Hedge Fund-of-Funds? Anybody? Anybody at All?

Ashby Monk 

In January 2009, Yale’s CIO David Swensen called the community of hedge fund-of-funds (HFoFs) “a cancer on the institutional investor world.” He also went on to say that these intermediaries…

“…facilitate the flow of ignorant capital. If an investor can’t make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There’s also more fees on top of existing fees. And the best managers don’t want fund-of-fund money because it is unreliable. You need to be in the top 10% of hedge funds to succeed. In a fund of funds, you will likely be excluded from the best managers.”

Ouch. That’s pretty bad. When the architect of the “Yale Model” and the acknowledged guru of institutional investment says you’re a cancer, you know you’ve got problems. And, as it turns out, that seems to have been the case for HFoFs these past two years.

In the past two months, two rather interesting reports have been published on the decline of  HFoFs. An aiCIO article entitled “The end of 3 and 30” was really compelling. And, yesterday, Citi published a new study entitled “The Growth and Impact of Direct Investing,” which offers survey results that show institutional investors giving up on HFoFs and making investments in hedge funds directly. Here’s a blurb from the latter:

“The shift to direct hedge fund investing has been dramatic since the global financial crisis — particularly among larger pensions and sovereign wealth funds…The roots of this shift in investment approach had begun around 2006–2007. Larger pension funds and early sovereign wealth fund investors had gained exposure to hedge funds via traditional fund-of-fund managers earlier in the decade but, for economic and diversification reasons, had opted by mid-decade to build out their own capabilities to select and manage their hedge fund portfolio. The global financial crisis and Madoff scandal accelerated the move toward direct investing, particularly as a second wave of sovereign wealth money began to enter the market.”

I’ve been writing about direct investing for a while, and, in my view, the case for in-sourcing hedge fund allocations is a strong one. (Given Swensen’s comments, it’s not like I’m going out on a limb here.) You save a ton on fees. You have more control over your assets. You have a better understanding of your fund’s exposure. In short, I’d expect the trends shown below to continue on in the same direction.

4 Responses to “Hedge Fund-of-Funds? Anybody? Anybody at All?”

  1. 1 Andrew Rozanov June 28, 2011 at 5:30 pm

    Hi Ashby,

    As a fund of hedge funds specialist, I couldn’t leave this alone… This is such a tired argument… We keep hearing this all the time, and yet we also keep hearing about all the mis-steps and screw-ups that certain institutional investors make in trying to go it alone… Of course, a minority of institutions will be able to do it, if they commit sufficient resources and hire the right people… Which – by the way – costs a lot of money… But for the majority, it still makes sense to hire a fund of funds… Now that doesn’t mean any fund of funds – there are rotten apples everywhere, not least in our industry pre-crisis… But you really shouldn’t paint everyone with the same brush! For what it’s worth, here’s my rebuke to this type of argument from last year: Welcome to funds of hedge funds 2.0
    Andrew Rozanov, head of sovereign advisory services, Permal Investment Management Services
    27 Sep 2010
    A few commentators – including Financial News – have recently pronounced the demise of the funds of hedge funds industry, suggesting that the financial crisis has landed a mortal blow. Critics have focused on fees levied, disappointing aggregate performance in terms of returns and risk management, and the growing trend towards “disintermediation”.

    Andrew Rozanov
    While one has to agree with some of these comments, and necessary changes are indeed taking place, it is unfair to paint the entire industry with the same brush, describing it as dying, slowly or otherwise. This is akin to the internet sector epitaphs after the dotcom crash, a period that produced such successes as Amazon, Google, eBay and many others.

    Sadly, all too often, only the failures are highlighted, not the successes. Instead, consider those funds that have long track records – sometimes multi-decade ones – successfully managing assets, producing positive returns in different macroeconomic environments, over different market cycles. Remember a large number of funds ran the rule over Bernard Madoff, yet firmly refused to invest.

    Over the years, many have developed sophisticated proprietary tools for manager research, portfolio construction and risk management. Typically, these are some of the older and more experienced firms, that appeared long before the recent hedge fund boom, accumulated unique knowledge, human capital and technology, and often maintained exclusive focus on hedge funds. These are the firms that represent the core of the industry and constitute the engine and platform for future growth.

    Now consider fees and aggregate performance. On the former, rather than rejecting a second layer of fees outright, should one not ask what investors are getting in return? On the most basic level, if a fund of hedge funds consistently produces attractive risk-adjusted returns net of all fees, then surely this would not be an objectionable proposition.

    On a broader note, even if an institutional investor were to develop an internal platform for direct investment in hedge funds, it might still choose to keep allocations to a few select funds of hedge funds to benchmark and evaluate the in-house team, to source new ideas and identify up-and-coming managers, and to provide an insurance policy against in-house key-man risk.

    As for aggregate performance, one should keep in mind that it is precisely that – aggregate – and is not a clear reflection of today’s sector. Within this structure, there are a diverse set of funds, including many of the less liquid, more complex and leveraged strategies, most of which have either already closed or are a fraction of their original size. The result has been an overdue clear-out, leaving the sector far leaner and better prepared for its next phase of development.

    Looking at risk factor exposures, different hedge fund strategies offer vastly different risk profiles. For example, most market neutral and relative value strategies will on average be short liquidity and short volatility, producing a steady stream of attractive returns during quiet periods, but underperform dramatically during volatility spikes and market dislocations.

    Conversely, discretionary global macro and systematic trading strategies will on average be long liquidity and long volatility, delivering completely different return profiles, which are more helpful in times of crisis and dislocation.

    Individual underlying managers may be extremely good at their respective strategies, but they are unlikely to be best placed to offer advice on constructing optimal multi-strategy portfolios, taking full account of exposures and allocations to various risk factors.

    Only a strong team of asset allocators, with solid grounding and long experience in the hedge fund industry, and an appreciation of institutional portfolio construction issues, are in a position to help. Such specialists increasingly reside in top institutional-quality funds of hedge funds. This is why we are optimistic about the prospects for our industry – we are witnessing the emergence of a new, much more institutionally oriented model. Funds of hedge funds 2.0. Welcome to the next level.

    • The views expressed in this article do not necessarily reflect the views of Permal

    • 2 Ashby Monk June 28, 2011 at 5:51 pm

      Hi Andrew:

      Good point! There are going to be stars that can generate value for their clients. If you’re an HFOF that generates great returns net of fees, then of course you’re future’s bright. So it’s clearly not fair to paint them all with the same brush.

      I’m curious: What’s your read of the aiCIO report or the Citi report?

      Thanks again for the comment. Cheers! Ashby

  2. 3 MMcC June 29, 2011 at 12:37 am

    Andrew touches on the informational disadvantages that insti investors endure when they attempt to in-house manager selection. These can be particularly acute in many of the markets we often discuss on this board, especially those where local practice and legislation require hedge and hedge-like managers to adopt investing techniques that are less than straightforwardly comparable with those in developed markets. As a wholly-imaginary example, were we to consider the QDII investments of a respected American university with a god-awful hockey team, that DIY mindset might preclude them from investing in a number of funds that a good FoHF would exploit, resulting in a vanilla portfolio that is often difficult to distinguish from a market tracker.

  3. 4 Ashby Monk June 29, 2011 at 8:17 am

    Again a really good point. After all, I’m a big proponent of “local” knowledge. In a way, a HFOF earns its fees on the back of these information asymmetries. Thanks for the comment, Mike.

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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