February 07, 2019

FOF Portfolios For Family Offices: Methodology Overview

Michael Fox-Rabinovitz

Michael Fox-Rabinovitz
Managing Partner/Capricorn Partners

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 Table of Contents

  • Desired Portfolio Characteristics


  • Annual Return Expectations


  • Hedge Fund Universe Overview


  • Sample Core Managers


  • Portfolio Construction


  • Investment Evaluation: Qualitative


  • Investment Evaluation: Quantitative


  • Portfolio Monitoring


  • Liquidity Considerations


  • Negotiating Terms

Desired Portfolio Characteristics:


  • Largely market neutral
  • Explicit emphasis on capital preservation
  • Fund managers with a history of solid returns over time
  • Individual investments that exhibit low cross-correlations to ensure that volatility is as low as possible on both
    • o month to month basis
    • o year to year basis


Annual Return Expectations


One of the most important tenets in asset management is to set realistic goals and expectations from the very start, and the question of realistic return is at the heart of every strategy. While the answer clearly depends on the investor’s risk tolerance, targeted terminal wealth and the time horizon, there are some general considerations that reflect fairly the expected return of the asset class.


As a frame of statistical reference: according to FT since 1980 the average hedge fund annual return was 12.6%. Given that there are several biases always present in this data (survivorship bias being the key one), and also assuming that this includes the full gamut of strategies across the risk spectrum, a return of 10% for rather conservative lower volatility funds would be a fair target.


Understanding that it is impossible to talk about returns without mentioning risk, the expected annual volatility of the return stream is also about 10% for a portfolio of hedge funds where risk exposures are balanced across multiple sources of return in order to achieve the most consistent performance possible across all future environments.


It is possible to put together a portfolio of hedge funds that generate fair return per unit of risk taken (Sharpe ratio of 1), and with active work it is also possible to create the portfolio that will have lower volatility and higher return resulting in a Sharpe ratio in the 1.5 range.

Hedge Fund Universe Overview


Hedge funds employ a wide range of trading strategies that generally fall into four main categories:


  • Directional
  • Global macro
  • Event-driven
  • Relative value (arbitrage)


These four categories are distinguished by investment style and each have their own risk and return characteristics. It is possible for hedge funds to commit to a certain strategy or employ multiple strategies to allow flexibility, either for risk management purposes, or to achieve diversified returns.




Directional investment strategies utilize market movements, trends, or inconsistencies when picking stocks across a variety of markets. These types of strategies have a greater exposure to the fluctuations of the overall market than do market neutral strategies


Global Macro


Hedge funds utilizing a global macro investing strategy take sizable positions in share, bond or currency markets in anticipation of global macroeconomic events in order to generate a risk-adjusted return. Global macro fund managers use macroeconomic ("big picture") analysis based on global market events and trends to identify opportunities for investment that would profit from anticipated price movements.


Event driven


Event-driven strategies concern situations in which the underlying investment opportunity and risk are associated with an event. Managers employing such a strategy capitalize on valuation inconsistencies in the market before or after such events, and take a position based on the predicted movement of the security or securities in question. Events generally fit into three categories: distressed securities, risk arbitrage and special situations.


Relative value


Relative value arbitrage strategies take advantage of relative discrepancies in price between securities. The price discrepancy can occur due to mispricing of securities compared to related securities, the underlying security or the market overall. Relative value is often used as a synonym for market neutral, as strategies in this category typically have very little or no directional market exposure to the market as a whole.




Sample Core Managers


To fulfill the core mandate of building the Desired Core Portfolio, the best strategy is to draw on a list of well known and proven managers with long track records and sizeable AUM.


The firms on the list that follows have been in existence since early 1990's and each manage from $5 to $10 Billion of investor assets. The funds below have proven themselves as best of breed by generating years of consistent returns combined with strong focus on controlling risks.


When putting together the final investment portfolio, it will be important to pay close attention to the mix of sub-strategies in the multi strategy funds, as on global portfolio level we do not want to find ourselves in a situation where we are overweight one or two sub-strategies by virtue of the component funds concentrating their trades in those areas.


