| Keith Haydon |
Keith Haydon found himself working in finance almost by accident, but the career path he forged when he got there makes him uniquely suited for his job as CIO of London-based fund-of-hedge-funds firm Man FRM, which he joined in 2004 after a 15-year career as a macro proprietary trader. The history major got his start as a bond analyst after graduating from the University of Cambridge in the early ’80s with no specific career plan in mind. But it turned out that his personality traits made him a perfect fit for a job in finance. “I have a very low boredom threshold, and I found I liked being in groups of people more than I thought I liked being in groups of people,” he recalls. “From there you kind of go wherever they’ll have you.”
Haydon followed that job with stints as a proprietary trader at Morgan Stanley, HSBC Holdings and Deutsche Bank, gaining a unique appreciation for the challenges of earning strong risk-adjusted returns in a hedge fund portfolio. These challenges were thrown into sharp relief by the 2008 financial crisis, which took a heavy toll on hedge funds: They fell 20 percent, on average, that year. The damage to the fund-of-funds model was more severe. After the crisis it became clear that most of these managers — previously seen as savvy investors that had entrée to the world’s best hedge funds and that charged their own fees for the privilege of accessing them — had failed to deliver the two things they were supposed to provide: due diligence and capital protection. Fund-of-funds assets shrank by nearly 47 percent.
Haydon and his FRM colleagues took a hard look at their business and identified four problems with funds of funds as investment vehicles. The first and most obvious is fees. With funds of funds generally charging a 1 percent management fee and a 10 percent performance fee on top of the typical 2-and-20 fees charged by the underlying hedge funds, the hurdle to achieve great returns becomes almost impossibly high.
“As a client, if you paid fund-of-fund fees and hedge fund fees at the typical levels, the hedge funds had to make a ridiculously large amount of money before the client got what he needed,” says Haydon.
In addition, the fund-of-funds model is meant to offer diversification, but Haydon discovered that too much diversification meant that FRM’s funds of funds weren’t taking big enough bets to generate the kinds of returns that both the clients and the firm needed to justify the costs of investing. The third issue is what Haydon describes as portfolio mobility: If a fund-of-funds manager suddenly becomes concerned about the equity markets, for example, it can’t quickly reduce its exposure to equity managers because most underlying funds require at least 45 days’ notice to pull out money — and once you get out, sometimes managers won’t let you back in; this can lead to a degradation of the quality of managers in a portfolio.
Last, there is the issue of business stability. The entrepreneurial nature of hedge fund managers is one of their best assets, Haydon notes, but it also means their businesses can change quickly for better or worse. “If they’re small enough to be able to be nimble and move around and you’ve not got capacity problems, these days, with all their costs, there is a risk that they’re quite close to the edge in commercial terms,” says Haydon, 55. “And if they get big enough not to have any commercial problems, then you start worrying that with thinner liquidity in the world, it’s quite hard for them to move their capital around and produce returns from active management, which of course is what you’re paying them for.”
Haydon says his firm’s 2012 acquisition by London-based asset management giant Man Group gave his team the tools to mitigate these problems. By investing in underlying managers via managed accounts and harnessing the risk technology of Man’s in-house investment businesses — like its flagship Man AHL commodity trading adviser program and the Man GLG discretionary funds — Haydon and his team could see more clearly the risks their portfolios faced. Also, FRM’s access to AHL, GLG and Man Numeric, a Boston-based systematic equity manager Man Group acquired in 2014, allowed FRM to purchase customized systematic strategies with daily liquidity to help address the portfolio mobility problem (allowing it to reduce or increase exposures to specific strategies). It also enabled it to take advantage of what Haydon calls spare capacity, or investing in interesting trades that the firms couldn’t scale up in their commingled funds.
According to Haydon, FRM is better positioned to handle both market and business problems than it was before the Man acquisition. But the hedge fund industry as a whole is bracing itself for a new set of challenges. Hedge funds have delivered disappointing returns to investors, on average, for several years, most recently posting a decline of 1 percent in 2015, according to Chicago-based industry tracker HFR. Haydon says the bloodletting during the second half of last year was particularly troubling and raises questions as to whether the hedge fund industry will maintain its ferocious growth — and whether it deserves to.
“I do feel like there is a need for an industry that produces returns by shorting or by active management when the returns from passive securities are not going to get you there,” he says. “That’s clear to me. But the hedge fund industry clearly isn’t meeting those needs head-on, and it is charging a lot of money for it.”
Haydon recently spoke with Alpha Managing Editor Amanda Cantrell to discuss the newest challenges facing the hedge fund industry — and the two risks that concern him the most.
