How Can Fund of Funds Stay Relevant?

Date: Wednesday, December 12, 2012
Author: Parin Shah, ProHedge.co.uk

Fund of Funds have found it increasingly difficult to operate in a Post-Madoff world. Fund of Funds have seen a steady decline in their allocations as a proportion of total hedge fund assets from 72.9% to 43.3% in 2012. All the while, hedge funds have experienced continual asset growth to a figure that now stands above $2tn. How can the fund of funds model stay relevant in an ever changing environment?

Clearly, Fund of Funds need to adapt to a new industry environment and seek out where they offer advantages over direct investments. Speaking at IBC’s 11^th Annual Hedge Fund Operations & Executive Responsibility Conference, Gabriel Bousbib of Gottex Fund Management believes that this new future will involve both consolidation in the Fund of Funds space and a move to unbundling the value chain, offering the key services that customers desire. Fund of Funds must play to their strengths, and as Bousbib states, a key strength is expertise relating to niche players in the hedge fund industry: “traditionally smaller hedge funds outperform and there exists the potential to marry Fund of Fund expertise with the performance of smaller hedge funds which find it harder to raise direct.”

There have of late been a spate of acquisitions of Fund of Funds by both Long-Only Managers (Franklin Templeton acquiring K2 Advisors) and Private Equity houses (KKR acquiring Prisma). The rationale for these forays, states Bousbib, lies in the broadening of the product range and size of investment: “these acquisitions enable you to deliver the entire range of risk and price this offering very attractively”. In effect the cost of operating Fund of Funds is increasingly being met through product subsidisation. “Fund of Funds is a very operationally costly business. Fund of Funds must merge, cut headcount and become more cost effective,” adds Bousbib.

In unbundling services across features such as operational due diligence, portfolio monitoring, and risk management Fund of Funds are able to gain from a broader and more holistic relationship with investors, tailoring products to meet their needs. While many in the industry frequently talk of Fund of Funds competing with traditional investment consultancies such as Mercer and Albourne Partners, Bousbib advises care to be deployed when entertaining such suggestions: “it is very different to write research reports compared to deploying capital.”

Asian hedge funds represent a great example of how Fund of Funds can add value through niche expertise. As Asian hedge funds tend to be smaller, have less infrastructure, fewer controls and are subject to less stringent regulations, investors are often more comfortable deploying capital to Fund of Funds for investment in this space. Particularly in the credit hedge fund space, fund manager selection can be very complex. “Investors want to deploy capital where there is complete transparency of position,” reasons Bousbib and in having developed relationships with fund managers of several years, Fund of Funds can provide this alongside managed account services.

Ultimately, Fund of Funds can help hedge fund investors, who are now more institutional in make-up, to solve what would otherwise be a tricky problem. A fear of headline risk has seen growing allocations towards larger funds but “smaller funds tend to outperform larger funds by 200bps per year,” Bousbib says. And post-crisis, the operational elements of a fund that have a tremendous impact on the survival of funds have become crucial to investors. What are the consequences of this? “This has led to smaller hedge funds desperately scrambling to put the right infrastructure into place. A lot of these fund managers are also struggling to raise capital. What we tell them is “why don’t you leverage our infrastructure, and you as a manager, carry on managing money?””

For investors, Fund of Funds can deliver more efficient allocations, an independent perspective on operational reviews and superior transparency. A separate operator can also help mitigate a number of important operational risks. Pricing is one crucial area with Fund of Funds able to deliver insightful, independent NAVs free from manager bias and distinct to those produced by administrators who may lack the proper expertise. “Managers tend to be a little careless in negotiating agreements with prime brokers and counterparties. We continue to see this,” highlights Bousbib. In such an instance, the voice of a Fund of Funds with its global footprint and capabilities can be a real asset to both managers and investors.

“Here is a way for investors to have the best of both worlds,” proclaims Bousbib. But does this new world order of dynamic Fund of Funds sound too good to be true? There is always the cost of such an offering, which Fund of Funds have frequently been maligned upon in the past. Even on this basis Fund of Funds might be able to offer a compelling service at a reasonable price. As the bearing of cost occurs in part by managers and in part by investors, the relevant cost to investors is at the 20bps level. “This is effectively a combination of a super middle office slash risk manager all baked into one,” quips Bousbib. And from the sounds of it, it’s here to stay.