Exotic fund recipes will only work for talented chefs

This essay appeared in Citywire Selector on September 10, 2009.

Give one chef a kitchen stocked with exotic ingredients, advanced appliances and the newest culinary theory and you may end up with a dish worthy of a few stars. Give another the same tools and you end up with a disastrous meal and very upset diners. The difference is primarily driven by the skill and talent of the operator but even in the hands of an expert, blow-ups can happen.

An analogous scenario exists in our industry. Even with the best tools and most advanced theories, some fund managers end up making a mess. The menu says: ‘steady (positive) and uncorrelated returns’. When the meal arrives, it is anything but. Botched 130/30 strategies, absolute return strategies that are absolutely dreadful and long/short funds that fall short of expectations.

Driven by both investment and commercial interests, a convergence of paradigms is being crystallised in a new generation of funds. Ucits III represents the most advanced liquid vehicle for the incorporation of current theory and sophisticated investment instruments.

While commentary has mainly focused on the new purpose-built strategies – 130/30, absolute return bonds, market neutral, long/short, etc – just as significant are the changes taking place beneath the surface.

Fund managers across all styles and disciplines are implementing a broader range of tools and tactics. In some cases this is subtle, like a chef applying a small amount of exotic spice to a classic dish – the flavour is modified slightly and almost imperceptibly.

A changing mindset and theoretical framework are driving evolutionary shifts in the industry. There is a developing realisation that the barrier which had set so-called alternatives apart from those areas seen as ‘traditional’ is permeable.

The notion of alternative investments has itself changed vastly over the past decade. What was once considered to be marginal now fills an increasingly central role in portfolios. Ucits III marks a key junction at which some of the techniques previously unavailable in a liquid vehicle are made accessible to a broad group of investors.

The structure has encouraged interaction between what had previously been disparate ways of thinking about investing. But to assume that because a new strategy uses the broader flexibility of Ucits III it will prove to be a magic bullet is a misunderstanding, and worse, dangerous. In the end, it will not be the tools that earn the credit or blame for success or failure, but the manager.

Further, the fewer the constraints and the more innovative the tools available to managers, the more important the skills and diligence of the selector. In fact, as the rate of innovation and number of participants grow, so too will the discrepancy between successful and failing managers.

Each manager must be evaluated on his or her own merits within the scope of the strategy he or she is managing. No exception should be made for a manager who has a history of ‘running a short book’.

The road to innovation is littered with failures at the hands of the well intentioned and the skilled – hedge fund managers have been no exception.