Anyone reading the financial headlines in 2008 can be forgiven for thinking the hedge fund industry quietly folded its tents and melted away into the desert. Not so, says Maggie Rokkum-Testi, General Manager and CIO of Thalia SA. Despite a decline in overall assets under management of 43 percent between 2008 and 2009, the industry survived and has been slowly rebuilding itself.

“The hedge fund industry is not dead,” she says. “It has come out of 2008 stronger than before and we are starting to focus on our long term goals again.”

Founded in 2003, Thalìa (the name in Greek means ‘to bloom’) is an alternative asset management company 51 percent owned by BSI SA of Switzerland and 49 percent by Italy’s Generali Investments. As the company’s Chief Investment Officer, Ms. Rokkum-Testi oversees a portfolio of funds of funds (FoFs).

“What happened in 2008 was a complex mix of events,” she explains. “The tipping point for the fund of hedge funds industry was the Madoff scam, which totally panicked a number of investors whose managers hadn’t done their homework. Even for those of us who had done the ground work and were not exposed, it was a period when we had to work hard to manage the emotions of our investors.

Avoiding Madoff, and indeed any attempt at fraud in the hedge fund industry she points out, is largely down to doing proper qualitative due diligence on all funds in the portfolio. The first, simple rule is to understand the investment strategy of a hedge fund and be able to explain where performance comes from. Then, checks should be made on who can sign off on cash, how the money flows from a client into a fund and how it gets invested. If those checks had been made on the Madoff schemes they would have immediately set off alarm bells.

But even before the Madoff scheme collapsed and before Lehman Brothers closed its doors, there were signs of problems in the market. “Just by speaking regularly with our fund managers throughout the year we became aware that something was going on in the world of convertibles,” says Ms Rokkum-Testi. “We began to see some uncharacteristic disruptions in the market during July and August, which gave us indications that we should start reducing some of our exposure.

A more universal problem for FoF managers and investors was the issue of liquidity. Many managers failed to match their assets with their liabilities, resulting in a liquidity crisis that triggered sell-offs. The more astute FoFs monitored the liquidity of the underlying hedge funds and the liquidity requirements of their investors and match their portfolios with those expectations. “We don’t offer monthly or bi-monthly liquidity through our FoF portfolios if we don’t have it,” Ms Rokkum-Testi points out. “We offer quarterly, if the funds underlying our FoF are quarterly.”

Picking winners
Estimates of the number of hedge funds in operation varies, but most analysts agree that the figure is in excess of 10,000, and choosing funds to suit an individual investor’s needs can be a minefield. Following the 2008 meltdown there has been a trend for Investors to focus on the more liquid strategies, such as long/short equity, but beyond that there remains a plethora of unique strategies, each influenced by the manager’s own capabilities, experience and instincts that can exploit market opportunities.

As a result, although the purpose of the hedge fund remains to spread an investor’s risk exposure, managers are paid to take risk, so if you aren’t careful and don’t understand the investment strategy, you may expose yourself to unwanted risks. That’s where the capabilities of an experienced hedge fund investor are most valuable.

The basic long/short equity strategy attempts to hedge against risk by balancing undervalued stocks for the long portfolio with overpriced equities for the short portfolio. That seems straightforward enough, but within that umbrella tactic is a vast array of sub-strategies and individual quirks. There could be a geographic focus on, say, European, Asian, global or American equities. Managers could follow an aggressive growth strategy, or focus on distressed securities or emerging markets.

Timing and liquidity also play a part, with strategies to hone in on fixed income, merger arbitrage, market timing, short selling and fundamental value investing. Some of the more complex strategies include opportunistic, where the manager looks for one-off opportunities related to corporate activities or earnings announcements; multi-strategy, which modifies allocations depending on the manager’s reading of the market; and global macro, which attempts to profit from different central bank responses to changes in global economies and uses leverage and derivatives to enhance performance.

So, investing in a hedge fund becomes a strategic choice in itself, and one that the small to medium sized investor is often not prepared to make. “If you are a single wealthy person or small institutional investor you would have to diversify across at least five or six funds minimum to spread your exposure to the different investment approaches,” Ms Rokkum-Testi points out. “This is where the fund of funds can add value, because they have the expertise and the manpower to analyse funds and understand which combination of strategies will suit investor’s own risk and liquidity needs.”

Building a Fund of Funds
Each fund strategy has its own return and liquidity drivers and its own risk profile which must be matched to the needs of the investor. An institution with a medium to long term outlook would be well suited to a FoF that has a bit less underlying liquidity, such as a multi-strat, fixed income arbitrage fund that requires longer time to fruition. A private client with spikes of liquidity needs would be better placed in a long/short fund that provides higher redemption frequency.

Many FoF managers rely heavily on quantitative analysis when choosing the funds to include in a specific portfolio, but Thalia prefers a more qualitative approach. Of paramount importance is the fund manager himself. “We’re investing in talent,” says Ms Rokkum-Testi. “There may be times when we go on the hunt for someone in a specific strategy niche, but we won’t invest in a manager just because he is a long/short manager in the US, for example, we will invest because he is a good manager.”

Of the 10,000 funds available, Ms Rokkum-Testi believes there may be only about 500 that would be serious considerations for investment. The first problem is finding them, when there is no comprehensive database of funds, many of which are private. Having assessed the talent of the individual manager and gathered background and reference details, Thalia works to build a relationship through which they can get to understand his investment process and strategic ‘edge’. Finally, they go through an exhaustive due diligence process to make sure they understand the fund’s structure and operational processes.

All of this, of course, costs money. In the FoFs industry, there are fees on top of what the hedge fund managers already apply, but Ms Rokkum-Testi believes that FoFs deliver good value. “We do the investment due diligence, operational due diligence, we understand the market, manage the portfolio and keep a close eye on the risks,” she says. “That is how we avoided things like Madoff, but it is really hard to put a quantitative value on that kind of investment safety.”

The group is proud of its performance through 2008, when they were able to avoid locking money up, changing redemption terms or creating any liquidity terms. Although the size of funds under management shrank, they went on to have their best year in 2009, and are on track for their growth target of $4-5bn under management.

Some of that growth will come from new fund concepts, such as private funds for single investors. One of the most critical issues for FoF or hedge fund investors in 2008 was the variation in risk appetite and liquidity requirements among the pool of investors. In many cases, investors with an appetite to remain in the market found themselves abandoned by others who, for various reasons, pulled out. The solution for many wealthy individuals and institutional investors is to have your own private fund of funds.

Private funds are certainly not for everyone – the minimum size for an FoF in the long/short space is around $20m, and for more complicated funds in the fixed income or global macro arena it is more like $50 to $100m – but there are several advantages. Your fund is designed around your own liquidity requirements and will not be subject to the disruption of other investors’ changing needs. You will have direct access to the team responsible for managing your fund, and you get full transparency on the entire process.

“Transparency is a key issue in our industry, especially post 2008,” Ms Rokkum-Testi comments. “If you own a FoF that has 25 positions you should know exactly what funds are in that portfolio, but many FoFs only offer the top five positions and may not even indicate position sizes. The danger here is that a medium sized investor purchasing three or four FoFs may be doubling or tripling their exposure to a manager without knowing it. It is very important that the end investor gets the information he needs in terms of what kind of managers they have in the portfolio.”

For more information: www.thaliainvest.com