09/11/2011 Author: Will Wainewright

FoHF: The state of play

Following a tough year and continued questions over the validity of the fund of hedge funds model, HFMWeek spoke to four FoHFs of varying size about their investment approach and why the sector still provides a valuable service to investors

While it has been a tough year for the single manager hedge fund industry, spare a thought for those running funds of hedge funds (FoHF). The sector has had to deal with a host of difficulties, not least the poor performance of the funds they invest in, which has led to YTD losses of -5.26% according to Hedge Fund Research. For many funds, this has been compounded by waning interest from investors, question marks over fees and continued attacks on the role played by FoHFs.

There are signs of hope too, however. Hermes BPK Partners, the $2.1bn FoHF, has just launched a $550m long-short equity FoHF, which has been seeded by a single investor. But how has the wider industry fared this year? In order to understand the pressures faced by the sector, HFMWeek spoke to four FoHFs about how they have adapted in uncertain conditions, and found them to be in confident mood about their industry’s prospects. The four funds differ in size and provide a range of different structures and investment methodologies, but all are convinced that substantial opportunities lie ahead for those flexible enough to take them.

Permal Group: $21bn
Permal Group, among the world’s five-biggest FoHF providers, is understandably bullish about the future of the industry, having seen assets rise by around 10% in the last year. Company president Omar Kodmani has no time for cynics who argue the industry is in decline. “That accusation is a broken record,” says Kodmani. “There are players in the industry who add value by discovering smaller managers and combining various strategies in a portfolio.”

However, he admits a flexible approach has been key to the global company’s recent growth, both in terms of its offering to investors and investment policy. “Our recent focus has been to identify the talented managers and ask them to create customised solutions for us. We can then structure these within our own $7bn managed account platform. This is a step removed from the standard FoHF model,” Kodmani adds.

And how have the uncertain conditions this year affected the firm’s policy? “We have been more activist in our investing approach, which means changing our portfolio more frequently and responding to opportunities as we see them.”

Macro has become a key focus, with manager numbers rising by a third, to 45 out of its 180 total. “Markets across the world are being driven by what happens on the front pages and not just on the business pages,” says Kodmani, adding that Permal is now 40% exposed to macro across its funds. Given that “seven or eight” macro managers are turned over every year, this could be an area of opportunity for funds. Special situations funds are the other key area of interest, with ongoing searches taking place for European and US distressed managers.

Inflows, Kodmani says, have been strong as a result of continued institutional interest. “The US has been very positive for us and we have also done well with European corporate pensions and large institutions in Asia.” The importance of institutional investors to FoHFs should not be underestimated, he adds. “The fund of funds industry has opportunities for growth because there will always be institutions who seek a professionally guided approach to hedge fund investment.”

Signet: $1.4bn
“This year has been a challenge,” admits Tim Gardner, global head of sales and marketing at $1.4bn Signet. “The private client market has been very quiet and the real interest has come from institutional investors. We have done well in the Middle East and UK, but overall it has been lukewarm.”

Assets run across Signet’s six FoHFs and four customised solutions have fallen accordingly during the last year, not helped by YTD losses of more than 4% in its fixed income flagship. However, redemptions have eased during the current quarter, which has seen flat flows so far. More positively, Signet, which has principal offices in the US, the UK, Switzerland and Hong Kong, is at the vanguard of the movement by some FoHFs to adapt their model in tough times. “We embraced the advisory model about a year ago,” explains Gardner. “We are using our expertise to offer a service that is tailored to clients’ needs. If they don’t want our expertise in terms of our existing products they can leverage it through a customised portfolio.”

Signet’s business is therefore split between its old fees model – 1.5/5 – and the advisory model in which, Gardner says, fees are something of a work in progress. “It is turning into more of a partnership business and it takes longer to close these deals. Fees will look different in the future and are likely to be more performance- or success-based than traditionally.” Signet is currently working on potential mandates with family offices that could be worth $100m each.

Another source of business is existing clients “looking for something different”. They may want to think about going direct with a customised portfolio but don’t have the time or resources to commit to the process. Signet is currently competing with three other FoHFs to offer a customised solution to an existing client. “I definitely think initiatives like these are the way forward,” says Gardner.

In terms of areas of strategy interest, the credit/macro mix in Signet’s flagship fund has recently increased from 50/50 to 75/25 in credit’s favour. “We really like credit at the moment and think the next 12 to 36 months are going to be really good for the strategy,” says Gardner. “A good amount of our credit managers are US-based but we are starting to pick up good opportunities among European managers.”

Culross Global Management: $600m
After providing funds of hedge funds for 16 years, London-based Culross has more experience in the market than most. However, it has nonetheless proved a tricky year for the firm, whose four FoHFs are worth a total of $600m in assets and focus on directional themes.

“Performance has been marginally negative this year but we have seen a bit of asset growth, which has been good,” says partner Chris Keen. “Inflows have been from institutions and pensions and outflows from individual investors.
“It is a difficult environment to invest in anything, especially as so much of what has been going on has been influenced by macro circumstances and policy,” he says. “But this is an environment in which macro managers should thrive, and our macro side is filled with managers who we think will be able to master the circumstances.” Another key current trend for Keen is deleveraging by banks: “Banks selling assets will be a theme that will create opportunities.” 

Culross has upped the number of managers on its platform by 10-15% this year as the firm’s risk management methodology has kicked in to spread overall risk. “This happened in 2008,” adds Keen. “Investors would expect us to adjust to the risk environment by doing this.”

However, the instability of the macro and wider economic picture brings opportunities to FoHFs in terms of attracting investment, says Keen. “Whereas there are plenty of investors who look at this climate and don’t want to invest in anything, institutional investors are looking to diversify their portfolios. FoHFs offer that diversification.”

Cube Capital: $1.2bn (with $700m FoHF)
For a sub-billion-dollar FoHF charging fees of 1.5/10, which some observers would view as old-fashioned, Cube Capital is extremely  confident about the future of its industry. Investors would appear to agree, having pumped millions into its $700m global multi-strategy flagship during the last 12 months, meaning that overall assets have increased by over $100m, despite YTD losses of around 3%.

“We would argue that we are fairly unique and can offer a distinctive proposition to investors,” says Peter Madsen, head of business development at the $1.2bn fund manager, which has a hedge fund and discretionary offering beside its FoHF. “But we can’t afford to be complacent. We need to be sure we are communicating our ability to add value beyond what a typical FoHF offers.”  That caution would perhaps explain Cube’s fresh marketing drive to attract investment, which started in Europe last year before moving to Asia and the US this year.

“We have found there to be significant interest in funds of hedge funds in the US and UK, but less demand in Europe,” says Madsen. “We’ve also had significant interest from the Middle East and South Africa.” Another initiative that Cube, which launched in 2003, is undertaking is the creation of custom-built funds for larger investors. They already provide one product worth $100m to a private client, and are in a process of building a second for a large US pension fund manager.

As for most FoHFs, it has been a tough year but analyst Karim Shalak says Cube runs a macro book overlay to moderate the downside. “We have also actively allocated to managers investing in what we believe are dislocated markets,” he says.

Cube is looking to add managers in the areas of European structured credit, where they have one manager, and the US mortgage-backed securities market, where they have two. “Another area of interest is European collateralised loan obligations, which are pricing in very high default rates,” says Shalak, adding they are in no rush given the volatility. Cash reserves have increased from 5% to 10% of the portfolio, a common theme across FoHFs as they look to protect assets.