Hedge funds-of-funds managers in midst of metamorphosis

The financial crisis forced firms to change in order to survive

Hedge funds-of-funds managers — those that survived tortuous outflows since the 2008-2009 financial crisis, that is — are swiftly remodeling their businesses.

Their investment management processes haven't changed dramatically, but the vehicles in which they offer their strategies and how they are distributed are rapidly changing.

See associated story: Hedge fund asset growth barely misses double digits for year

The latest innovations springing from the survivalist minds of hedge funds-of-funds executives span a wide spectrum, including:

• hedge fund mutual funds offering daily valuation and liquidity;
• hybrid hedge fund-private equity funds of funds investing opportunistically, featuring three- to five-year liquidity lockups;
• hedge fund beta strategies that can be used in combination with alpha-generating hedge funds-of-funds portfolios;
• new investment capabilities, such as private equity, to create broader alternative investment boutiques; and
• single-strategy funds offering concentrated exposure that institutions increasingly are including in their traditional asset class portfolios.

New vehicles

“Hedge funds of funds are in a perfect position to capitalize on changes in the markets since the financial crisis by translating their ability to evaluate hedge funds into new, different vehicles,” said Susan McDermott, Chicago-based partner and chief investment officer-institutional advisory of investment consultant Pavilion Advisory Group Inc.

A big part of survival for hedge funds-of-funds managers is recognizing new markets and relying less on old sources of capital, said Scott Schweighauser, president, portfolio manager and partner, Aurora Investment Management LLC, Chicago.

When institutional investors began to invest directly in hedge funds after the financial crisis, hedge funds-of-funds firms were forced into a round of innovation, Mr. Schweighauser said.

“Now the vehicle in which a hedge fund-of-funds portfolio can be offered is much more flexible, more modular, which means the solution can be offered in the format the investor needs and we don't all look the same anymore,” said Mr. Schweighauser.

The range of vehicles available to investors encompasses traditional commingled hedge funds of funds; separate account versions of flagship strategies; fully customized portfolios; and retail mutual funds, he said.

Aurora's latest innovation is a hedge fund mutual fund launched in March. Assets totaled $145 million as of Aug. 31. Aurora's advantage is that its parent company, Natixis Global Asset Management LP, handles retail distribution.

In Pensions & Investments' June 30 ranking of the largest managers based on worldwide assets managed in hedge funds of funds, Aurora ranked 13th with $9.6 billion.

Mesirow Advanced Strategies Inc., Chicago, launched a series of stand-alone opportunistic hedge funds of funds with lockup periods of between three and five years in February, said Greg T. Fedorinchik, senior managing director and head of the global client relationship team.

Five strategies now are offered: corporate liquidations; European credit and structured products; secondary collateralized debt obligations; distressed non-agency retail mortgage-backed securities; and distressed emerging market debt arbitrage trades.

Hedge funds of funds with longer-dated structures “provide the ability but not the obligation to deploy capital so there is dry powder when dislocations occur” while the “illiquidity advantage” allows the manager to “weather the storm without becoming a forced seller in distress,” said Mr. Fedorinchik.

Mesirow was ninth with $13.1 billion as of June 30 in P&I's ranking.

Separation important

The separation of hedge fund alpha and beta has become “very important ... we are at the beginning of a very powerful story,” said Lionel Erdely, CEO (USA) and co-chief investment officer in the New York office of Lyxor Asset Management Inc.

“The large institutional investors we talk to say the thought process has really matured,” Mr. Erdely said, noting that by better understanding the sources of alpha and beta return in a strategy like long/short equity or fixed income, investment officers are more willing and able to include the hedge fund approach in their traditional asset classes.

Lyxor ranked 16th in P&I's ranking with $9 billion of hedge funds-of-funds assets.

Hedge funds-of-funds manager GAM took the unusual step of creating hedge fund beta portfolios based on Barclays PLC's risk premium indexes, said Anthony Lawler, portfolio manager and head of customized portfolio solutions, GAM Alternative Investment Solutions, London.

The new GAM portfolios are forward-looking and actively manage left-tail risk to avoid sharp declines during severe market downturns of one or two standard deviations, Mr. Lawler said.

Interest in the 18-month-old portfolios has been strong in Europe and is picking up in the U.S., he said.

GAM's hedge funds-of-funds assets totaled $5 billion as of June 30, placing it 28th in P&I's ranking.

Grosvenor Capital Management LP, Chicago, struck a deal in August with Credit Suisse Group AG to acquire New York-based Customized Fund Investment Group, said Michael J. Sacks, CEO of Grosvenor.

After the deal closes later this year, Grosvenor's assets will total $41 billion: $18 billion from CFIG and $22.9 billion from Grosvenor, which ranked fourth in P&I's ranking.

Pumping up Grosvenor's assets was not the acquisition driver, Mr. Sacks said. “The combination of Grosvenor and CFIG creates a new capability to offer customized separate account approaches for institutional investors across a range of alternative investment strategies,” Mr. Sacks said.

Not all hedge funds-of-funds managers are busy innovating.

“Our strategies have remained very steady for some years now,” said Thomas P. Murphy, senior partner and U.S. head of fiduciary, based in the Boston office of Mercer Investments.

Mercer's less avant-garde approach seems to have appeal: hedge funds-of-funds assets grew 84.1% to $5.5 billion in the 12 months through June 30, earning the firm the 25th spot in P&I's 2013 ranking.