This publication recently interviewed multi-asset hedge fund specialist FQS Capital, exploring some of the challenges for the sector in a market where liquidity can sometimes be patchy.

With
markets proving volatile at times, patchier liquidity will mean that
capacity constraints on some hedge fund strategies have to be closely
monitored to protect performance, FQS Capital, the hedge funds arm of a
family office business, says.

The issue of capacity limits has arguably become even more severe
because some strategies, outside of highly liquid areas such as equity
long/short, can see returns fall off significantly if individual fund
sizes rise above a certain point. A paucity of convertible bond issuance
at certain periods, for example, is a case in point for funds
exploiting price discrepancies in this field. (Knowing when a fund is
“too large” is not an exact science, however.)

This capacity issue is the sort of matter that FQS Capital
and its managers wrestle with as they seek to deliver consistent,
long-term returns from the hedge fund strategies to which its clients take
exposure.

Penny Aitken,
investment manager at FQS Capital, recently spoke to this publication
at her offices in London’s City district about the challenges of the
hedge fund sector. The firm oversees about $100 million of client money
and besides London, has an office in the US. It does not - due to rules -
disclose performance data. The invested funds are mainly held by the
partners and the family office, although it is starting to open up to
external investors.

“Patterns in trading, product innovation, cost/methods of execution,
regulatory changes and technological advances have affected and continue to
affect the liquidity dynamic in markets. So hedge funds will need to
adapt to this,” she said.

“Size [of hedge funds] is becoming much more important. You hear a
lot of people saying how difficult it is to execute in these markets,”
Aitken, an accountant by training, continued.

“Funds will need to exercise much more discipline about assessing
where their capability lies in terms of total assets that they can
manage before their size and ability to manage at this size starts to
dilute returns. We are very focused on monitoring asset flows in funds:
wary of seeing large inflows and the performance and operational
pressures this can lead to.

"An ability to manage assets is not just a function of market
opportunity but also the firm’s ability to scale up to cope with larger
sums of money both in terms of ideas, scaling them, risk managing them
and processing them on the back office side. It is a key risk factor in
monitoring hedge funds: how they manage growth and where they draw the
line/ what this means for return expectations and the quality of those
returns,” she said.

Rigour

Short-term data – such as the recent sharp gold price drops or
eurozone debt moves - can be unsettling, which is all the more reason to
adopt a rigorous investment discipline over time, she said.

And the short-run figures can certainly stir concerns as to whether
this $2 trillion hedge fund industry has lost some of its touch. Since
the 2008 financial crisis, hedge fund performance has been mixed. From
the start of this year through to the end of April, Hedge Fund
Research’s HFRI Fund Weighted Composite Index has risen by 4.37 per
cent. That compares with total returns – capital growth plus reinvested
dividends - from the MSCI Index of developed countries of 11.3 per cent.
Of course, those figures mask considerable variety in performance on
specific hedge fund strategies, not to mention the funds themselves.
In April alone, for example, the strongest gain, at 2.29 per cent, was
from Macro Systematic Diversified; the weakest result was the Short Bias
Index (funds which make money from a falling market), at 2.77 per cent.

Understanding how different strategies sit together in a portfolio is
part of what FQS Capital does for clients. The firm’s website gives a
flavour. Its investment research team, based in London and New York, uses
proprietary quantitative and risk investment analysis, and creates
diversified portfolios from a universe of funds drawn from all sectors,
strategies and geographical areas.

Monitoring and maths

The disciplined approach that Aitken and her colleagues adopt in
monitoring hedge fund performance is very much part of the intellectual
DNA of this business, which was set up by Dr Robert Frey, its executive
chairman and largest shareholder, and FQS chief investment officer. Dr Frey was, among other roles, the
former managing director of Renaissance Technology Corp, the hedge fund
business.

To underscore his credentials in these fields, Dr Frey is a research
professor on the faculty of Stony Brook University, New York, where he
is the founder and director of its quantitative finance programme in the
applied mathematics and statistics department. He is also an adjunct
professor on the faculty of the University of Chicago. FQS is, then,
very much a "rocket scientist" sort of investment house.

The investment process is highly data-intensive; a great deal of work
goes into finding out how much of a return stems from the market – or
“beta” - and how much can be explained by skill/techniques – the
“alpha”, Aitken said.

“We believe in long-term data and we are data junkies here. A lot of
decisions can be made over the short-term and that can be very
misleading,” she said.

“We do look at shorter term data (quarterly flows into strategies or
investor sentiment shifts quarter to quarter) but we prefer to base our
decision making on longer term historical data that we see as more
reliable and robust,” she said.

Key person risk

One issue that an investment house such as FQS Capital, and its
peers, needs to address is how to protect performance not just from when
funds expand beyond a certain size, but if a smart manager with a solid
track record defects to a rival, or retires.

This kind of “key person risk" is an important area as the hedge
fund sector has become more “institutional” and marketed its services to
clients such as pension schemes, family offices and banks. When someone
such as George Soros, for example, chooses to retire from running
non-family member money, it is not always easy to replicate his skill
and market hunches. One cannot clone a John Paulson – the man who
famously bet correctly on the sub-prime mortgage meltdown (although he
has lost money on subsequent market calls).

Aitken acknowledged that the “key person risk” issue is not an easy
one to resolve, but research work can be done to examine hedge fund
strategies delivering repeated returns over time. “Intellectual property
in hedge fund strategies is not always replaceable,” she said. “The
vulnerability to `key man risk’ will never entirely go away.”

As is often mentioned at debates about the pros and cons of “active
versus passive” investment, an issue that comes up is whether the
“alpha” can be consistently delivered to justify performance fees on
funds. Aitken is adamant that paying for alpha is worthwhile. “We do
think that alpha persists and you can prove that a strategy is the right
one,” she said.

Aitken said that “investors should pay for two things via hedge
funds: alpha/ idiosyncratic returns as well as returns they cannot
source cheaply and efficiently from other areas of the markets that may
still be appealing if blended in a way [to] diversify risk.

“What we do not think is that investors should pay hedge funds fees
for market factors they can source from lower cost options like exchange
traded funds, and so on”, she continued. 

“Some of our managers have records going back to the 1990s and in big
liquid markets. I don’t buy into the idea that alpha is all about
short-term opportunity,” Aitken said.

Some shakeout is still needed in the market after the rapid expansion
of the hedge fund industry over the past decade, she said.

The monitoring work that Aitken and her colleagues do requires a lot
of people and data, and this has to be paid for. That said, Aitken
pointed out that investors, faced with the typical “two and 20” annual
management fee and performance haircuts of hedge funds, are more
demanding than before about getting good value for money.