18/03/2010 Author: Zaki Abushal

A matter of confidence

The faltering fortunes of the FoHF model have seen funds lose assets, not as a result of performance, but due to a new dawn of investor awareness, and a fresh drive towards direct investing. What will it take to revive the fund of hedge funds space?

During the heady days of the hedge fund industry, any new product launched into the market place was accepted by investors and the industry without so much as a query to value or validity. Investors had taken their eye off the ball and allowed product providers, particularly funds of hedge funds (FoHFs), frequently pushed by consultants, to adopt a laissez faire approach to their business model. This free-and-easy approach ended in 2008, when underperforming and illiquid FoHFs were deemed battered and broken by many investors.

Performance has improved, but with heightened vigilance now a fact of life, 2008’s volte face is continuing to punish the FoHF model, as investors drain away and assets sink. Research this week has shown that assets under management (AuM) at FoHFs are continuing to fall, slipping to $625bn at the end of 2009, from $744bn in 2008. With performance up last year, this subsidence is purely down to investor redemptions, despite a forced plunge in management fees as managers try to lure investors back.

Today’s problems were forged in the past. Inevitably, and for a lot longer than is generally conceived, investment consultants and FoHFs have edged ever closer to one another. Even the concept of investment consultants offering FoHF products is not new. Russell Investments established the first of its FoHF products in June 2001, well before the boom in hedge fund investing, establishing the company as a trailblazer in the alternatives space. The move made perfect sense; why just advise on FoHF offerings when you can set out on your own and collect all the fees from institutions?

At the time, institutional investors, relatively new to the game and unsure of the role hedge funds played in their portfolios, turned to investment consultants and FoHFs to fill that skills gap. But the game has changed. “The fund of hedge funds industry was used by institutions to become more familiar with hedge funds. Now, the fiduciary often has ten years’ experience with hedge funds,” said Charles Gradante, founder of hedge fund advisory firm the Hennessee Group. “Fiduciaries have now decided to go direct,” he said, making hedge funds the clear beneficiaries of declining FoHF fortunes.  

These sentiments are strongly backed by the newly formed Towers Watson (a merger between Watson Wyatt and Towers Perrin). “In 2009, Towers Watson’s clients showed continued interest in direct hedge funds, with a 10% growth in the number of mandates awarded compared with the previous year, while demand for FoHF mandates fell. Mandates for direct hedge funds now account for 85% of all hedge fund searches (up from just over half in 2008),” according to Craig Baker, global head of manager research at Towers Watson.

For all the talk of the blurring between funds of hedge funds and investment consultants, it actually looks like some clarity has returned to the marketplace. A best-of-breed FoHF is emerging, while, for the likes of Russell Investments, poor performance and redemptions have put paid to its in-house FoHF offerings. Russell Investments shut down its two FoHFs, Russell Alternatives Strategies and Russell Alternatives Strategies II, in April 2008, right in the middle of the redemption frenzy that was sweeping the industry. Now, it has no dedicated FoHF products, and none of its multi-manager offerings invest in hedge funds. In contrast, Consulting Services Group (CSG), an investment consultant in Memphis Tennessee, still provides an in-house FoHF product to its clients, alongside its traditional advisory services. Not only has CSG suffered through its FoHF performance in 2008, but the investment consultant was also tied up in a pay-to-play scandal and at the end of last year it sued Morgan Keegan & Co for losses suffered in several collapsed RMK funds.

Of course, profitability is just one issue, questionably more telling is the issue of conflict of interest. Depending on which side of the fence you sit, the other side risks massive conflicts of interest operating both an investment consultant advisory and a FoHF, raising questions of manager selection, favouritism and fee revenue. You can be sure, in today’s climate, institutional investors will want to know the ‘whys’ behind every decision made concerning their capital, and any sniff of a scandal could be fatal.

In the short term, investment consultants will take the safer and less-costly approach of slowly dissolving their in-house FoHF businesses, if they haven’t already done so, while external FoHFs are already changing their internal models, as they attempt to win back the confidence of investors