How did Forsyth get into the fund of hedge funds business?
Djounov: Forsyth was established in 1991 by Paul Forsyth and began by publishing independent research and ratings of investment funds. About four or five years ago we started to receive increasing requests for hedge fund research, and we made a strategic decision to use our research talents to create fund-of-hedge-fund portfolios which we manage. Unlike our research on long-only funds which are available for sale to clients, our hedge fund research is kept proprietary.
Today we manage approximately $500 million in hedge fund assets.
Forsyth invests in over 100 hedge fund managers. Why so many?
We believe that the biggest risk involved in investing in hedge funds does not come from the investment side, but from the operational side of the business. The monitoring and managing the fund's operations is where most hedge funds fail.
While investment-specific risk can be diversified in eight to 15 funds, the operational risk from each fund is still significant if you have a concentrated number of them. Seven to eight years ago, people used to think that investing in the largest hedge funds would limit the risks. But since then failures at Long-Term Capital Management, Beacon Hill Asset Management and Manhattan Investment Fund have proved that this isn't necessarily the case. The best way to protect against operational risk is to diversify among several funds.
Although we invest in over 100 hedge funds, about 60% of our assets are in 30% of the funds. We maintain smaller investments in the other funds which allows us diversify and invest in early stage managers and get insights into which funds will be the new stars as they emerge.
Does such a large group of managers dilute the fund's return?
This assumes that there are a small number of managers who have superior alpha generation abilities. However, we have found no evidence that alpha is proprietary to a handful of managers. Alpha is cyclical and portable and it's not necessarily the same guys who produced it five years ago who can produce it today.
How much trading goes on in your portfolio?
We've owned some funds for up to eight years, and some for only four months. It really comes down to the skill of the manager and we stay on top of this. If a manager produces negative returns for three consecutive months we have an automatic rule where we redeem from that manager.
The amount of turnover in the fund is a function of market opportunity. For the two years prior to the last six months, most strategies were producing positive returns. However, in the challenging environment of the last six months, many funds were unable to prove themselves. At the peak we were investmed in 160 hedge fund managers, but over the last six months we have begun redeeming and we are currently invested in close to 110 managers.
How do you allocate exposure to different managers? Do you engage in tactical asset allocation?
We don't believe that anyone has a consistent ability to forecast the future, so we don't engage in tactical asset allocation.
Instead we look at what we believe are the three factors that influence a manager's ability to generate alpha. Firstly there is market momentum, which is driven by the spread between short- and long-term interest rates. This factor is important for long/short equity managers and fixed-income funds that have a directional component.
Secondly, market volatility has a strong influence on the ability of relative value strategies to generate alpha. The third factor driving hedge fund returns is the market perception of risk. Strategies that are event driven or rely on a catalyst for a re-pricing of a security are driven by a market's perception of risk. Oil prices are a very important factor influencing this. When prices are high or expected to rise, the market perceives higher risks. Currency volatility and interest rate changes are other signals.
When we allocate to hedge funds we don't classify them by strategies, such as long/short, macro etcetera. Rather we look at which of these three factors drives their returns, i.e., momentum, volatility or risk. We call this our three-pillared approach and allocate one third of our hedge fund assets to each pillar.
When all three factors work together, opportunities for alpha are the greatest. However there can be circumstances when all three collapse, such as earlier this year. In this environment hedge funds will find it very challenging to make money.
Forsyth recently opened an office in Hong Kong. What is the firm's strategy for marketing in Asia?
Our business model is distributor based. We bring to Asia international offshore perspective and know how to provide portfolio solutions the market wants..
Whereas most of our business used to come from IFAs, we are now more focused on private banks. As we reach half a billion in hedge fund assets, we are now at a point where we can move our clientele up-market. We're also finding people to join the team who have private banking experience. Whereas 20 years ago private banks exclusively sold their own products, they're now considered as client advisors with fiduciary obligations to present the best solution to their clients even if it is not available internally. Forsyth has definitely benefited from this trend.
In Asia we've identified big markets like Korea and Taiwan, but know that to operate effectively in these markets communication in the local language is a must. Guy Medcraft, who heads our Hong Kong office, is the only expat in the office. The rest of the team members are all Asians with a local language capability.
Do private banks prefer to white label your products?
White labelling is a cyclical trend. In the current market environment when there is a risk of underperformance banks prefer not to white label. It's much easier to blame someone else when returns are bad or react by sacking the manager. In bull markets, however, bank's prefer to white label and use their own brand.
What differentiates Forsyth in Asia from other fund of hedge funds offered to distributors?
Distributors in Asia are increasingly appreciating the need to look at their hedge fund investments, particularly in light of recent scandals. The fact that we are regulated by the UK Financial Services Authority gives investors confidence in our standards and operational procedures.
One of the distinguishing factors of our fund is that it can be converted into multiple fully hedged currencies. With the weakness of the US dollar, many people have been interested in multi-currency structures.
The other feature that differentiates us is that we offer investors an opportunity to earn an income from their hedge fund investments. Our funds offer two share classes, one an income option and the other a roll-up option. The income option is particularly relevant to retirees. Usually they would be forced to liquidate from a fund in order to receive an income, but we have a distribution share class that aims to pay a dividend twice a year. This allows the investor to stay in the fund without liquidating.
What do you think of Asian hedge fund managers? Do you invest in any?
We do invest in Asian hedge funds. As the industry here is fairly new, the average quality of the managers is probably superior to the US and Europe, where the markets are more established. At the moment, it is only the most skilled managers who have been able to leave their jobs to set up a fund. However because the industry is new, the skills involved for hedging in the market and operating a hedge fund business have not been developed. You see very few second-generation hedge funds in Asia. This gives the Asian hedge fund industry a higher embedded risk, but this will change with time.
How do you think hedge funds will perform over the next six months?
I am quite positive about the next sixth months. The market believes we are now at the end of the interest rate cycle. So this important negative catalyst has been eliminated. Also with the US elections over, this source of uncertainty has passed and managers can go back to taking a fundamental approach to the market. Confidence is certainly on the rise, and this can be measured by hedge fund managers' gross exposures that have recently been rising. This confidence creates liquidity in the market and further opportunities for funds.