By dint of having founded the first American fund of hedge funds, Richard Elden has seen a lot more ups and downs than most of the competition. He’s watched the rise and fall of markets, the ebb and flow of economies, the arrivals and departures of politicians — all part of a great patchwork of life experience that from his vantage point in Chicago lends him a heartland sense of acceptance. “We’ve been through a financial crisis, and that’s almost over,” says Elden, 75. “Now we’re starting an economic crisis.”
The broader problems Elden says he sees coming will affect consumers and nonfinancial businesses alike and may take a long time to reverse, a vision unnerving enough to rattle anybody. But he seems unfazed, bolstered by a realization he had almost 40 years ago: that a certain breed of largely market-neutral investment professionals called hedge fund managers had figured out how to achieve consistent gains regardless of whether stock indexes went up or down. Diversification became Elden’s watchword, stemming from his fascination since early adulthood with the potentially rich payoff of spreading wealth among assets, and despite having been steeped in the University of Chicago notion that markets make everyone equal.
His attitude has obviously stood the test of time. Hedge fund managers are still around, and so is Elden, whose beginnings as a fund-of-funds manager go back to 1971, when he struck out on his own after a stint as an equity analyst with Chicago-based investment bank A.G. Becker & Co. to launch Grosvenor Capital Management. His goal was to find managers who added alpha year in and year out, to package portfolios around those managers and then to sell the portfolios to individual investors. It was a model that took off like gangbusters, ensuring Chicago a special place in fund-of-funds history, a position on which it continues to build.
By 1973, when the Sears Tower surpassed the World Trade Center as the tallest structure in the world, Elden was getting enough work to bring on a partner, Frank Meyer, who had been a colleague at A.G. Becker. Eleven years later the trinity that ultimately shaped Grosvenor was completed with the hiring of Roxanne Martino, a former fund auditor. Elden, Meyer and Martino, working roughly as co-equals, researched managers, huddled with clients and grew their fund of funds from a nifty local business into a key player in a global movement.
Elden’s diversification infatuation is still paying off across the fund-of-funds industry, and it seems especially prescient from the vantage point of this year’s messy markets (see “What Stampede?”). Through the end of October, the HFRI fund weighted composite index, which tracks about 2,700 funds of funds, was down 16.05 percent, compared with Hedge Fund Research’s multistrategy index, which tracks hedge funds and was down almost 18 percent — meaning simply that funds of funds have outperformed their underlying hedge funds, which speaks to the value of a diversified fund of funds when markets struggle.
But even fund-of-funds supporters qualify their endorsement given that such funds levy fees on top of those charged by hedge funds. “The layer of fees, in certain instances, can be justified,” says David Gold, a New York–based consultant for WatsonWyatt Worldwide, an adviser to corporate pension sponsors and other institutional investors. The case usually made is that if a fund of funds provides solid due diligence and adds value to portfolio construction, it can earn its fees, which typically follow a 1-and-10 model — 1 percent for administrative costs plus 10 percent of profits. Gold says that for an investor to go it alone in determining which hedge funds will succeed requires “a level of common sense” that may be more easily described than achieved, a selling point that seems to have served the fund-of-funds industry well.
Funds of funds have long been so ubiquitous — and so widely accepted — that it’s hard to imagine a world without them. Why they emerged from Chicago is a study in time, place and psychology; it was perhaps the ideal petri dish for such an industry. “It started in Chicago because Dick Elden and I started it there,” says Meyer with a shrug. Meyer is semiretired today and lives in Florida — he won’t say how old he is, but he and Elden are of the same generation. (Meyer still advises some well-known firms, including SkyBridge Capital, a major New York–based hedge fund seeder.)
From their base in the Midwest, Elden, Meyer and Martino managed to keep what was probably a valuable distance from stock traders in New York and short-sellers in California, maintaining a certain objectivity. Chicago had other advantages too. The city’s derivatives exchanges created an army of investors who understood risk and sought returns on holdings that were uncorrelated with their day jobs. And the concept did not exactly emerge out of left field: By the time Grosvenor was founded, Chicago already had an established group of funds with holdings scattered among the city’s many commodities trading advisors — in essence a small commodities fund-of-funds industry.
Martino says that when she first joined Grosvenor, she would attend CTA conferences because their professional forums best addressed what she was doing. Eventually, those conferences evolved into funds-of-hedge-funds seminars: “There are thousands of conferences and all these publications now,” she points out. “Twenty years ago there was nothing.”
