A potential path for small funds of funds

Date: Monday, September 20, 2010
Author: Hedge Fund Portfolio

A persistent view exists that the fund of funds (FF) industry is on a steady but inevitable decline. I agree that the industry is currently purging. The purging process will be painful and last as long as investor bullishness stays low. How will this purge play out? A growing consensus is that large FFs will attract a dominant portion of capital flows while small FFs will either be acquired or forced to offer specialized products. Let me offer a slightly different (and long-winded) perspective on the potential future for small FFs.

There are primarily three pools of capital that look at FFs: Institutional Investors, UHNW investors (family offices) that are under-staffed, and HNW investors who access FFs via distribution channels. Institutional Investors will likely focus only on large (and some mid-sized) FFs, just as conventional wisdom predicts. Because UHNW and HNW investors have a more opportunistic bent, they will not stop looking at smaller FFs. However they will tighten their focus on aggressive performance and highly liquid redemption terms. Other factors such as buffer potential (translate: ability to make +5% in a year like 2008), tightness of process, niche-ness of product will be interesting but secondary.

Given these prospective investor preferences, small FFs will attract capital primarily if they are competitive on redemption terms (M-35 or better) or performance target (+15% net annualized). For an industry that has survived on Q-65 redemption terms with 5-7% annualized return, these aggressive new targets will be a bit of a shock. In fact, to illustrate how scarce the number of FFs that have produced outstanding performance are, consider this: I screened for FFs that produced 15+% annualized return with -20% max drawdown over the prior five years and I found only 5 firms - Balestra (via its Spectrum FF), Culross, Double Eagle, Efficient Access, and Persistent Edge.

So what are the takeaways? First, small FFs that survive the purging process will be those that make money and not necessarily those that offer niche products or a first-class investment process (though these factors will matter); in fact, quantitative measures like risk-adjusted return will only matter if that return number is high enough to attract interest. Second, given the large mismatch between likely demand for and existing supply of first-class FF performance, there will be room for additional high-octane FFs. As such, this actually might be time for those with adequate resources to enter the FF business or restructure their current products (note: I emphasize adequate resources; capital raising will be difficult in the short-term).