22/06/2011 Author: Shannon Hawthorne

Where are FoHFs headed?

Tarnished by the fall-out of the financial crisis, the FoHF sector has picked up the pieces and posted record growth in HFMWeek’s recent AuA Survey. But with recovery outpaced by its single manager counterpart, it is clear that funds of hedge funds’ role as an investment tool is changing along with investors’ needs

The fund of hedge funds (FoHF) industry is in the midst of revival, or so the figures would suggest. With overall industry performance still uneven, not to mention the lasting reputational damage caused by the financial crisis and, of course, the Madoff scandal, it may have come as a surprise to some that the sector grew by a record-breaking $45bn, or 4%, to $1.1trn in the six months ending 30 April, as revealed by the most recent HFMWeek biannual Assets under Administration Survey.

While impressive, said growth was somewhat overshadowed by that of the single manager sector, which grew by $430bn, or 15%, to $3.24trn, adding credence to the argument that capital is increasingly flowing into the hedge fund industry via direct allocations.

It’s a trend that is well-documented, the argument being quite simply that as institutional investors become more comfortable with, and experienced in, the hedge fund space, they will naturally move towards direct investments.
The Massachusetts Pension Reserves Investment Management (Prim) board, which manages $51.2bn in assets, is a prime example. With seven years experience of the hedge fund space via FoHF investments, the board recently announced plans to shift $300m into direct investments.

“We felt that [investing via FoHFs] was an appropriate first step into hedge funds,” says Hannah Commoss, senior investment officer, public markets. “Over time, we expect that the direct programme will grow and that the FoHF programme will shrink, though it’s difficult to speculate on the pace of that shift.”

The concept of FoHFs as a ‘stepping stone’ into the hedge fund sector is a common one, with the vast majority of institutional investors making their first foray into the space clearly lacking the knowledge and internal infrastructure to head straight for direct investments.

“Direct investments were not one of the options, and that was probably a good thing,” says Donald Kendig, a trustee at the $1.9bn Santa Barbara County Employees’ Retirement System (SBCERS) on its decision to invest in FoHF Arden Asset Management back in 2006. “When just starting, it’s hard to instantly build a diversified
portfolio.”

The challenge FoHFs do face, however, is offering enough added value that they remain an attractive option to those investors that feel they may be in a position to allocate directly to single managers.

“The key issues are around the ways in which a FoHF’s management process and infrastructure can make life easier for the investor, for example, by providing access to return drivers and managers that they wouldn’t otherwise be able to access themselves,” says Craig Stevenson, senior investment consultant, manager research, at consulting firm Towers Watson.

An investor looking at the composition  of a FoHF manager whose underlying portfolio comprises largely of sizable high-profile single managers would be forgiven for thinking that they could have made the same selection themselves, while avoiding the extra layer of fees. “Where FoHF managers add particular value is in their search expertise – that is, not simply picking the big headline fund managers but also having the ability to find and select newer, more idiosyncratic managers,” says Chris Jones, chief investment officer of FoHF Key Asset Management.

And while investors investing directly may opt to stick with, if not the biggest managers, then those with a relatively sizeable track record, FoHF firms with the necessary infrastructure are not restricted in the same way.

“We as a fund of funds can invest day one with managers provided we’ve done our due diligence and we feel there’s a solid investment story there,” says Stephen Oxley, managing director of FoHF Paamco. “We’re prepared to take that risk because we have the resources to monitor the behaviour of the manager through transparency and our understanding of underlying positions.”

But what about fees? No discussion on the future of the funds of funds industry can ignore the issue, often cited by investors as a reason to move away from FoHFs.

“[Institution investors] are most cost-sensitive and because of size have better negotiation power”, says William Keunen, global director at administration firm Citco Fund Services, who believes that FoHFs have become increasingly client-centric, post-crisis. “Long-term compensation and incentive arrangements, focused portfolio offerings and tight controls of their cost-base have created firms with cultures and structures that are in alignment with investors interests.”

