The Costs of Changing Investment Funds

Institutional investors change the composition of their portfolios due to their funds' poor performance, style drift, change in key personnel, etc.  When a fund is replaced, securities will have to be sold and bought.  The investors will try their best to minimize any costs and manage any risks.  The costs can be split into these categories:

• Direct - fees to hire a transition manager, trading commissions and taxes
• Indirect - bid and offer spreads and market impact
• Opportunity - prices of held securities being adversely affected by other traders
• Administrative expenses - finding the replacement manager, legal fees, rewriting fund documents and marketing material and custody fees

It is suggested that a transition manager be used if 2 or 3 of the following criteria apply to the portfolio:

• Transaction volume is more than $50 million
• Complex transition across asset classes or with daily valuations requirement
• Investor does not have resources for executing transition
• Out of the markets risks are higher because of allocation or settlement cycle differences
• Low tolerance for out of the market risks

The manager is usually rated by "implementation shortfall".  This compares the target portfolio's performance against the transition portfolio's performance.  This shows actual return versus theoretical return if there was an instantaneous switch to the new portfolio.

The source for this article, written by Freeman Wood and Paul Sachs of the Mercer Sentinel Group, can be accessed here.

Notes from a Hedge Fund Survey - Part I

Last month, SEI and Greenwich Associates published part 1 of the Fifth Annual Global Survey of Institutional Hedge Fund Investors.  There were several themes that emerged from the report for investors.

• Allocations to hedge funds are rising but at a slower rate than last year.  In 2012, they are projected to be 17.8% of investor portfolios.  They were just 12% in 2008.  The increase is led by endowments.
• The top goal for institutions for hedge fund investing is absolute return in 2011.  This was in response to the poor performance of the HFRI Index.  In prior years, the goal was to mitigate risk by investing in non-correlated assets.
• Investors use hedge funds to manage their investment risks through diversification among investments to decrease volatility
• More institutions are investing directly into hedge funds rather than funds of hedge funds.  According to Citi Prime Finance, investors are unhappy with paying an additional layer of management and incentive fees, are concerned that funds of funds are too diversified and want to have more control over their portfolio.  The larger institutions have the resources to invest directly.  Of the smaller ones (less than $500 million AUM), 64% use funds of funds.
• Most popular strategies are the simpler ones:  equity long/short, event driven and credit
• Limited interest in re-allocating to UCITS or mutual funds
• The most important challenge for hedge fund investors is having performance expectations met.  This is probably in response to the 2011 performance.  In 2010, when returns were good, then transparency was important.