Back down to earth for hedge funds of funds

Posted 07 29 2008 3:40PM

Hedge funds of funds, which have been among the more widely used ways of investing in hedge funds in the past few years, have recently been declining in popularity. New York State's $150bn pension fund is one of several that have shifted money out of funds of funds, instead opting to invest directly in hedge funds that it chooses itself.

A fund of funds, for a small additional fee, selects a basket of hedge funds for an investor. These vehicles became popular because, in a rather secretive industry, investors often found it difficult to get information about which hedge funds were worth investing in. A fund of funds takes on the burden of research, sifting through the 8,000 funds to choose the best. It also shifts its assets around among different strategies, reducing a particular asset class by redeeming or halting inflows into certain funds or loading up on others.

The benefit to the investor is also one of diversification. Instead of putting their money with one or two funds, they spread it across up to 100 held by the fund of funds. Returns tend to be less volatile than with just one or two funds.

Funds of funds rocketed into prominence in the early 1990s, riding the wave of hedge fund growth to account for 45 per cent of industry assets by 1994. Around the turn of the century they slumped in popularity but then rebounded. Now, for the first time in 10 years, they have dropped in their share of assets.

Last year, funds of funds accounted for 42.7 per cent of the industry's $1,800bn assets under management, according to Hedge Fund Research. That was down from 45 per cent in 2006.

One reason for the slight decline is, coincidentally, the growing maturity of the market and the growing confidence that many investors have in hedge fund investment. For many institutional investors, such as pension funds and endowments, as they become more familiar with hedge fund strategies - and as the amount they allocate to hedge funds has grown - they start to think of bypassing the funds of funds and going to direct investment, making their own decisions about which ones to invest in.

The extra fees charged by a fund of funds can also be a sticking point, especially if investors start to feel competent enough to choose for themselves. In an industry that already charges high fees - typically, investors pay the hedge fund manager 2 per cent of assets and 20 per cent of the performance of a hedge fund manager - the fund of funds adds fees of another 1 per cent of assets each year.

There is evidence that funds of funds do not add much value. Their net returns tend to be slightly lower than the return from hedge funds overall, and with the additional 1 per cent fee, the returns are even further depleted.

Individual funds of funds do vary greatly, however. For small endowments or individual investors, the diversification argument is, nonetheless, a strong one. Thorne Perkin, who is in charge of business development at New York-based adviser Papamarkou Asset Management, says: "For small clients, a fund of funds makes perfect sense. For larger, wealthier clients we have less focus on fund of funds. If you already have 10 to 15 hedge funds, then you don't need a fund of funds."

There are two main alternatives for investors who do not want to pick their own selection of hedge funds or have the financial capacity to choose for themselves. First, they can invest in a multi-strategy fund. This type of fund is becoming increasingly common as hedge funds balloon in size. The fund switches strategy to suit market conditions.

A second possibility is to use hedge fund consultants or financial advisers to help with selection. These often charge the same 1 per cent of assets as fund of funds, but they offer a more customised service and can advise on an entire portfolio.

Some funds of funds still attract huge amounts of investor money. Permal has doubled its assets in recent years to $37bn. One advantage of funds of funds is they are often able to gain access to funds that are closed. The company, which has been in the business for many years, was an early investor in Jim Simons' Renaissance fund, for example.

However, individuals and institutions can also position themselves to do this. Once an institution becomes known to the hedge funds and is considered a desirable investor, it will develop relationships that open doors.

Perkin says Papamarkou, which specialises in private equity and hedge fund investing, has also been able to get access to desirable funds. "Private clients are more attractive to hedge funds than institutional clients," he says. "There is less of a process in making the investment decision.

"We often get calls from funds which are closed but have new capacity opening up. [When] Greenlight [the $5bn fund managed by David Einhorn] had an opening, they gave us a call. Cantillon, managed by William von Mueffling, is another one we got clients into."

Papamarkou looks for "under-the-radar, up-and-coming managers", says Perkin. "Our greatest success in finding good funds has come from word of mouth."

That is also true of funds of funds.