David Alexander and Tony Peyser have been investing in hedge funds on behalf of clients and for their own accounts for 25 years. The catalyst for their foray into alternative investments was James Cramer, the former hedge fund manager and current host of CNBC's Mad Money, who came knocking on the door of their New York City-based firm, Peyser & Alexander Management Inc., in 1986.

Alexander, an attorney, and Peyser, a certified public accountant, had founded the multifamily office in 1983 to provide tax advice and preparation, general investment advice and asset allocation to high-net-worth clients.

"I've known Jim Cramer all my life, I grew up near him in Philadelphia," says Alexander. "So, when he launched his hedge fund, we were one of the places he called when he was leaving Goldman Sachs. We introduced him to some of our high-net-worth clients, and some of them decided to invest in his hedge fund." Cramer left his hedge fund in 2001.

Soon, the partners were analyzing and getting exposure to other hedge funds, run by heavy-weights such as Mark Kingdon and Art Samberg. In 1991, they decided to pool some of their clients' money into a diversified fund of funds rather than continue to invest in single managers.

"We felt we could control risk better by having multiple hedge fund managers in there," says Peyser. "And you could get access to some of the best managers for a lot less money."

Two Businesses
As their fund-of-funds business expanded, it eventually became a separate company, P&A Capital Advisors, which is the general partner of the funds.

"The family office and the fund-of-funds operation are two separate businesses," says Alexander. "Tony and I spend about 90% of our time on the fund-of-funds business as opposed to the family office business, where we have four partners who run the day-to-day operations." All told, 20 people work on the family office side, and nine on the fund-of-funds side.

The family office business today is stable, with revenue growing somewhat. "We've never tried to make this a mass market operation," says Alexander. The firm's clients represent a broad range of net worth, from $400 million down to less than $50 million. Many are upper-level executives in various industries, including the entertainment industry. Others are retired, having accumulated substantial net worth.

One well-known client is the best-selling thriller writer James Patterson, who was the focus of a recent New York Times article that discussed his wealth management philosophy and his association with Peyser & Alexander Management. (In the Times article, Patterson put his accumulated wealth at upward of $100 million.)

Funds Of Funds
Peyser and Alexander came relatively early to the fledgling fund of hedge funds sector. In 1991, when they launched their first fund of funds, there were 694 hedge funds and only 127 funds of funds on the market, according to Hedge Fund Research Inc. By 1994, when their second fund appeared, those numbers had increased dramatically, to 1,654 and 291, respectively. By the end of the first quarter of 2011, HFRI counted 7,285 hedge funds and 2,133 funds of funds.

P&A Capital Advisors offers four funds of funds to investors. Some family office clients invest in the P&A funds, says Peyser-"if it's deemed appropriate by them and by us."

Most of the funds' growth, however, comes from registered investment advisors and family offices and through the firm's work with consultants to smaller institutions. The P&A funds are currently represented on several institutional platforms, the largest ones being National Financial Partners and Oppenheimer & Co.

Assets under management have grown at a moderate pace and today stand at $375 million. That suits the two founders, who say they want growth that's slow and steady. In 2010, they brought on board Robert Rosenbaum from Altegris Investments to serve as director of business development and client relations to help the funds business grow.

Each one of P&A Capital Advisors' funds of funds allocates to 15 to 20 managers-"enough diversification to mitigate risk, but not so many that we become an index," says Peyser.

The flagship P&A Diversified Managers Fund LP, launched in June 1991, has a majority allocation to generalist managers that emphasizes a long/short equity strategy. The fund gives a smaller allocation to some specialist managers-by industry focus such as healthcare and technology and by trading strategy, including event-driven and distressed. The aim is to provide equity-like returns with substantially less volatility.

Since inception, the fund's average annual rate of return is 13.5%, which compares favorably with the S&P 500 return of 8.5% and HFRI's fund-of-funds composite return of 7.5%. The fund has been less volatile than the index, but more so than the composite.
P&A Multi-Sector Fund LP, rolled out in April 1994, is designed to be used as a U.S.-focused "core equity" vehicle-an alternative to a committed long-only investment in a portfolio of U.S.-domiciled equities. The fund's primary focus is on fundamental research-driven equity themes. Its emphasis is on specialist managers, while allocations to generalists are intended to reduce volatility and enhance consistency of returns. It also focuses on credit strategies.