ALPHA: You said your team identified four major problems with funds of funds as investment vehicles. How did you go about solving them?
haydon: The facilities at Man Group offered us a variety of potential solutions to these problems. If you’ve effectively got in-house risk systems analyzing the risks of the hedge funds you invest in, you feel much more confident that you know that the numbers you’re looking at in detail are correct. And if they don’t look like they’re correct, you can figure out exactly why and correct them. That’s allowed us to get closer and to measure more, so that we know more about what we’ve got. That’s simple, and it comes from the in-house risk systems and the use of managed accounts to invest in other hedge funds. Lots of people are doing it; there’s nothing very special about that. So what did you do that was special?
I think the thing that is special is that our risk management infrastructure has been built for our own hedge funds and that we’ve got the full range, from quantitative equity to futures-style management to complex credit instruments to cash equities. We do the lot. When you allow for Numeric, AHL and GLG, those systems cover the full spectrum of hedge funds, so there’s not much that we don’t have. By using that technology on those accounts, we effectively can apply the same risk management standards in allocating to outside funds that we can as owners of our own funds. So it doesn’t feel any different in that situation — investing in somebody else’s hedge fund but using your own risk management software to look at it — than it does from owning your own hedge fund and employing the guy who’s running the risk. It means that I have daily position-level transparency on what the manager is doing; I’ve got filters on what he’s got that flag anything that exceeds my expectations in terms of the losses he can accumulate, the size of the positions he’s in, the instrument types he’s trading and so on — even the liquidity buckets within which they fit. And my ability to interrogate that data is powered by what is essentially $150 million-plus worth of infrastructure, which you are unlikely to be able to afford to build unless you’ve got substantial hedge fund assets of your own to pay for it and justify it.
In practical terms, how does this help you?
Because you have so much more control and insight on what the manager is doing and how their business is working through this account where you get to see all the trades going, you are able to have fewer hedge funds in your portfolio than otherwise. You can have a more concentrated portfolio because you’ve got a better grip on that real source of instability in managers. But I think that’s probably only half of the whole thing. The other half has been to address those first three problems, which is how do you take more risk, how do you manage to get lower fees, and how do you manage to get more mobility? Well, the answer is you have to look for it.
And where did you find the solution?
Our portfolio mobility used to be very low. It was made up entirely of hedge funds which we knew and loved, and had whatever liquidity terms they offered us. And it turned out the portfolio was too immobile to be managed in response to a rapidly changing environment. So what we thought was, we need a bunch of components in the portfolio that have systematic processes with clearly transparent exposures and very high levels of capital efficiency — in other words, a small amount of capital invested leads to a big change in the exposure at the portfolio level. Most of the time when you move hedge funds around, that doesn’t happen. And they need to be very liquid. We looked around the world for processes that looked like alternative return streams that had those characteristics and found very little. So we decided to build them ourselves using AHL and Numeric. And we’ve essentially built out a sequence of about nine different systematic processes on which we have daily liquidity, which have these characteristics of being totally transparent to me and which are designed to be very capital-efficient. Using those things I can tilt that portfolio one way or another with respect to not just the equity exposure but particularly my ability to control the amount of momentum I have in the portfolio.
How do you use these tools in your portfolio?
We have introduced roughly a 10 percent allocation to one of our core commingled fund-of-funds portfolios to a set of return-generating engines that have those characteristics and allow me to adjust the exposures to things that are a bit more complex than simply equity exposure, such as momentum, in order to get the number down if it’s got too high or up if I am not taking advantage of the opportunities available to me. Because they’re very capital-efficient, they contribute something like 25 percent of the risk in the portfolio. It’s almost like running an overlay in alternative strategies instead of an overlay in currency.
We still do use some managers who have tail-hedging characteristics, but I treat that now as very much a third part of the risk management process, as opposed to the only part, which it very much was in 2006, when I would have a tail-hedge manager sitting passively in my portfolio all the time and I would hope to hell that what happened is he made a lot of money when everyone else lost it. It was tricky because he wasn’t explicitly offsetting the risk, he was just taking a risk another way. We all grew very fed up with the fact that it didn’t work very well. But I did that because I actually didn’t have the ability to trade directly myself, and we didn’t have the in-house expertise to do it.
There is one more thing I have increasingly been looking at, which I wouldn’t and probably couldn’t do outside the context of my current circumstances. What I’ve actually ended up doing in a lot of places is taking what you would regard as spare capacity.
What is that?
It’s a very interesting phenomenon in the hedge fund industry — particularly in the systematic space but also in the discretionary space — that when you sell a flagship product and it’s successful and it grows, you usually hit a constraint, which is that some part of it doesn’t want to grow anymore because it’s actually full up. It’s at this point a responsible manager will stop growing the product, as any more risk in a single name will distort the product.
