18/03/2010 Author: Stephen Oxley

Comment: Stephen Oxley

There seems little doubt that institutions in Europe, particularly pension funds, are allocating to hedge funds again. The bounce-back in hedge fund performance and new highs in equity markets have together inspired pension funds and their consultants to re-board the diversification train.

In general, there seems to be a preference for asset classes and strategies that provide diversification from traditional bond and equity allocations. The trend towards reductions in domestic equity exposure and increased exposure to corporate and non-domestic fixed income continues, along with a rise in real estate allocations; private equity is out of favour for some, but infrastructure is in. Absolute return is a key strategy because it is seen as providing both growth and diversification. In the UK, a new strategy has emerged, known as ‘diversified growth’, which looks suspiciously like a panacea for all portfolio management issues, and often includes allocations to hedge funds and other alternatives.

But there is another trend playing out in the implementation of hedge fund investments. It appears there has been a substantial switch in sentiment away from funds of hedge funds (FoHFs) and towards direct allocations. Consultants are reporting a surge in single manager appointments, while FoHFs are receiving a smaller proportion of the new asset flows from pension funds. Why is this happening? And is it a good thing?  

As a FoHF manager, you might expect me to express an emphatic ‘no’ to that last question and a claim that this will all end in tears. It is of course not that simple; the arguments have a lot more to do about what is right for investors than what is right for protecting vested interests. We also need to recognise that what is suitable for one institution may not be appropriate for another.  

There are a number of forces behind the trend towards direct investing. First, there appears to have been a re-rating of the perceived risk of direct investing. The development of some hedge fund firms as institutions in their own right has given trustees comfort that this is no longer a cottage industry. These are brand-name firms which can be thought of in very much the same way as large long-only asset managers.

Second, consultants have built up their research on well-known hedge funds, and fiduciaries have the comfort of knowing they are investing alongside other similar institutions. At the same time, improved governance and resources at some pension funds have enabled them to develop in-house expertise and in some cases operate what amounts to an internal FoHF.  

Third, there are also questions being asked about the value that FoHFs provide and the quality of their service offerings. This is not just the old double fee-layer argument, but also questions recent performance and poor liquidity in some areas.  

Finally, some FoHFs have undoubtedly damaged the image of the multi-manager approach through inexcusable investments in Madoff and the implementation of gates and suspensions during and after the financial crisis.
But have the risks of direct investing changed? And do FoHFs detract from the value proposition? Take any random group of hedge funds and arrange their returns on a scatter chart and you will see an enormous dispersion. Some do extremely well in a particular year, others very badly. Yet others disappear off the chart never to be seen again. Do the same exercise with long-only fund managers and you find you have a much tighter bunch clustered around the index return. In fact, individual hedge funds look a lot like individual stocks. The dispersion argues for a portfolio approach. It also highlights the fact that, from time to time, hedge funds implode. And being large does not provide immunity from that risk: witness Amaranth and Galleon. Blow-ups will happen again and if it happens to a hedge fund with multiple institutional relationships it could be very damaging for the perception of hedge funds by institutional investors.

FoHFs do a lot more than provide an arms-length protection from blow-up risk. Many institutional FoHFs are leading the way in operational due diligence and in negotiating better terms with the underlying hedge funds. Hedge fund fees have been set too high for too long and FoHFs are working to use the collective bargaining power of their aggregate clients to make sensible fee arrangements with managers and to build separate vehicles to segregate institutional client assets. No individual institution has the resources at hand that a large institutional FoHF can employ. Investing in hedge funds remains an area that is resource intensive and requires continuous and detailed monitoring.

Stephen Oxley is managing director of Pacific Alternative Asset Management Company (Paamco)