Since inception, the fund has returned 13.4% on average annually, with a standard deviation of 10.2% versus the S&P 500 index's 15.6%.

P&A Select Strategy Fund LP, which launched in April 2001, seeks to diversify managers among multiple strategies within certain target ranges-value oriented, 20% to 50%; non-correlated, 20% to 40%; growth oriented, 10% to 40%; opportunistic trading, 5% to 20%; and emerging managers, 0% to 10%. The fund has returned 5.6% annually since inception, beating both the S&P 500 and the fund-of-funds composite, with a standard deviation of 6.8%.

In the P&A Balanced Fund LP, which was launched in January 2003, a 60% to 70% allocation goes to equity hedge fund managers who adhere to generalist and sector-specific long/short strategies; and 30% to 40% goes to non-correlated strategies, including event-driven investing/special situations, distressed securities, risk arbitrage, relative value trading/pairs trading and convertible arbitrage. This fund has failed to outpace the S&P 500, returning 6.2% annually versus the index's 7.2%, but has been only half as volatile with a standard deviation of 7.7%.

In addition to the four funds that are open to investors, P&A Capital Advisors also offers the P&A Diversified Insurance Fund LP, which was launched in June 2007 to provide an alternative investment opportunity for holders of variable life insurance or annuity contracts. The product allocates just under 20% equally to the firm's four funds of funds and 20% to external managers who have selected expertise, investment strategy and demonstrated performance in a particular area.

2008 Fallout
Like most funds of funds, P&A funds suffered big losses in 2008 at the outset of the financial crisis, down between 21% and 25%-but still outperformed the market. The HFRI Fund of Funds Composite Index that year was down 21.4%, while the S&P 500 index was down 39.3%. The P&A funds recovered handsomely in 2009, a strong year overall for hedge funds, with returns in the 18%-to-21% range.

The firm's assets under management fell by 30% in 2008, owing to negative performance and net capital withdrawals. Many managers in the fund of funds sector experienced similar losses. HFRI counted some $41 billion in total net outflows from funds of funds in 2008, and the hemorrhaging nearly tripled the next year.

The P&A funds' relatively modest redemptions compared with peers had a lot to do with investors' expectations, says Rosenbaum. Many fund-of-funds managers positioned their funds as bond-like products with low volatility and low correlation, but when the financial collapse hit, they did not deliver on this promise. The P&A funds, in contrast, were positioned as hedged equity vehicles, complements to long-only funds that would do better than the market. Although losses were substantial, P&A fund investors were not completly surprised, and most stayed on, he says.

Sourcing And Due Diligence
The fund-of-funds business has changed in many ways since Peyser and Alexander began to analyze hedge fund managers. Peyser says that when they were starting out, they had to beat the bushes to find managers who met their rigorous investment standards. Today, sourcing is a matter of screening the plethora of new managers who have flooded into the hedge fund space. Referrals from their current managers and Wall Street clients carry a lot of weight in the selection process.

The partners say they are looking for strong academic and professional pedigree in their managers. James Cramer, who came to hedge funds by way of Harvard and Goldman Sachs, is their touchstone in a way. Very important, too, is a prospective manager's track record and how he or she performed in down markets; the partners tap former colleagues on trading desks for useful insights.

Peyser and Alexander's due diligence road map, developed over the years, entails quantitative and qualitative analyses as well as thorough scrutiny of a prospective manager's operations and background checks of key personnel. The quality of a manager's service providers is a key element here-they want to see "gold coast" vendors. Why is this so important? Recall one of the uglier hedge-fund blowups of the past decade. The principals of the Bayou Hedge Fund Group set up a fake accounting firm to provide investors with misleading audited results after their funds sustained poor returns.

Site visits and face-to-face interviews with prospective managers are integral to their due diligence. The partners say they do not want to hear a hard sales pitch. They want to develop a strong and lasting relationship with the manager, and transparency is crucial to this end. After a manager is selected, regular monitoring and evaluation continue.

Another change for P&A Capital Advisors has come in asset allocation. "We have much less capital allocated to any one manager than we did at the beginning-a hard limit of 10%," says Peyser. He says an incubating manager rarely receives more than a 2% to 3% allocation, increasing to 5% to 6% for a mid-tier manager. Most of the core managers get 6% to 9% of capital.
The partners consider it their job "to construct an all-weather portfolio of the best hedge-fund managers, with the goal of making positive returns while seeking to mitigate undue risk," Peyser says.