21/07/2010 Author: Stephen Oxley

Comment: Stephen Oxley

Cost-cutting is in the air. Layers of bureaucracy are about to be sliced from public services and it is tempting to look around and see what fat can be cut in other areas; both personal and professional. Unnecessary mobile phone bills?  Extravagant travel expenses? Funds of hedge funds (FoHF) managers? Surely we can get by without them?  
FoHFs have indeed found themselves caught by the axe-wielding investor looking to reduce overheads. The argument is simple; FoHFs are an additional layer of cost on top of already-high hedge fund manager fees; cut them out and go straight to the supplier.

But before we allow the axe to fall, some serious questions need to be asked. Firstly, it is questionable whether a FoHF really does end up costing more than the direct investment alternative. Secondly, rather like an airline cutting its maintenance budget, the additional risk taken could be catastrophic.

Ten or fifteen years ago, observers of the hedge fund industry predicted that it would merge with, and become largely indistinguishable from, the traditional fund management industry. No one was quite sure what this would mean or whether or not it would be a good thing.  To some degree, and at one end of the scale at least, it appears that the prophecy has come to pass.  

In 1995, the three largest hedge funds in the world were Tiger, Soros and Moore Capital. Their clients were mainly rich individuals and wealthy families. Today, the list has changed and the largest hedge funds have five to ten times the AuM of those early super-funds. But the biggest change, however, is in the client base.  

The largest hedge fund firms are seen as safe, institutional and blue-chip, and by attracting the direct allocations of institutional investors, they have grown to elephantine proportions. But as one FoHF manager I know puts it, “if you are going to hunt elephants, you need to be sure you can get them out of the jungle!”

Which brings us to the real costs of investing in hedge funds. Institutional investors in large hedge funds will probably find that their investment carries a full 2/20 fee, is locked up and is commingled with that of other investors. Larger FoHFs, on the other hand, are a) more likely to prefer smaller niche and emerging funds; b) will have probably built a separate account allocation for many of their managers and; c) will have used the combined power and size of their investment to negotiate significant fee reductions.

In pure cost terms, the aggregate fee being paid to the FoHF and the underlying funds may well be comparable to that paid by direct investors. And that doesn’t account for the value added through portfolio construction, strategy allocation, risk management, due diligence, experience and monitoring that FoHFs can provide.

Bureaucrats, as any student of French will tell you, are people who spend most of their time in offices. In the debate over cuts in public services, the word is often used pejoratively to denote so-called ‘paper pushers’ as opposed to the real ‘front-line workers’. In a professional services area like fund management, however, bureaucrats are the front line. If you lose them – you may start losing battles.

FoHF professionals are the ultimate front-line office workers. They spend a lot of their time in other peoples’ offices, digging around, checking, auditing, interviewing fund managers and traders, asking difficult questions, reviewing trades, monitoring compliance with policy and cross referencing with the administrator. Or even visiting the administrator (how many direct investors or their consultants can say they have done that?).

Regrettably, despite their front-line role, FoHFs can be seen as nothing but another unnecessary layer of bureaucracy to cut. But a super-sized hedge fund is still a hedge fund. Swanky offices and smart marketing personnel can’t hide that fact. And the larger a hedge fund is, the larger its likely positions. This is one of the reasons why FoHFs are increasingly working with their institutional clients to build diversifying, niche and specialist portfolio solutions that may complement risks taken elsewhere.

Concentrating your sources of expected alpha could lead to disappointment. The mission of finding diversified sources of alpha for investors, of mitigating agency risk and improving the governance of those investments to represent the clients’ interests is far too important to be sacrificed on the alter of phantom cost savings