Funds of funds maintain popularity with institutional investors

Andrew Collins, business development director with Fortis Prime Fund Solutions, argues that for the foreseeable future, funds of hedge funds are likely to remain a significant part of the hedge fund industry.

The growth in the assets of funds of hedge funds in 2006 and the beginning of 2007 continued unabated. This trend confounded many critics of the asset class who argue that the diversification benefits of funds of funds do not justify the double layer of management fees, particularly when viewed in the context of the modest returns they tend to deliver compared with the better performing single manager hedge funds.

If investors were dissatisfied with returns from funds of hedge funds, which did not perform particularly well last year, there was little sign of it in asset flows. Growth in the funds of funds area was particularly strong in 2006 at around 30 per cent.

The continued appeal of funds of funds is also evident from the point of view of investment managers seeking to consolidate their positions in the alternatives market. In 2005 alone just two transactions resulted in approximately USD50bn in funds of funds assets changing hands, with the acquisition in November 2005 of Permal, one of the five largest fund of hedge funds managers in the world with USD19.3bn, by Legg Mason, and the deal under which Julius Bär acquired GAM and its CHF66bn in assets under management from UBS.

All the indications are that these types of transaction are set to continue, amid a general trend toward consolidation in the asset management industry and continuing moves by large asset management groups to expand their presence in the alternative investments market through acquisition.

In addition, there is also the issue for institutions and pension funds entering the market of how to obtain capacity in some of the larger and more successful hedge funds that are closed to new investors. One option might be to seek that capacity through the acquisition of a fund management business that already has capacity with those underlying managers.

In the long run, it is possible that many institutions will opt for multi-strategy funds over funds of hedge funds, for reasons that include the desire to avoid a double management charge structure, especially as they become more familiar with the market. There is speculation that multi-strategy funds might eventually replace funds of hedge funds as the customary point of entry to the alternatives marketplace for new investors, but there is little sign that it is happening yet. Certainly the fund inflow figures for funds of hedge funds suggest that they are continuing to hold their own.

The double-charging issue is one that may in some cases be mitigated by deals that funds of hedge funds can strike with their underlying managers, but while some arrangements like this are in place, many of the most successful and sought-after underlying managers don't need to cut deals.

In fact, there is anecdotal evidence that some investors, funds of funds included, are paying managers performance fees in excess of the industry standard of 20 per cent - occasionally as much as 30 or 35 per cent. In these cases, the investor in the funds of funds may tolerate this level of performance fees provided they are receiving a satisfactory net return. Given diminished return expectations over the past couple of years, few investors would quibble with a 20 per cent return net of fees. Ultimately, managers who are ready to negotiate on fees or capacity may not be the best choice for funds of funds and their investors.

An exception, of course, is fledgling funds that have not yet had the opportunity to demonstrate sustainable strong performance. However, when funds are in their sweet spot of between USD500m and USD1bn in assets and their performance is good, it is more difficult for funds of funds to negotiate capacity and the underlying manager has more power to dictate investment terms.

Notwithstanding these issues, there is every indication that funds of hedge funds will continue to play an important role in the alternative investment strategies of institutional investors for some time to come. Only a handful of institutions today have the experience and expertise to put together a portfolio of hedge fund investments, and for many investors it will always make sense to draw on the fund selection and monitoring skills of others. For the foreseeable future, funds of hedge funds are likely to continue to be a significant part of the hedge fund industry.

In this environment, funds of hedge funds, and in turn their investors, can benefit by taking advantage of an integrated service offering. What makes Fortis unique in the market is that in addition to its traditional service offerings to funds of funds of administration and custody, in which it is a global leader in the alternative investments field, it is one of the very few banks that combines these services with the provision of leveraged finance to funds of funds.

As funds of hedge funds seek to demonstrate their competitiveness to institutions as an alternative investment solution, the opportunity to bring financing, custody and administration under the same roof may have increasing appeal.