[The hedge fund industry is very dynamic and both advisors and investors can benefit from closer analysis of trends and changes happening in the space. Hedge funds that creatively evolve with the industry will succeed, while stagnant firms may be left behind. We discussed the hedge fund industry with Steve Togher, director of research at Cross Shore Capital, which manages both a larger, more established hedge fund manager portfolio and the Cross Shore Discovery Fund, which allocates to newer or under the radar hedge fund managers. We asked him, from their unique vantage point as an investment research firm and institutional investor focused on long/short equity hedge funds, what are some of the changing trends in the space and how do they see the hedge fund industry evolving?]

Hortz: What are you uncovering from your research on the hedge fund industry?

Togher: Like most industries today, innovation and adaptation are central to long-term survival. The hedge fund industry is no different. Managers need to make adjustments to their business models, investment strategies, and risk procedures as they grow in response to changing market conditions. It requires a commitment on the part of the firm’s management to incur the costs and endure the process of building an adaptive, best-practices firm. We see more of that adaptation in the Discovery portfolio, the smaller manager product, although we do see instances in our larger portfolio as well. We are working on ways that we can select managers that are better suited to these changing investment environments as we go forward.

As an example, what is really challenging today for the industry, especially for fundamental, bottom-up, long/short equity funds, is incorporating new views and analysis into their risk management. Of the possible adjustments, the most important is incorporation of market-factor exposure into portfolio construction.  What we have learned post the 2009-2014 equity market is that factor exposure is as important as stock picking. One thing that makes factor analysis so challenging is the varied number and nature of market factors: value, growth, market cap, volatility, commodity, geopolitical, interest rates…the list goes on and on.  Getting the right balance of factors with the appropriate weights and formulating a process to incorporate knowledge of these exposures is key.

Essentially what we do is construct a portfolio of the best long/short hedge fund managers that we can find based on their stock picking and risk management capabilities. We ourselves are not tactical in making short term market calls, etc. However, we will adjust to what we perceive as long term trends in the market such as increasing volatility impacting the return streams of managers, many of which employ buy-and-hold type strategies.   

Hortz: You would expect more innovation from newer emerging hedge fund managers but give us an example of what you are seeing from some of the larger Long/Short hedge fund managers you like?

Togher:  Larger, well established funds will almost always make changes incrementally; they have the bandwidth, staff and resources available.  For example, one larger $16 Billion event driven manager we allocate to is continually innovating their process to manage risk if something unexpectedly goes wrong or circumstances change. An example of one of the things they are doing is designing a systematic overlay for use in constructing a portion of their short portfolio to help manage unexpected volatility. They have developed this overlay slowly and methodically and it has been very successful.

On the other hand, we do see more of that kind of investment adaptation in the Discovery portfolio, the smaller manager product, and the changes are often more dramatic and immediate.  For example, a smaller manager we are looking at evaluated the balance between market caps across its long and short books, trading frequency and liquidity, following un-expectantly high losses in 2011.  Within one-quarter’s time-frame, the portfolio manager implemented new investment and risk guidelines to help with portfolio rebalancing and turnover.  These new guidelines have worked well thus far.   

Hortz: Can you give us more examples of new trends/approaches that you see coming from newer hedge fund managers?

Togher:  An interesting strategy that we have come across in our research is Alternative Beta. Alpha is generally viewed as market out-performance from manager stock-picking ability and beta is viewed as performance attributed to market movements.  In a simplistic example, if the equity market is up 5% in a given year and a long-only equity fund is up 7%, then 2% of the fund’s return is alpha and the rest is beta.