By Frances Denmark
| Jeffrey Scott: While saying that we haven’t seen strong returns is a fair analysis of the industry as a whole, it’s not a fair representation of the best hedge fund managers. |
The investors who call upon Jeffrey Scott are looking for a portfolio manager with a strong radar for sources of alpha in a lower-return world. Scott, 47, has spent the past year building an outsourced chief investment officer division for the consulting firm Wurts & Associates in Seattle, where he heads up the $1.3 billion discretionary asset management unit. The sum is much smaller than the $40 billion he previously managed for Alaska’s sovereign wealth fund, the Alaska Permanent Fund in Juneau, and before that, the $56 billion he managed for Microsoft Corp.’s absolute return portfolio. But, says Scott, the job of helping investors balance risk and return through carefully selected alternative assets is more critical than ever. At Microsoft, Scott learned how to create a risk-based portfolio management strategy that uses an active risk budget to allow for opportunistic investing. He then brought this idea to Alaska. “If you try to build a static portfolio in a dynamic world, my guess is you’re going to follow the waves of the market,” says Scott. “If you think about the great investors out there, from George Soros to Warren Buffett, they’re not running static portfolios.”
Institutional Investor Senior Writer Frances Denmark recently spoke with Scott about his views on the right way to allocate to hedge funds in a portfolio and the state of the industry today.
Alpha: Institutions have been investing in hedge funds for years now. How can they improve the way they allocate?
Scott: Many still lack the knowledge to build something more thoughtful than the traditional allocation. When they want hedge funds, they select either a fund of funds or a host of hedge funds and put them in a bucket called “hedge funds.” It’s not integrated with the portfolio from a risk factor or risk analysis standpoint. The theory that diversification is a free lunch, in practice, is fraught with problems.
If you have an equitycentric portfolio, which most institutions have, and create a hedge fund bucket, it will probably have equity betas between 0.3 and 0.5. That will exacerbate your downside in a falling equity market, especially if you took that capital from your fixed-income portfolio or Treasuries.
How do you approach hedge fund allocation?
It depends on the size of an institution. A larger one may first want to obtain a diversified portfolio with beta exposures, and alpha. The second strategy is to find managers who tend to produce positive returns when an investor’s biggest exposure, usually equity, is negative. They may be looking at macro hedge funds, or commodity trading advisors, or momentum-based hedge fund managers to build an allocation to protect them on the downside. If constructed well, that may be more effective than a tail-risk hedging strategy.
We’re seeing higher-octane alpha production in the equity space. But studies show that long-only manager return doesn’t last and if you adjust it for risk and net of fees, it’s not really there. So what people are doing is building an equity beta portfolio and then instead of using long-only managers, they’re going right to hedge funds. So you see equity long-short and equity market neutral strategies instead of long-only managers.
How far beyond long-short or arbitrage strategies are you venturing?
We try to uncover a hedge fund strategy that’s in a niche market that is producing something that you just can’t get in the traditional space. They may be involved in direct lending or some sort of bankruptcy debt. Maybe they’re involved in royalty streams or reinsurance-type strategies.
When you integrate hedge funds with the rest of the portfolio, aren’t investors concerned that the recent lackluster performance of hedge funds might bring their overall returns down?
If you think of hedge funds as an asset class like large cap equity, then its performance has been lackluster. But if you think of hedge funds as a strategy that incorporates many types of beta and alpha production, it can be quite additive. Hedge funds are not an asset class. They’re strategies that add to the overall portfolio. When you take 10,000 hedge funds and say the median is lackluster, I don’t think that’s the way to analyze what hedge funds are about. While saying that we haven’t seen strong returns is a fair analysis of the industry as a whole, it’s not a fair representation of the best hedge fund managers. There are more than a handful of hedge funds that are producing a different return stream and producing alpha that would be useful for an institutional portfolio. The median hedge fund has not produced robust returns. That said, there are those that have produced.
Do investors feel it is getting harder to vet hedge funds now?
It’s no harder than it was five to ten years ago. In fact, it is somewhat easier because of the increase in service providers. There are entire businesses that do operational due diligence as well as those that do risk analysis and return attribution. It actually is easier to pick hedge funds than it was ten years ago.
Where is the hedge fund industry now on the evolutionary scale?
The maturity of the industry has been interesting in that we’re seeing more and more assets go to the larger funds, those greater than $5 billion. Public institutions and even private institutions are leaning toward the comfortable, “safe” hedge fund managers. The question is, will those hedge fund managers protect their alpha production skills, or will they just let their AUM grow?
How do you think the largest hedge fund managers will handle continued growth?
It appears that some managers are very thoughtful about where they’re extracting their alpha and the size of the opportunity. If you think about Long-Term Capital Management, they were extracting alpha, but because it became so big there was a target on their back, and it was easy for other investors to beat them at their own game. Think of the whale at J.P. Morgan; producing alpha it became too big and too fast relative to the size of the market, and the market actually turned on the whale. What happens is, there is a limit to the opportunity set for how they produce alpha, and some of them have recognized that and have closed their funds.
