Funds of hedge funds struggle to regain traction

Funds of hedge funds remain in an unenviable state, with new studies showing they have not regained traction with investors in the post-crisis era.

Seven per cent of pensions plan to cut their investments to FoHFs over the next three years, according to the Pension Fund Asset Allocation Survey conducted by bfinance. Part of the reason is a growing trend of direct investment by pensions into hedge funds, says the consultancy.

However, they plan to raise their allocations to the overall alternatives sector during the same period into asset classes such as infrastructure (35%) private equity (24%) and real estate (13%). Only emerging-market debt (35%) was as highly favoured as infrastructure.

The respondents represent $350 billion across corporate and public pensions, insurers and foundations and endowments, with three-quarters holding more than $1 billion in AUM.

A separate report by Preqin on FoHFs – which were previously significant allocators of capital to Asian hedge funds – shows that the industry hasn’t recovered in the four years since the financial crisis.

Assets in FoHFs stood at $552.8 billion as of August 30, down from $589.5 billion at the start of the year and $644.5 billion at the beginning of 2010.

“Although the performance of funds of hedge funds improved in 2012, asset flows have remained negative for the year,” says Preqin. In the first eight month of 2012, FoHFs returned an average of 6.26% in the year to September, against -1.5% negative performance for 2011.

The number of FoHFs has also been falling steadily over the past four years to 3,410 in August, compared to about 3,750 at the industry’s peak in early 2008, when it managed $800 billion in assets.

The amount that FoHFs allocate to Asia-Pacific hedge funds has likewise been dropping, accounting for only 8% of industry assets, compared to 11% in 2007. The figure that invest in North American hedge funds has remained steady, at 40%, while FoHFs with a global investment mandate have grown to 34% from 28%.

Preqin cites the key reasons for the industry’s decline as being a doubling in fees – by which investors are charged for performance and management by the FoHF manager and those of the underlying funds – and increased direct investments into hedge funds.

“Investors have started to build up their own investment and due diligence teams for allocations to hedge funds,” the report notes. “They believe that funds of hedge funds may not be able to really assess and look at risk as each different investor does.”

The FoHF industry is undergoing a consolidation phase, in which smaller managers are being acquired by larger managers, including those not traditionally associated with alternatives.

In September, for example, Franklin Templeton agreed to buy a majority stake in US-based K2 Advisors to gain an exposure to the hedge fund asset class.

But the prognosis for FoHFs is not all bad, with Preqin predicting that lower fee charges, better performance and improved due diligence practices may lead some investors back to the asset class.