to be highly correlated. Meanwhile they saw the Barclays CTA Index up 14% over the same period. This caught their attention and they began to take a closer look at CTAs. Institutions also saw that while some hedge funds were gating or suspending redemptions due to liquidity mismatch, CTAs generally offered monthly liquidity to their investors and accurately valued their portfolios as they tend to trade highly liquid, price transparent futures and currencies.

Defining “Institutional Quality Managers”
In defining what is institutional quality, consultants say they put an emphasis on:

• a historical ability to create excess returns over a benchmark
• a repeatable investment process
• separation of duties
• a strong chief compliance officer
• the people – are the same people in place that created the same track record?
• an articulate valuation policy
• risk management
• liquidity management
• quality of service providers
• business continuity
• the size of the assets relative to the strategy and how the assets have changed

Towers Watson’s Neel Mehta wants to understand how the portfolio managers think as opposed to simply how they have made money in the past. “Once we understand the process, we talk about trade examples, macro views on market, and how these translate into returns.”

Massey Quick says they may select a stock out of the portfolio and ask the manager specifically how the stock was identified, who did the research, what made the manager decide to put the stock in the portfolio, why it was sized the way it was.

The consultants are interested in talking to other team members besides the portfolio manager. “Very often you can get more from meeting the analyst than meeting a portfolio manager. You get a different perspective on the manager. We can talk about process and how the manager has traded on past ideas, how the compensation structure actually motivates the analyst. You also have to meet the chief financial officer, the chief executive officer and understand the business plan of the company,” adds Mehta.

Understand what motivates the manager. Often, large managers don’t want to take on enough risk. Think about wider issues such as the correlation between stock price and assets under management and try to calculate how much money is made by growing assets (inflating the stock price) versus generating revenue from the incentive fee on good performance, observes Mehta.

Character and integrity are also important. Investors remember those managers who closed their funds in 2008 because they didn’t want to pay back the draw downs and reopened under a new name.

On the managed futures front, Steinbrugge advocates hiring CTAs with well built out research teams and seeing how much transparency they give investors into the process. This is because CTA models tend to evolve over time. He suggests looking at managers in the mid sized range i.e. $2 billion to $10 billion as this group is large enough to support a substantive research team but not too large where their alpha may be diluted over a growing asset base.

The above is an excerpt from Infovest21‘s April issue of Investor Focus. The full issue can be obtained by contacting Infovest21 at 212 686 6440.