AQR: New S.M.O.O.T.H. Fund fights the good fight

Quick shout out to AQR (a large US quantitative manager) who have a post out fighting the good fight against some of the big issues with funds with high levels of unlisted assets – this includes many of the large industry super funds in Australia. Three of the key issues they raise:

1. Reporting quirks mean the risk of the funds look low, not because they are actually low, but rather because of the way the assets are valued:

As with many of our other alternative strategies, [S.M.O.O.T.H.] offers attempted low to zero correlation to traditional markets – but in this case we are also offering what we are dubbing “doubly uncorrelated”™© returns. The Fund’s actual underlying liquid investments, as we do in most of our alternatives, strive to be uncorrelated to traditional markets (recall we do not think this is true for most hedge funds). But now, due to our new proprietary S.M.O.O.T.H. process2, even if we fail to deliver this lack of correlation, the S.M.O.O.T.H. Fund will still report 3 returns mostly unrelated to normal markets.

2. This proprietary process involves implementing our normal hedged liquid alternative process, but only marking to market occasionally, and then reporting some combination of the weighted average of the prior few years’ prices, with a healthy weight also given to our own unaudited estimates of what the Fund is likely worth (based on how we think it should’ve performed).

3. The astute reader will notice the use of the word “report.”

2. The fees are usually much higher, can sometimes be charged on money that you haven’t even invested yet, and there are oftentimes other fees on underlying assets (or construction contracts) that can be diverted to either the asset manager or related parties

Of course, the same long-term returns, but delivered with way more stability, comes at a price (to you). These funds will not be offered at competitive fees, as is our norm, but rather will feature the traditional 2 and 20 fee model. In addition, we may charge some fees based on capital you have not invested with us yet but expect to later. We also might receive some additional fees from the underlying assets themselves (we’re still working on how to do that as quants but are optimistic that we can get there). We think this is only fair given how smooth the S.M.O.O.T.H. Fund will be. This Fund will be amazingly easy to stick with, and the long-term should truly be great. That’s worth a premium and we don’t feel even slightly guilty about it. 

3. The leverage used by the funds is often obscured – this was a key to the downfall of Babcock & Brown and Allco in the financial crisis. Basically, the model is that if you can gear up an investment a lot (and hide the gearing from investors) then you can outperform the market on the way up and attract lots of investment and fees, with the risk being that when the market turns your investors lose far more than they thought they could:

many of AQR’s normal liquid alternatives make some use of leverage to hit their return targets (gearing up what we think is an attractive, but too conservative unlevered return). The funds underlying our new S.M.O.O.T.H. offering will do exactly the same thing. But, given the structure and designed opacity, investors will hardly notice! So, besides its masking of difficult to stomach volatility, the S.M.O.O.T.H. Fund also greatly reduces what we’re calling “perceived leverage.” In turn, this allows us to use even more actual leverage, so we do.  It should be a very calming change.

Damien Klassen is Head of Investments at the Macrobusiness Fund, which is powered by Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Integrity Private Wealth Pty Ltd, AFSL 436298.

Comments

  1. Mmmmm … there are many advantages to having exposure to unlisted assets too. In the end it really boils down to picking your manager and fully understanding the risks inherent in the fund, including the liquidity situation i.e. it won’t be easy come, easy go.

    Those funds advertising themselves as ‘low risk’ are obviously misrepresenting the situation but a reputable manager would not. On the fees front, the good firms buying unlisted companies typically do substantially more work / due diligence than those buying listed companies because the information is often harder to come by, so higher fees are inevitable.

  2. Lets not forget the the SMOOTH fund launch also comes at the same time as many of AQR’s flagship strategies delivering poor performance over 1,3 & 5 years periods. Including one of their funds having a 3+ stand deviation downside event!

    Lets not get too caught up in manager marketing pitches….

  3. thomickersMEMBER

    Haha!! that was fantastic. Everyone who is in an industry fund with lots of underlying unlisted private equity or property should look the “short selling” report on Blue Sky Alternative Investments written by Glaucus Research. Basically some non-top tier firms are very aggressive with overstating performance or pushing profits far ahead of their maturing fair value. The result is that performance fees are realised much sooner but the fair value of assets in their later lives do not justify the high fees claimed.

    • thomickersMEMBER

      another example would be ASX listed URF “US Masters Residential Property Fund Unit”. It has superdooper liquidity issues whilst still paying out a dividend. The liquidity has run dry due to claiming higher valuations and crystalising performance fees well before the investment horizon of the asset.