Multi-strategy Managers

1) Bridgewater Pure Alpha

2) Highbridge Capital

3) Eton Park Capital management

4) King Street Capital Management

5) Davidson Kempner Advisors

6) Maverick Capital

7) Taconic Capital Advisors

8) Canyon Capital Advisors

9) York Capital Management


Global Macro Managers


1) Moore Global

2) Wellington Management

3) Brevan Howard


The following three funds deserve a close look as well. Although their strategies are not market neutral they are high quality funds with great proven managers


1) Viking Global Equities - Long Short Equities

2) Pershing Square - Activist Equities

3) Appaloosa Management - Distressed


While the core should be formed from the investment vehicles mentioned above, it is important to include a range of niche pure alpha generating strategies that are completely uncorrelated. This sometimes means expanding the investable universe to look at managers with shorter track records, smaller AUM and possibly more volatility and less liquidity, but who provide pure unique and uncorrelated alpha.






Portfolio Construction


There are various ways of putting together an optimal portfolio, with the two principal ones being the classical MVO approach (Markowitz) and the more flexible and intuitive Black-Litterman variation. For the purpose of the following discussion it will be assumed that one of the aforementioned methodologies is used as the main optimization algorithm.



The ultimate goal of a FOF Portfolio Manager is to create an optimized portfolio of largely uncorrelated return streams calibrated to balance each other and to deliver a targeted return with the lowest possible volatility.


The definition of a well-diversified portfolio is highly dependent upon factors that are unique to each investor. Only when those factors are defined can the term itself be clearly defined. Those factors include: risk tolerance, targeted terminal wealth, interim cash flow needs, investment horizon and the universe an individual is willing to accept as the pool from which they will select their assets.


The question of how many funds it takes to create an optimally diversified portfolio has been on the minds of asset management practitioners for decades. In their iconic 1977 study Elton and Gruber worked out an empirical example of the gains from diversification and their results indicated that the gains from diversification level off when the number of assets in a portfolio is about 30.


This number is consistent with a lot of other studies done after, so it is a generally accepted wisdom that a portfolio composed of 20-30 units that are not perfectly correlated with each other is considered to be optimal.


One key thing to keep in mind when constructing a portfolio of funds is that asset correlations are by no means static. Correlations can and do change over time, and even a relatively small change can have a significant impact on portfolio models. Changing correlations will affect the dynamics of the portfolio and need to be responded to by changing allocations and in some cases, replacing some of the assets in the portfolio.


The degree of diversification of the portfolio can be tracked and measured using several different methodologies such as:


  • Herfindahl Index can be used to measure the level of diversification relative to an equally-weighted portfolio
  • Average correlation among investments can be useful in estimating diversification. Normally three correlation numbers are calculated (overall, correlation in up markets, correlation in down markets).
  • Factor diversification. Factor diversification analysis using principal component analysis (PCA) can provide additional information on diversification benefit of the portfolio.






Investment Evaluation: Qualitative


Thorough review of DDQ is an integral part of the process and is conducted in all cases. It is required for each investment under consideration, and detailed review of every aspect of that document is the first step in making an investment recommendation. Given that, there are several core areas that need to be examined in great detail, namely:


  • 1) Alpha generation – are we likely to get paid sufficiently for our risk and does the stated strategy provide a clear and compelling opportunity for return
  • 2) Alignment of interests – is the manager properly incentivized to make money, and also is he properly disincented to lose money
  • 3) Independent oversight – are there reputable third party service providers in place to prevent and discourage questionable reporting practices
  • 4) Transparency – is the manager transparent with regards to his positions, risks and investment strategy
  • 5) Liquidity – are the liquidity terms consistent with the fund strategy as well as being fair to investors
  • 6) Infrastructure – does the fund have effective and comprehensive mechanisms to execute its strategy and mitigate portfolio risk and drawdowns


Six categories of issues outlined above are the key to determining whether or not a particular fund is a good candidate for consideration for inclusion into a portfolio. Within each of the top level categories, there are a number of sub points which should be reviewed and carefully evaluated.


Based on extensive information gathered through interviews, written materials and analysis, a grade of 1 to 5 is awarded for each metric and the findings are summarized by assigning a final numerical grade to each investment based on the weighted average of the metrics.