“I’ve often thought of Chicago as the Second City, but at the forefront of finding niches that weren’t part of the markets in New York,” notes Brian Ziv, a co-founder and managing partner of Chicago-based Guidance Capital, a $570 million fund-of-funds firm started in 2001. Whether in options, futures or funds of funds, he says, Chicago investment professionals have traditionally sought opportunities overlooked in bigger financial centers like New York and London. “There’s a hotbed of investment expertise here and easy access to hedge funds on both coasts,” he explains. San Francisco is five hours away by air; New York is two and a half.
The Second City also has scores of money management and consulting firms and is the place where Arthur Andersen & Co., the once mighty accounting firm, came to global prominence before its entanglement with Enron Corp. The presence of so many well-staffed service providers hasn’t hurt the local growth of funds of funds. “A number of people here started in consulting and then moved into the hedge fund business,” Ziv points out.
In the beginning nobody knew what made a good fund-of-funds manager. “There was no industry,” says Meyer. But because it was possible then to know most every hedge fund manager, and because hedge funds had not yet grown gigantic and unfathomable, the industry held few secrets. It was relatively easy to uncover which firms had good performance and which firms were bluffing, who was being hired and who was being fired, what strategies were working and which ones weren’t.
Grosvenor would follow a fund’s progress for some time before jumping in, and money was put in only as fast as it could be put to work. The firm collected its own data because there were no commercial databases as there are today (nor were there any hedge fund investor relations departments). Most funds consisted of one or two managers, one or two analysts and a secretary.
Meyer says he learned early on to take a manager’s past success and compare it with more recent performance. Had the initial returns been a stroke of luck? Had the manager been able to generate a huge return on a small amount of capital on a bet that might not be repeatable? Or had the manager discovered a system to generate alpha in most market conditions, and was his performance truly uncorrelated?
Grosvenor was geared from the beginning toward high-net-worth individuals, not the pension funds and endowments that now fuel much of the hedge fund industry’s growth. “In the early ’70s an institution had a real problem investing in a hedge fund,” Meyer says, noting how old-school institutional investment law — the “prudent man” rule — required evaluation of individual holdings rather than lumping them in with overall returns. The Employee Retirement Income Security Act of 1974 changed that practice, but it still took time for institutions to fully embrace alternatives.
Nevertheless, funds of funds had instant advantages.
“At the very beginning a lot of hedge fund managers were worried about having more than 14 investors,” for fear that they would run afoul of Securities and Exchange Commission limits, Meyer recalls. By law they would have had to register with the SEC as advisers if they took on 15 or more clients, so hedge fund managers welcomed the sizable capital that typically came with a single investment from a fund of funds.
Eventually, investor demand drove fund-of-funds managers to discover and support more hedge funds, and Grosvenor became a champion of new managers, though identifying them was usually easier said than done. “You had to find talented people and encourage them to start a hedge fund,” says Martino. “That was a lot of work.”
But the effort often paid off in spades. The rewards of finding an exceptional manager before everyone else did could be enormous, something Grosvenor executives learned by being early investors in Chicago-based Citadel Investment Group and Stamford, Connecticut–based SAC Capital Advisors, two giants of the industry today.
Grosvenor didn’t have the field to itself for long. Others saw what the firm was doing and started their own fund-of-funds operations, in Chicago and elsewhere. Along the way the Grosvenor partners split up. Meyer went across town to start one of those new firms, Glenwood Capital Investments, in 1987. It was Meyer, in fact, who gave Citadel founder Kenneth Griffin his start in 1990, helping the then–22-year-old manager raise $4.6 million to invest using convertible arbitrage strategies he had developed as an undergraduate at Harvard University. In 1994, Glenwood entered into a joint venture with London-based Man Financial to reach investors outside the U.S. In 2000, Man acquired the firm outright, and today Glenwood, which manages $7 billion and has 42 employees, keeps its overhead low by relying on Man staff for marketing, compliance and systems expertise.
Chicago-based Harris Alternatives, another fund of funds, hired Martino as a portfolio manager in 1990; in 2001 she was named president. Martino, 51, today oversees $14 billion in assets and 65 employees. Elden left Grosvenor in 2006 to start Lakeview Investment Manager, which runs an activist fund of hedge funds. Grosvenor remains a private, Chicago-based partnership, listing $27.4 billion in assets under management as of June 30. In 2007 the firm sold a minority stake to Hellman & Friedman, the San Francisco–based private equity firm.
