Will Funds of Hedge Funds Stage a Comeback in 2014?

Date: Tuesday, February 4, 2014
Author: Preqin

Funds of hedge funds have been met with difficult challenges in the past six years due to mixed returns, capital outflows, a large number of fund closures and industry consolidation. As a result of higher fees and dampened performance, 2013 saw a number of institutional investors move away from multi-manager funds in favour of direct investments. Although this trend is likely to continue, recent evidence indicates that funds of hedge funds are attempting to redefine themselves in order to help investors regain confidence in the multi-manager structure. 

Despite both single and multi-manager hedge funds showing improved performance in recent years, funds of hedge funds have not been able to recoup the losses of 2008 at the same pace as direct funds. According to Preqin’s Hedge Fund Analyst online service, funds of hedge funds generated returns of 7.96% for the 12-month period ending 31 December 2013, compared to a net return of 5.12% in 2012. Moreover, Preqin’s benchmarks indicate that over the longer term, funds of hedge funds have generated positive returns in four of the past five years, recouping the losses posted in 2011 (-4.05%). Investors may be attracted to the lower volatility exhibited by funds of hedge funds; the volatility of multi-manager funds is on a steady downward trend, with three-year volatility for funds of hedge funds consistently below 5% in the past three years. In contrast, the three-year volatility for single-manager hedge funds has fluctuated between 5% and 10% within the same period. As a result, investors seeking modest gains with low volatility were generally well served by funds of hedge funds in 2013. 

In recent years, the fund of hedge funds industry has seen a steady contraction in total assets under management since its 2008 peak of $1.2tn. According to the 2014 Preqin Global Hedge Fund Report, industry assets had fallen to $810bn by the end of 2012 and $786bn by the end of 2013. However, North America-based fund of hedge funds managers, the largest contributors to the global total, are demonstrating a slight reversal of this trend. Fund of hedge funds managers in this region grew their assets by 5.5% from $508bn in December 2012 to $536bn in December 2013. Although the figure is still below its 2008 peak of $626bn, North America is the only region to witness an increase in assets under management of its fund of hedge funds industry in each of the previous two years. 

Preqin’s Hedge Fund Investor Profiles online service reveals that all major institutional investor types have increased their direct investment exposure in 2013, resulting in a reduction in the proportion of investors allocating to multi-manager funds. However, with improved performance and consistent low volatility, investors may find use for multi-managers within their portfolio. Thirty-three percent of searches initiated by investors currently listed on Preqin’s Fund Searches and Mandates online tool include a fund of hedge funds component. Of these fund of hedge funds searches, 22% include a search for managed accounts; the ability of fund of hedge funds managers to offer access to customized portfolios is attracting some of the more established investors. This customization ability and continued low volatility means that there will continue to be a market for funds of hedge funds, and it is investor appetite which will determine the size of the industry going forward.