Back to the roots with a high-risk hedge fund

Date: Wednesday, April 9, 2008
Author: James Mackintosh, Financial Times

Talk about a high-risk hedge fund and most people assume it is a tautology. This year’s sudden collapses of the $2bn flagship fund of London’s Peloton Partners and the $1bn New York-based Focus Capital, as well as a raft of smaller funds, has done nothing to change that view.

But a small group of hedge fund investors actively seeks out the riskiest hedge funds – and believes such funds allow them to chase high returns while avoiding the peril behind the blow-ups of the past 12 months: leverage.

Rather than find “safe” investments and add gearing to boost returns, they look for managers who aim high by investing only in their best ideas, by taking a view on market direction or by seeking trading opportunities.

“This is hedge funds returning to their roots, to the characteristics of the last decade,” says Tom Gimbel, managing director of Optima Fund Management, the $6bn New York fund of hedge funds.

In the mid-1990s, big hedge fund names such as Julian Robertson of Tiger Management and the Quantum fund of George Soros regularly racked up gains of 20 per cent or more a year – with the occasional big loss. But as institutional investors such as pension funds and university endowments became big buyers of hedge funds, the high-octane funds of the past were replaced by managers looking for a few percentage points above bonds.

Still, there are plenty of wealthy individuals who like the high-rolling hedge fund style of the past and are ready to take the risk of bigger losses to chase higher returns.

Optima is one such investor. It runs a $350m fund that buys only the “best ideas” funds of hedge fund managers, each of which holds typically only 10-20 positions.

Another is Eddington Capital Management, a $200m London fund of hedge funds that aims for high returns by employing a mixture of non-leveraged approaches.

“Given the choice of high leverage and what we do, I think the high leverage is the risk,” says Alex Allen, chief investment officer of Eddington.

The main danger of leverage is the risk of margin calls from lenders. As an investment drops, the gearing magnifies the fall, leaving less investor capital. But lenders typically impose a minimum percentage of investor money per dollar of borrowed money – a “margin” – forcing the fund to sell assets to repay some of the loans in order to maintain the margin.

Forced sales of less liquid assets into a falling market – such as the mortgage securities held by Peloton or the Swiss mid-sized company shares held by Focus – can see vicious price markdowns. Focus investors suffered severe losses while Peloton’s ABS fund suffered complete losses. Last year, similar missed margin calls on subprime mortgage securities wiped out two hedge funds run by Bear Stearns, and many other funds have had to be rescued by investors or banks.

But high returns cannot be had without risk. Optima’s Focus Fund frequently finds hedge funds in which it invests down close to 10 per cent in a month, while Eddington’s Triple Alpha fund has had one hedge fund it picked drop by a quarter in a month. They aim to minimise this risk by spreading it out, buying lots of high-risk funds on the basis that drops at some will be offset by big rises at others.

“We are looking to get a much higher return than our peer group and in order to do that you have got to take some sort of risk,” says Mr Allen.

Those risks are borne out in much bigger monthly moves for Eddington’s funds than is usual for funds of hedge funds, which generally aim for low volatility. The biggest monthly loss for Triple Alpha was 3.56 per cent, part of a bad run in 2004 when it ended the year up barely over 3 per cent. In January, when hedge funds had one of their worst months this decade, Eddington’s fund was flat, and last year it rose 16.47 per cent.

The real danger is that several of the underlying hedge funds do badly all at once, without big offsetting gains from others. But Eddington’s strategy is to find managers specialising in different areas, with the aim of minimising this risk. One of its main concerns before investing, Mr Allen says, is to ensure that the hedge fund can survive big losses without the margin calls or investor redemptions that often force closure of underperforming managers.

Eddington has just launched an onshore listed note, via Nomura, allowing UK investors to get tax-efficient exposure to a mixture of Triple Alpha and a macro fund of funds. Macro hedge funds specialise in bets on economic themes, interest rates and currencies.

Optima’s approach is more specialised, using only equity managers, but it too tries to diversify across different styles of investing to ensure funds do not all drop at once.

Mr Gimbel says Optima’s research shows the best ideas of hedge fund managers provide not just better returns, but better returns for the level of risk taken – as well as better returns than diversified hedge funds from the same manager.

He declines to discuss performance, citing US regulations. But, according to databases, the Optima Focus fund is relatively volatile, rising close to 20 per cent last year before dropping back 7.5 per cent in January, when many equity hedge funds suffered.