As a matter of policy, it is also very important to track approval and rejection reasons, so that overtime an in house database of statistics is generated, and it becomes possible to use that as an effective reference point for future evaluations.


After the fund has passed the initial screening it will then be necessary to conduct a thorough analysis of its impact on the existing portfolio, as well as a host of other statistical analysis. Below are some of the more relevant metrics with brief comments as to their usefulness and usage.


Investment Evaluation: Quantitative


Total return (absolute) – clearly the essence of the investment, how much has been made

Return attribution – provides insight into what factors contributed to the return of the investment and to what degree. Important not only for separating true Alpha from various Betas, but also for gaining clear insight into true drivers of portfolio performance

Return stream characteristics (skewness and kurtosis) – provides further insight into the smoothness and stability of the return pattern

Volatility – core risk measure for a given investment, needs to be tracked on annualized, rolling and periodic basis to alert the manager to possible dangers or violation of pre-established risk parameters

Maximum drawdown – two dimensional metric where the amount of decline as well as the length are tracked, important as an additional reference point for investment’s risk

Upside / downside capture – the degree to which the fund correlates to the market moves separated between up and down scenarios. Provides insight into how the investment will behave under different regimes

Sharpe Ratio – Most widely used risk / reward indicator and a useful tool to quickly compare investments. Due to the fact that it treats both upside and downside risk the same not the most appropriate metric to be used for an absolute return vehicle

Sortino Ratio – return to semivariance, measures excess return per unit of downside risk and is a much more appropriate metric than Sharpe

Sterling and Calmar Ratios – risk metrics designed to measure portfolio risk via the drawdown metric on a rolling basis. Both are relevant given the requirement to monitor both monthly and annual volatility levels.

Omega ratio – appropriate metric for hedge funds, it involves partitioning returns into loss and gain above and below a given threshold, the Omega ratio is then the ratio of the probability of having a gain by the probability of having a loss.




Portfolio Monitoring


Accurate risk measurement and diligent monitoring of various aspects of the portfolio is the key to running a successful investment organization.


Setting up the infrastructure, and choosing the exact set of appropriate metrics is a very important, and, at the same time, highly customized exercise. Below is an example of some of the core monitoring and review procedures.


Manager Monitoring Process



  • Article and industry publication searches
  • Review inbox for performance and any relevant information



  • Collect performance information from all managers, look for performance anomalies
  • Review correlation tables by strategy and manager
  • Selected Onsite visits



  • Review organizational changes within each manager
  • Review of 3rd party service providers



  • Financial statement reviews


Portfolio Monitoring Process and Reports (Monthly)


  • Concentration analysis
    • o Strategy
    • o Sector
    • o Single name
    • o Single issue
    • o FX
    • o Geography
  • Performance attribution
  • Risk trend analysis
    • o VaR
    • o CVaR
    • o IVaR
    • o Volatility
  • Largest winners/losers
  • Liquidity analysis
  • Style drift
  • Monte Carlo simulations
  • Scenario analysis / Stress testing


Danger Signals


  1. Exceptional performance good or bad – any time there is an extraordinary event whether good or bad, it is very important to understand the source of the spike, as it may serve as a possible clue to violation of risk limits or strategy constraints
  2. Style drift - dramatic changes of style are rarely for the better, and in fact affects the future return streams and the correlation of the manager to other portfolio investments
  3. Document surprise – unusual terms or disclosures in offering circulars, audited financial statements, or even newsletters may serve as a catalyst to take a closer look at a fund
  4. Management turnover - departures of key incentive fee based personnel may point to not only possible deterioration of future returns, but also serve as an indirect indicator of yet unseen problems within the hedge fund
  5. Assets managed - dramatic increase or decrease in asset size may signal style capacity or loss of major investor confidence


In addition, there are several studies that should be done on the portfolio on periodic (monthly or quarterly) basis:


