Liongate Capital Management’s office in London’s Soho is in a class of its own, even by Mayfair hedge fund standards. With a view directly into film-maker Ridley Scott’s office from his refurbished Georgian town house dating from 1720,

Randall Dillard, founder of Liongate, has a window on a world almost as rewarding as that of hedge funds.

Mr Dillard is a relatively recent convert to hedge funds. He moved into the fund of hedge funds business largely as a means of looking after his own money

following a career in the London’s financial district, latterly as head of the merchant banking operation at Nomura.

Jeff Holland, co-manager of the Liongate Multi-Strategy fund and a former vice-president at Deutsche Bank, suggested he invest in a portfolio of hedge funds.

“I was sceptical at first. Knowing how volatile long-only funds were I thought hedge funds would involve higher risk and volatility.”

He set up Liongate in early 2003 and began calling on hedge fund managers to find out about the risks they took and how they ran their businesses. He concluded that hedge funds were lower risk than long-only funds andhadthey outperformed them, too.

He attributes the outperformance to the unregulated nature of the sector, allowing them to leverage portfolios and use more complex instruments, and to the reward structure that attracts skilled managers.

ButBut he warns howeverthat there is one big variable that needs to be highlighted. Hedge funds have outperformed by trading on price anomalies; the weight of capital now chasing hedge funds is making the traditional hedge fund markets more efficient with less opportunity for gain.

As a result, there is now a much wider dispersal of returns, which is good, according to Mr Dillard, because “it means the skill of the hedge fund manager is becoming much more important”.

This is a crucial claim among fund of hedge fund managers, underlining the importance for investors of using such a vehicle rather than trying to unearth the best single strategy managers themselves.

But Mr Dillard has another warning for investors about the nature of funds of funds. The orthodox view is that funds of funds with overmore than $1bn of assets are superior. “The reality is that they are starting to track the fund of funds index.” He says the average return of the 15 largest funds of funds in the HFR index was closely correlated with the HFRI fund of funds composite index in 2004.

The big funds will end up increasingly competing with the index and will have to lower their fees. “The only reason people are not buying the index now is because it is not good enough yet,” Mr Dillard says.

The trend for large funds to mirror the index is due to the structural limits these funds face, making it difficult for them to invest in the smaller hedge funds. “If they only want 20 to 30 managers they cannot go into smaller funds because they are too big. So they tend to start picking fund managers by whether they can take money in, which limits the returns they can get.”

He says fund of funds with more than $1bn are limited to 29 per cent of the hedge fund universe. The optimal size is about $500m, where it is still possible to cover the investable universe.“When a fund of hedge funds’ assets under management begins to hit $1bn, there is a risk that returns could suffer.”You start to lose the optimal risk adjusted return after $500m. After $1bn the effect is noticeable – there is a decline in returns.”

For the Liongate fund, with will close for good when it reaches $500m. Withhas $110m currentlyunder management, that is some way off. It reopened at the beginning of the year, having closed three days after its launch in April 2004, to establish a track record.

It has had some success, winning the InvestHedge award for best new fund of funds in March this year. It has returned 25 per cent in dollar terms over the

12 months since launch, with no down months across any of the its four currency share classes.

It currently has exposure to 12 hedge fund strategies spread across up to 35 managers.

Mr Dillard’s investment approach starts from a macro basis. “We look at which strategy across the whole world has profit potential given today’s trading cycles, then find managers who can to execute safely and profitably.”

Last year, it was difficult to make money in traditional strategies, and Liongate changed about a third of its managers. “The flatness of the market meant we had to take money out of strategies where we were not being rewarded. “We moved quickly to reposition the portfolio, which is one of the reasons we outperformed the market.”

Areas the fund favoured in 2004 were Japanese mid-caps, and niche strategies in the US in areas benefiting from demographic change. “For example, small savings and loans were being acquired by larger banks where they had branches in areas of high population growth. We found long/short managers in that area.”

Energy was another strong theme, especially in the last half of the year as oil prices began to surge.

It is still outperforming and remains very interesting, says Mr Dillard, as do parts of Japan. “We also like event-driven strategies but are limited by the problem of finding managers who adopt a more active approach rather than just riding the beta,” he says.