As markets have been volatile, 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.

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 its clients take exposure to.

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 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.

Rigor

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 of 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 flavor. 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. He is also chief investment officer at FQS. 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 program 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.