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Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence
Investors Challenge Long-Only Portfolio Managers’
Ability to Add Shorting as a Skill Set
Despite these structural advantages, many investor and
intermediary participants in the survey had mixed views on
the ability of traditional asset managers to successfully offer
hedge fund products to the more sophisticated institutional
audience, where these managers compete head-to-head
with independent hedge funds. Most of these concerns
related to the skills required as a portfolio manager moves
from having managed primarily a long-only to a long/short
fund. This ability to identify and successfully execute a short
trade idea was one of the most debated and discussed points
in the survey.
Some respondents expressed their view that managers
emerging from a career spent focused on long-only investing
are not suited for shorting. They cited the experience of
130/30 funds as an example of a failed expansion of skills into
the long/short arena. These less constrained long strategies
emerged in the mid-2000s. They gradually introduced
shorting and a minor degree of leverage into the directional
long portfolios, but under strict constraints and monitoring.
These funds performed poorly during the 2007-2008 period
and damaged many investors’ faith in long- only managers
expanding their focus.
The reason for many participants’ concern relates to
perceived differences in the research process between long-
only managers and traditional hedge fund organizations.
Most long-only managers rely on their proven fundamental
approach that examines a set of securities to establish their
relative value. These managers are accustomed to the concept
of overweighting and underweighting the mix of securities
they own in a given sector or market. Many investors and
consultants expressed concern that these managers use their
least favorite buy recommendations as a stand-in for their
short trades. They note that wanting to own less of something
is not the same as wanting to short something.
Respondents of this view indicated that they were looking for
managers that were able to pursue alpha on the short side.
They are looking for managers able to think about portfolio
construction as a multidimensional opportunity across the
long side, the short side, and potentially even the hedge
portion of a trade. In this view, each of the trade elements
can be constructed and managed in such a way as to provide
independent opportunities to generate alpha. Many feel that
making this leap in thinking is highly psychological and that it
is a difficult transition for most portfolio managers.
There was also concern that the magnitude of mistakes on the
short side is greatly exaggerated by the nature of the trading.
Investing with inexperienced short managers was thus seen
as potentially risky for institutions that are averse to volatility
and poor performance in their portfolios.
“ We like to run a fund on paper at full capacity to understand
what the strategy could support in terms of eventual size.
When we have that sense, we stake the fund with enough
money to prove the strategy out in the actual market
and begin to establish the track record. Depending on
the strategy, we have sometimes held at this stage for up
to 3 years,”
– Asset Manager With Hedge Fund Offerings
“ We launch funds with a very low profile and we tell managers
to expect small amounts to begin with. We launch with
mostly internal capital,”
– Asset Manager With Hedge Fund Offerings
“ We see some institutional investors that view hedge hfunds
within long- only firms as an asset – they feel that we are
better off from an infrastructure and controls perspective
than a stand-alone hedge fund,”
– $1-$5 Billion AUM Hedge Fund
“ Investors want to see that you have all of the benefits of size
in terms of corporate access and research breadth,”
– $1-$5 Billion AUM Hedge Fund
“ These guys might be great stock pickers, but we want to
see an established track record. Shorting is whole different
ball game. We saw this with the launch of the 120/20s and
130/30s a few years ago as those funds really got caught in
the quant crisis,”
– US Public Pension
“ There is a skill difference that comes into play. In many
ways, shorting is a psychological activity. Not every long
manager is suited to be a good long/short manager,”
– Asset Manager With Hedge Fund Offerings
“ The whole shorting side is such a difficult skill set.
Long only managers have such a tough time moving
into that space,”
– Endowment