Bernard Lee, former head of quantitative research at fund-of-hedge-funds manager Allianz Hedge Fund Partners, is starting a quantitative analytics group for hedge fund products. The group will select and monitor tailored hedge fund portfolios as well as offer advice and structure products, explained Lee at last month's Risk USA conference in New York.
The group is designed to act as the middleman between clients, such as college endowment funds, that want to gain exposure to hedge funds, but find individual hedge funds too risky and the double fees on structures such as some funds-of-hedge-funds with large portfolios too expensive.
Investors are skittish about purchasing single hedge funds because of the risk of the fund blowing up, Lee stated. Meanwhile funds of hedge funds often comprise such a large number of funds that their performance replicates traditional investments. Lee's group will advise on, and construct, smaller portfolios that preserve upside performance, while also offering some downside protection.
Protection against negative hedge fund performance is presently expensive because there is no real means of determining the likelihood that a hedge fund will lose money, explained Lee. For this reason dealers price protection as an insurance policy. Lee argues, however, that the performance of hedge fund portfolios comprising a few funds can be strongly correlated to style indices. If a problem occurs in a style, such as convertible bonds for example, all convertible arbitrage funds would start marking down their positions.
Lee has modeled a means of hedging this style risk by shorting corresponding style indices. An additional premium could also be charged in order to cover the idiosyncratic risk of a single manager performing badly. This would offer investors reasonable protection against catastrophic losses at a lower cost than full principal protection, he said.