Can you give an example of this? Numeric does cash equities, market neutral, in a huge universe of stocks, and they have almost infinite capacity in the top 500 stocks, so it’s almost as if they could take as much investment as you like in the full process that they have in that top 500 stocks without it constraining their ability to run the rest. If they’re going to grow the rest, the problems are going to come with the small-cap pieces or the bits in the emerging markets or something like that, but not with the top 500 stocks in the world. That’s not a problem. So they say, “If you wanted to buy our main program, you would have to pay full fees.” And I go, “Fair enough, but what happens if I want a thousand stocks?” And they say, “Ah, well, you can have that for less.”
So part of what we’re doing is going around and saying, ‘Look, can we have the spare capacity?’ Which I think is quite useful for us in the context of a fund-of-hedge-funds portfolio because I don’t have to pay you so much for it. And I believe I can do it in a capital-efficient way, and it’s not really costing you anything very much to give it to me, so you don’t have to charge me a high price. The manager has done all the work but can’t take any more risk in that single name without distorting the shape of the product. So the manager then goes around to his big investors and says, ‘By the way, you can have this for cheap on the side if you like.’ Essentially, what you’re doing is, you’re picking up the bit that has very low production costs for them and very low opportunity costs for them, and I can then have that tailored as I need to put into my fund-of-funds portfolio.
Another example of the same customization is with AHL, where they have conventional momentum medium-term, trend-following programs with lots of clever bells and whistles and so on and so forth which look to improve the Sharpe ratio, and they invest in a huge number of different markets. Therefore that’s relatively expensive. Whereas if I go to them and say, “Listen, how about just the top 50 markets?” they go, “Ah, we could do that much more cheaply for you.” We can then look to run it in a very capital-efficient account, so I’ve done that too.
Hedge funds didn’t exactly cover themselves in glory last year. Aren’t investors going to run out of patience?
The growth in the industry has been totally staggering to me. I think that when you get growth of the kind that you have, you’ll get setbacks. And it’s pretty painful when the hedge fund industry has to delever, particularly when there’s nobody on the other side of the trade. Unless you are a well-risk-managed hedge fund, you’re very vulnerable to that deleveraging process, which I think will come. If you haven’t got liquid books, if you’re in hedge funds that are in with the crowds, if those hedge funds haven’t managed their liquidity profiles properly, you’re going to have a very bad time.
How can you tell when a fund is well risk-managed and when it isn’t? It’s funny how radical the difference is between the two. I think you’re seeing that very clearly now. There are some funds out there now that are down 40 or 50 percent, and they probably haven’t done very much at all about changing their risk profile. They don’t think that’s what they’re meant to do, and they probably can’t anyway. These are the guys who bit us hardest in ’08, and for the most part we don’t own very many of them.
One of the key questions is, Is there a risk management culture? When you go in as a casual observer of a hedge fund, you know. For us the most exciting kind of environment is where you go in and their version of risk management is not to tell you where their limits are. When you talk to the risk management guy, the deal should be that he’s got a very good risk report, which he’s not terribly interested in explaining to you. He’s trying to figure out what can go wrong and under what combination certain instruments will correlate with what other ones and whether or not that constitutes a threat and whether that’s a risk they like taking or it isn’t. That’s a good sign.
What I’m really looking for is a risk management culture that is deep, powerful, properly resourced technologically, properly resourced in terms of personnel and genuinely curious and intellectually active. When you can feel all those things going on in a shop, then you have some reason to believe that the claim on the hedge fund’s part that it’s an absolute-return vehicle with managed risk is real. Otherwise you have to worry you’re confronting a marketing scam.
What worries you most when you’re looking at the portfolios of your underlying managers?
There are two issues that, when I look at those reports, I really care about. The first is net equity exposure. Net equity exposure is really important because when equities are going up almost everybody has a crack at it — your equity long-short guys get quite net long, your credit guys stop doing credit and start buying equity, your macro guys follow the trend so they’re long equity too, and by the way they are the guys who are supposed to diversify you if those things go down. So equity exposure is a key one, and you need to think hard about how you manage that one.
And the other one which I find increasingly is an issue is actually not an asset-class exposure; it’s the propensity to trade momentum. We all know that CTAs trade momentum, and the biggest exposure to momentum as a factor is CTAs, but a lot of others do it too. You find that stat arb managers increasingly have momentum overlays in their portfolios. One of the biggest single factors in our event-driven managers, for example, has turned out to be momentum. Sometimes short-, medium- and long-term momentum are all the same thing — and you suddenly realize that everybody is essentially trading an exposure that looks the same as everybody else, and when it flips round, you get very badly hurt. So it’s that ability for it to infect a whole portfolio of hedge funds that I think is hard to measure and very important to monitor in respect to that. I’d say if you are only allowed to look at two things on your risk report and think about those and interrogate those, I’d go for equity risk and momentum risk.
