It’s time consultants gave funds of funds another go

But those who dismiss funds of hedge funds as a spent force are overlooking a far more pressing issue: the problems presented by the rapidly rising power of investment consultants.

According to Deutsche Bank’s 2012 Alternative Investment Survey, the proportion of respondents using one has doubled in the past year to 60% and tripled since 2002.

Since 2008, institutions have increasingly bypassed funds of funds and invested directly in hedge funds, advised by investment consultants.

As a result, the fund of funds industry has seen net redemptions in every year since the 2007 peak, according to Hedge Fund Research.

Mainstream consultants have shifted from being hedge fund doubters to advocates, driven by relative hedge fund outperformance in 2008 and the diversification offered by some strategies. Just as their predecessors once emerged starry-eyed from meeting Mercury Asset Management, the current breed are in love with the household names of the hedge fund industry.

But this power shift throws up other issues. So enamoured are the consultants with direct investment that they have bulked up their in-house hedge fund research teams to meet increased demand for hedge funds from pension fund clients. They have become experts in hedge funds for business reasons, often making decisions on behalf of clients through the fiduciary model.

However, you can argue that this model presents potential conflicts because consultants are incentivised to encourage clients to invest directly, but draw on advice from their internal team.

Their use of external funds of funds is becoming increasingly rare. But in recommending that clients invest directly when putting together a hedge fund portfolio, mainstream consultants are effectively constructing their own fund of funds. And it is here that they are likely to fall short of their rivals.

Consultants may tout independence, but their fiduciary responsibility fosters the least risky options – and they have no skin in the game, something they always like to see from the managers they put forward. In sharp contrast, fund of funds managers put their own money to work, alongside their pension scheme clients.

Rather than taking a measured risk on a star or emerging hedge fund manager, the large consultants are more inclined to bet big on managing downside risk, picking “safe”, household names that will not get them fired if something goes wrong, as happened to Mercury.

Mainstream consultants have no track record of investing in hedge funds. Funds of funds have produced and managed performance and they were far from alone in struggling during the credit crisis.

Consultants argue that few fund of funds managers add enough value to offset the second layer of fees they charge. But the larger managers say they can negotiate fee discounts from quality hedge funds more effectively than consultants.

That said, the fund of funds industry has only belatedly realised it must justify the fees it charges. The over-diversified, low-turnover, multi-strategy fund of hedge funds has had its day. Those that remain in business have evolved their models and now differentiate themselves by offering bespoke mandates, advisory work or managed accounts.

Quality funds of funds can twin that with trading overlays, access to scarce strategies, genuinely uncorrelated returns or emerging talent. This is where the extra layer of fees can be justified.

The very best of these funds of funds go one step further and provide seed finance to new managers, the lifeblood of the hedge fund industry.

Do consultants bother with such funds, given these managers’ lack of a track record? Of course not.