  • Peer Group Analysis
    • o Qualitative Peer Identification - Identifying an appropriate peer group whose investment strategy and trading style most closely resemble that of the investment in question using qualitative criteria.
    • o Quantitative Peer Identification - Perform correlation analysis between performance of the fund and that of the large universe of potential peers
  • Regime Switching - On average, hedge funds have positive correlation to global equities and therefore are likely to produce positive performance during bull markets and lower or negative returns during bearish markets. Therefore, it is important to understand the fund’s behavior during different market environments.
  • Stress tests/Scenario Analysis - VaR alone does not provide information about the worst potential loss beyond a certain confidence level. Periodic stress tests and scenario analysis should be used as a complement to VaR.
  • Contribution to Risk - Even in a portfolio with an equal fund allocation, individual funds can have unequal contribution to portfolio volatility. Calculating such metrics as Incremental VaR for each of the portfolio component allows to identify the key risk contributors, as well as risk diversifiers.


Liquidity Considerations


As a fund-of-hedge funds it is crucial to know the lock-up periods of the hedge funds in which the FoF is invested so that the lock-up period at the fund-of-funds level is appropriate for such fund’s liquidity management purposes.


At the very minimum, a FoF should have a very detailed cash flow mapping system, where all the notice periods and fund lockups are entered and adjusted as needed on regular basis. Maintaining a clear and constant picture of the liquidity situation is a key risk management tool especially during the times of crisis of which we were all witness in the not so distant 2008.


As a general rule of thumb the lock-up should be as long as necessary for the investment manager to implement his strategy. For example, if a manager expects that it will take a year or more to see any results from the investment strategy, then the lock-up should be at least a year.   If the investment strategy is more short term in nature, like day trading, then the lock-up period should probably be significantly shorter.


However, the length of the lock-up is really a business decision that the manager will have to make and the manager should consider how potential investors may react to an overly long lock-up period. Managers should also be flexible with the lock-up in certain circumstances.


In order to fully understand the true liquidity restrictions though, it is necessary to consider all 3 investor liquidity constraining tools typically employed by the hedge fund community, namely:


  • Lock up Period
  • Notice period
  • Gates


Redemption restrictions can levy an important cost, however, if they prevent investors from withdrawing capital before anticipated losses are realized. In fact according to various studies

the combined cost of a two-year lockup and a three-month notice period can exceed 1.5% of the initial investment, roughly the same as the average hedge fund management fee for one year.


A much bigger threat to liquidity and investment profitability is actually the Gate provision. When fund managers can unilaterally suspend an investor’s real option to redeem, it can be shown that the cost of illiquidity can be as much as 15% of initial fund NAV. This suggests that hedge fund investors should be more concerned about the discretion asserted by fund managers in their partnership agreement, and conditions under which redemption suspensions can be imposed, rather than by the standard terms of lockup and notice periods.


As an interesting side note, the results from surveys of investors indicate the investors are receptive to the idea of paying a lower fee in return for a longer lockup period. Those surveys also indicate that hedge fund managers are willing to lower fees for longer lockup periods, and there are current examples of hedge fund managers explicitly offering various tiers of fee/lockup choices.



Negotiating Terms


While a hedge fund will obviously run pursuant to the terms of the main hedge fund offering documents drafted, the side letter does give the manager considerable flexibility to go outside the terms of the documents for certain investors.


There is a great deal of academic literature pointing to the fact that the hedge fund fee structures are changing and that fees are generally falling. As the once pervasive two-and-twenty fee structure becomes less common, it is believed that the new equilibrium median management fee and median incentive fee will be 0.95% and 13% respectively.


Given the general economic environment the hedge fund managers may be more receptive to entering into negotiations regarding the various aspects of the subscription agreement in order to prevent outflow of AUM from key accounts.


There are four core items that can be negotiated, namely:


Reduced Fees – the hedge fund manager will reduce or waive the management fees or performance fees for the investor.


Lock-up and liquidity – the hedge fund manager may reduce or waive the lock-up for a specific investor. The manager may also allow for greater liquidity (i.e. monthly withdrawals instead of quarterly withdrawals).


Information – the manager may agree to provide an investor with greater informational rights such as the ability to request a description of the exact positions of the fund at any given time.


Most favored nation’s clause – this allows an investor to get the best deal that the manager gives to any other investor. This clause is usually reserved for very large or very early investors.



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