Successful and influential, Elden, Meyer and Martino had many imitators — slow to catch on but eventually clamoring for a piece of the action, having overcome their initial doubts and fears — chasing demand from institutional investors. “For many, many years we would spend a lot of time explaining the concept,” Martino says. “Once consultants accepted it, the whole thing expanded.”
Today the customer base at Harris Alternatives, typical of funds of funds, is about 85 percent institutional.
As their business has grown, some funds of funds have gotten more complex, having adopted practices that make them more nimble than the traditional model allows them to be. Harris sometimes taps stopgap leverage, for instance, to take prompt advantage of hedge fund investment opportunities while waiting for cash flow from investors, preferring to borrow money rather than risk being shut out of an exceptionally promising fund. It also hedges — with derivatives and carefully weighted portfolios — to protect against short-term risk from managers with better long-term than near-term prospects.
Glenwood isn’t as aggressive as some competitors in using additional hedging or leverage, according to John Rowsell, who joined Glenwood in 2001 and took over as chief executive when Meyer left in 2004. But, he asserts, having such tactics at hand gives Glenwood more dexterity than it might otherwise have and adds value for investors. And Glenwood, like many funds of funds, has a track record of helping new managers launch by encouraging them to go out on their own and investing with them on day one.
“Part of the culture that Frank created is that the opportunities are in early investing,” Rowsell says. Because most start-up managers Glenwood supports come from established hedge funds, he says, they usually have track records and an understanding of what a good back-office operation should look like.
Like Glenwood, Harris supports promising new managers, though Martino says the firm’s preference is to leave the light on for visitors rather than beat the bushes for them: “Because we’ve been around for such a long time, hedge fund managers come to us.” Still, if Harris finds a manager it likes, staff members will go on the road to do on-site research.
Every Chicago fund-of-funds player says it is far more difficult now than it was even a decade ago to cultivate much of a personal relationship with fund managers. Perhaps no more than 50 hedge funds existed when Elden opened Grosvenor, and during the firm’s heyday the three partners were able to meet virtually every manager of significance.
Such intimacy is impossible now — there are an estimated 7,500 single-manager hedge funds worldwide today. And although the Internet helps hedge funds and funds of funds find each other, sussing out a manager’s psychological makeup, daunting as it can be, remains an important way to gauge the potential for alpha. “Data can tell you some things, but you have to be careful,” Rowsell says. “Data in a distorted fashion can tell you the wrong things.”
He credits Glenwood’s acquisition by Man with improving the firm’s knowledge of managers outside of Chicago, but that hasn’t kept him from spending a lot of days on the road himself.
Investment strategies have evolved and shifted, too, to keep up with market conditions. Meyer says that there are many fewer opportunities for short-sellers nowadays, for example, because too many competitors are pursuing the same bets — on disappointing earnings announcements and dying industries. “Strategies have become crowded,” Rowsell agrees, which means his staff has to work harder to uncover managers who offer true alpha. “You don’t want people just buying something because it’s exotic.”
Going forward, Meyer says, funds of funds may see more competition from multistrategy hedge funds, in which a large firm sprinkles capital among in-house managers, each following different strategies, creating in essence on-premise funds of funds with a built-in edge: “You get the advantage of netting,” he explains. Investors in a multistrategy fund pay performance fees on the net return of the total fund; fund-of-funds investors pay performance fees on each of the underlying managers who make money, even if their gains are offset by losses by other managers. Still, defenders of funds of funds argue for their viability, noting the recent spectacular failures of two multistrategy hedge fund firms — Amaranth Advisors and Ritchie Capital Management — and Citigroup’s abrupt closing this year of Old Lane Partners, a multistrategy fund it acquired in 2007. Such funds have bigger risk management issues than do funds of funds — one trader can bring down an entire firm, as was the case with Amaranth.
One risk funds of funds can’t get away from, of course, is the potential for panic-driven redemptions on underlying hedge funds, an issue of special importance of late. “I don’t mind taking a mark-to-market loss,” Rowsell notes. “I hate realizing a loss.”
Which raises a question — and an answer — in the mind of Richard Elden, progenitor of the current generation of fund-of-funds managers: “What does an asset allocator do at this stage? Do you raise cash or remain fully invested? I would argue that you raise cash and trade up to better funds.”
And then you wait.
Although Elden says he doesn’t know how fast the government’s efforts to right the economy will work, he says they will eventually have an impact. And he says he believes in his heart that five years, ten years, 20 years from now, those shrewd enough to have diversified will have proved themselves prescient.
His parting wisdom?
“The only free lunch in economics is diversification.”
