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How the Fund of Fund Industry is Evolving

Date: Wednesday, May 4, 2011
Author: Jeremy King, Asset Management Insights

If you believe the trade press, then you probably think that the fund of hedge funds (FoHFs) industry is in its death throes. We are all familiar by now with the headlines (covered in a recent post) as well as the statistics:

1. the number of FoHFs has fallen by a quarter since 2007 with 800 liquidations (28%) vs 9% for HFs (efinancialnews)

2. the value of FoHF total AUM has fallen 30% from $799bn to $564bn (HFR)

3. direct investments in HFs by DB plans, among the largest 200 U.S. retirement plan sponsors, were up 75.6% to $77.8 bn compared to FoHFs which were up 20.8% to $31.9 bn (P&I survey)

4. the HFRI Fund Weighted Composite Index was up 10.32% in 2010 (5.22% over 5 years) while the HFRI FOF Index was only up 5.68% (1.79% over 5 years) (HFR)

5. more state pensions invest directly in HFs than FoHFs (a turnaround from 2006) - with the change from FoHFs to direct HF investing coming from new allocations (Cliffwater)

The FoHF industry has also received heavy criticism from serious investors/ academics such as David Swensen (CIO Yale Endowment and an extremely influential investor and thinker). Mr Swensen's arguments are addressed in his excellent book 'Pioneering Portfolio Management', and were repeated to the WSJ in an interview (references below). The core criticisms are:

(a) that the fiduciary relationship between an investor and an investment manager is compromised by an unnecessary delegation of authority to an intermediary which clouds transparency and can lead to poor manager selection

(b) that investors must pay another level of  fees which are not justified by the resulting risk-adjusted returns

(c) top tier hedge funds and private equity managers do not want FoFs as clients - which compromises the quality of mangers accessible to FoFs

The first two criticisms are both fair and accurate. The third is true for a small number of well established managers but not the industry overall. Nonetheless, rather than making the case for avoiding FoFs altogether, these criticisms argue in favor of allocating to only the best FoFs - as measured by the originality of the firm's philosophy, a rigorous alignment of interests, the expertise of its professionals, the strength of its investment process and the nature of its performance. 

There is no doubt that institutional investors are making more direct allocations to hedge funds than previously. It is also undeniable that the FoHF industry has been shaken-up significantly since 2008 as a result of poor risk-management, mis-matched liquidity and shocking errors of judgment in manager selection (exhibit 1: Madoff). However, while many players will not survive the fall-out (and this should be welcomed), those rattling the death bell for the FoF business model, mis-read how the industry is evolving.

SEI/ Greenwich Associates’ October 2010 survey for example found that nearly half of the respondents invest exclusively in FoHFs (50% were F&Es, 21% public, 14% corporates and 13% consultants). Among institutions investing both in HFs and FoHFs, 60% of assets are directed to FoHFs. Unsurprisingly there are a higher proportion of corporates and smaller plans allocating to FoHFs compared to F&Es and other large investors (>$5bn).

There is little doubt that the industry has evolved significantly from the days of FoHF businesses built simply upon an off-the-shelf highly diversified portfolio of 20-100 managers for 1 and 5 or 1 and 10. Due diligence failures, increased competition, fee compression, and increasing investor sophistication, have radically remade the shape and business model of the typical FoHF. The old selling propositions: access to scarce capacity; expert due diligence; diversification; and quantitative risk management techniques no longer provide firms with an edge.

The sharp end of the industry has been allowing investors to access their managers directly for many years. Co-investments, early stage co-seeding opportunities, the creation of customized or completion portfolios and managed accounts have been the stock-in-trade of the industry leaders for well over a decade. These firms have developed long-term partnerships with their investors and, in the process, their firms have become truly client-centric and performance focused. Long-term compensation and incentive arrangements, focused portfolio offerings and tight controls of their cost-base have created firms with cultures and structures that are in alignment with investors’ interests.

Investors and their consultants are increasingly working with their FoHF providers and HFs to build customized or completion portfolios. Since the mid 2000s several large institutional investors for example, have realized that part of the solution to their long-term funding challenges involves substituting some equity beta with equity hedged, global macro and managed futures strategies. These hedge fund strategies are liquid and transparent while significantly reducing left-tail risk within the portfolio (managed futures are uncorrelated to equities). Most institutional investors do not have a sophisticated enough investment office, nor a broad enough sourcing network, nor access to deep enough performance data, to do this portfolio analysis/ construction work in-house.

HF seeding platforms and specialized FoHFs have been delivering portfolios of emerging HF portfolios (or single manager relationships) to institutional investors for over two decades. Given that the underlying managers may be located in Sydney, Hong Kong, Rio or South Africa, sourcing these opportunities requires a deep global network. Partnering with a provider of acceleration capital can provide investors with access to investment opportunities that may not be available elsewhere. Investors should of course only do business with the highest quality seeding platforms and FoHFs. They should also actively negotiate deal structures, revenue shares, direct manager relationships and exit or follow-on arrangements.

While investors should - and will - continue to reduce traditional beta factors in their portfolios, they will also increasingly require their asset managers to deconstruct the traditional FoHF value chain. Since Madoff, the balance of power has shifted significantly in the direction of investors, who will continue to pressure asset managers to price and provide individual components of the investment process on a tailor-made basis. Rather than buy an off-the-shelf portfolio for 1 and 5, the investor may, for example, wish to access on a stand-alone basis (or in combination):  individual managers (e.g. via managed accounts), the portfolio construction and analysis team, independent risk management services, thought leadership, hedge fund due diligence, multi-level reporting, trustee/ board education services or technology solutions.

This represents a blurring of the line between asset management and the traditional investment consulting industry. Industry consolidation should be welcomed because ultimately investors will receive more customized services for a fairer price.


1. My last post to Business Insider about FoHFs: http://www.businessinsider.com/fund-of-hedge-funds-cure-or-disease-2011-4
2. efinancial news article 09.20.2010:
3. Cliffwater report 01.24.2011: http://bit.ly/fi6lx6
4. SEI/ Greenwich Associates white paper:http://bit.ly/eWfppc
5. Transcript of David Swensen’s WSJ interview from AndyKroll.com: http://bit.ly/hNy7V