Strategy Allocation in Funds of Hedge Funds - IAM as an example

International Asset Management Limited is Investment Manager for Alternative Investment Strategies Limited, a Channel Islands Listed diversified portfolio of hedge funds. Through the Channel Islands Stock Exchange some top level information is made available.

For example, the strategy allocation as at 30 September 2010 was

Long/Short Equity	30.7
Macro	18.4
Credit	11.4
Fixed Income Rel Val	10.9
Event Driven	10.3
Multi-Strategy	9.4
Trend Followers / CTAs	5.3
Cash & Receivables	3.5
Fund of Funds	0.1

Source: International Asset Management Limited

Strategy allocation at a fund of hedge funds at any one time is a function of a range of factors covering the practical and the structural:
forecast returns per strategy, fund, and underlying market;
macro factor forecasts;
correlation and variance forecasts (or at least assumptions of stability);
fund historic performance compared to peer groups and strategy index returns;
benchmark weightings, normal allocation range per strategy;
strategic biases, and tactical shifts; 
cash flows, and liquidity of the underlying funds (notice period for redemption); 
frictional costs (spread on fund dealing, forward pricing, spread on underlying securities, redemption fees, premium or discount on traded funds, commissions);
and illiquid security constraints (side pockets and side cars).

In addition managers have the subjective influences to cope with - there will be anchoring to the selections made previously, both by strategy and by manager. There are relationships with managers to maintain, and not a single hedge fund manager likes receiving redemption notices, even if they are described to the fund manager by the investor as "rebalancing" or "just trimming an overweight". One investor I know told me that when he tried to diversify away from his very large holding in Soros' Quantum Fund by recycling just some of his gains in the fund, Soros told him it was all or none. He could take it all out or leave it all in but could not limit his exposure at the margin.This is where rationality meets a business man overseeing a business, and it is not seen as constructive in any way by the latter.

Still and all, the fund of funds managers have to manage. In former times, when positive fund flows extended to funds of funds as well as single manager hedge funds, the job of strategy/fund allocation was a lot more simple. The new inflows could be directed to the currently preferred funds and those that were being de-emphasised could be diluted down without any need for redemption notices.  That all stopped in mid 2008. Since then strategy allocation in funds of funds has required (for most funds of funds for most of the time) a redemption for every subscription. Given that there was a persistence of net redemptions as a businesss background for funds of funds well into this year it has been very challenging to activelly allocate to strategies and individual hedge funds since.

One of the advantages of the Listed (funds of) hedge funds is that they are closed-ended vehicles: the capital, if not permanent capital, is there for a finite medium-to-long-term period. This does not get over the need to redeem from one fund to subscribe to another, but at least for the Listed funds of hedge funds there has not been a wall of redemptions to cope with. And if market demand allows there may be tranches of new capital raised for quoted vehicles, to mimic the positive allocation/dilution tactic of open ended funds of funds that have positive flows.

The way that International Asset Management (IAM) has used this capacity to allocate to strategies is shown in the following table.


Strategy Allocation at Quarter End through 2010

	3Q	2Q	1Q	4Q’09
Long/Short Equity	30.7	27.4	38.2	35.4
Macro	18.4	17.7	16.9	17.2
Credit	11.4	9.5	9.2	8.3
Fixed Income Rel Val	10.9	11.4	8.9	8.2
Event Driven	10.3	11.9	9.5	12.1
Multi-Strategy	9.4	10.3	6.9	6.9
Trend Followers / CTAs	5.3	7.6	10.5	9.5
Cash & Receivables	3.5	4.1	-0.2	2.1
Fund of Funds	0.1	0.1	0.1	0.3

Source: International Asset Management Limited


A couple of strategy shifts are clear from this time series. In early 2010 capital was taken from Event Driven funds and allocated to Long/Short Equity. After the first quarter CTAs and Equity managers were used as sources of capital for additions to weightings in Multi-Strategy, Credit and to raise cash.


Rather like the approach to hedge fund investing taken by the Common Fund in the U.S., it seems that IAM used a core/satellite approach to portfolio construction, as the Top 10 holdings in Alternative Investment Strategies Limited has been very stable over the last year. The funds listed at the latest data point are shown below.

The Top 10 Holdings as at 30 September

Cobalt Offshore	5.82%
IAM Trading Fund	5.25
Claren Road Credit	4.87
SCP Ocean	4.86
Capula Global Relative Value	4.72
Arrowgrass International	4.71
WCG Offshore	4.66
York European Opportunities	4.64
Prologue	4.41
Diamondback	4.40

Source: International Asset Management Limited

The funds are the same as at the start of the year with only one exception (highlighted). The Top 10 funds accounted for 48.34% of the capital at the three-quarter stage.

The Top 10 Holdings of Alternative Investment Strategies Limited as at 31st December 2009

Cobalt Offshore	5.5%
SCP Ocean	4.75
IAM Trading Fund	4.74
Plainfield	4.62
York European Opportunities	4.20
Capula Global Relative Value	4.15
WCG Offshore	4.13
Claren Road Credit	4.11
Diamondback	4.06
Prologue	4.01

Source: International Asset Management Limited

There is a continual battle in reality and in marketing pitches about the relative contribution of the top-down (strategy allocation) and bottom-up (manager selection) in funds of hedge funds. The long list of practical difficulties given here shows that specifically since mid-2008 funds of funds have had less degrees of freedom in both of those regards than they had previously enjoyed, and that though there may be disappointment over the returns from funds of hedge funds over that period, there are also generic reasons why they have been as limited as they have been. There are other reasons for the under-performance relative to hedge fund indices and hedge fund averages, but they can be explored at another time.



Footnote: The net asset value performance of Alternative Investment Strategies since inception in December 1996 to 30 September 2010 is 146.84%, equivalent to an annualised rate of 6.75%.

ADDITIONAL: UBP ON STRATEGY ALLOCATION  (from their Outlook for 2011)
Larry Morgenthal, CIO of Alternative Investments at UBP Asset Management, believes that reports of the demise of hedge funds are premature. He is quite positive about the industry and believes hedge funds remain an attractive proposition: they provide diversification benefits and they have strong alpha generation potential.

With respect to the various hedge fund strategies, Larry Morgenthal goes on to say, "Allocating between hedge fund strategies is in some respects like dating - we have had a great relationship with credit, are having an affair with long-short equity and think that emerging markets could be marriage material, while macro is like an old flame - not large in the picture now but one we expect to get back together with in the future."

ADDITIONAL TWO: Send me some examples of funds of hedge funds strategy allocations (letters) and I will post a range of them here.