And while many in the industry would argue that the issue of fee structure warrants more attention than that of fee level, the latter remains a key factor in many investors’ decision-making processes. Indeed, Massachusetts Prim’s Commoss describes the board’s decision to move to direct investments as “primarily a fee-saving initiative”.

That said, what is perhaps most important is that investors feel confident they are getting value for money. “With regard to fees, put simply, you pay for value. If a manager is doing well in the FoHF space, they don’t need to make any changes to their fees,” says Tyler Kim, chief investment officer at Maples Fund Services.

Another key selling point for funds of funds is their ability to tailor their offerings to the specific needs of their investor client. “Investors and their consultants are increasingly working with their FoHF providers and hedge funds to build customised portfolios,” says Citco’s Keunen. “FoHF companies are turning more and more into advisory companies, to accommodate these new investors.”

As such, demand for more specialised products such as funds of managed accounts and single investors FoHFs, or ‘funds of one’, is on the rise. “FoHFs need that level of customisation to continue to attract investors – they need to be looking at the specifics of investor needs and the innovative ways in which these needs can be fulfilled,” says Maples’ Kim.

In essence, FoHFs need to be able to offer investors a service that they simply cannot get by going direct – but with a growing number of institutions opting to rely on advice of investment consultants, this is clearly becoming an increasingly challenging proposition for FoHFs.

“Funds of funds are now more likely to be in competition with consulting firms, which are increasingly moving into the area of individual hedge fund manager search, selection and monitoring – traditionally the role of FoHFs,” says Paamco’s Oxley. “That said, while it’s a challenge, it’s one that FoHFs can overcome because we feel that our industry has the right resources, the experience and the necessary quality and quantity of people.”

And while many still view direct investments and FoHFs as mutually exclusive, there is a growing awareness of the benefits of including both in an investment portfolio. “As investors become increasingly sophisticated, they are becoming aware of the benefits of using a FoHF manager to build a completion fund for their portfolio, as opposed to simply buying an off-the-shelf product,” says Key Asset Management’s Jones.

It’s an area in which Paamco’s Oxley is also seeing increasing demand. “The bulk of our business has always been in managed accounts or funds of one for clients but what we are seeing more of is demand for customised portfolios within that structure, where investors are asking us to build portfolios that meet particular liabilities or investment needs – and an example of this would be the construction of completion portfolios,” he says. “For example, a client with direct allocations that have a particular bias towards, say, long/short equity or global macro may ask us to build a portfolio that complements this.”

In fact, Oxley believes that, whereas previously many investors had a core allocation to FoHFs and a satellite allocation to individual managers, today you’re likely to see a core allocation into larger single manager funds, and satellite allocations to FoHFs, “That said, this is largely dependent on the respective size and expense of the investor,” he adds.

So what lies ahead for FoHFs? Yes, the headlines are filled with stories of multi-billion dollar institutions moving direct, but it’s easy for forget that not every investor has the staff or infrastructure to take this route. “While there are some large institutional investors that might consider investing in hedge funds directly [rather than through a FoHF], the investment community is comprised of more than just big allocators,” says Maples’ Kim.

“FoHFs are still an efficient tool for small- to mid-sized investors to get a level of diversification, without the need to build an infrastructure around it themselves,” agrees Maples’ global head of fund services, Toni Pinkerton.
Clearly, the FoHF space is continuing to grow, albeit at a slower pace than its single manager counterpart, but more important than the rate of the industry’s growth is the rate of its evolution.

“As with any investment class, there’s constant evolution and I believe that the model whereby a FoHF will work in partnership with an institutional investor and act as a solutions provider, rather than just a product pusher, is the way forward,” says Key Asset Management’s Jones. “That said, there’s a lot of inertia with some funds of funds who simply aren’t evolving, and I think, for them, it might be a case of adapt or die.”