Are funds of hedge funds set to fall out of favour, thanks to less-than-perfect performance, and the disincentive of a double layer of fees?
According to the latest figures from Hedge Fund Research (HFR), the HRFI Fund of Funds Composite under performed both the HRFI Fund Weighted Composite and the S&P 500 (plus dividends) in 2006. The indices returned 10.35 per cent, 12.95 per cent and 15.78 per cent, respectively.
But the industry is fighting back against suggestions that these headline figures will prompt institutions to move out of fund of hedge funds.
 | “I don’t think it is necessarily true that funds of hedge funds under-performed against direct investments in hedge funds,” says Stephen Oxley, partner at fund of funds house Pacific Alternative Asset Management (Paamco). He points out that published indices tend to include hedge funds which are actually closed to new investment. |
Performance issues
John Godden, chief executive of alternatives specialist IGS Group, argues: “I disagree with the argument that there were performance problems. Most good funds of funds produced 12 per cent, more than double the risk free rate, with much less than the risk of equity markets.
“People questioned in the summer whether it would be a bad year because of some significant problems in May and June, then there was a notorious blow up, which doesn’t actually make any statistical difference.” That blow up, of course, was of Connecticut-based Amaranth, in September.
But by October, Mr Godden says, it was apparent that, with decent results in November and December, “it would actually be a good year”. The HRFI Fund of Funds Composite duly produced 1.87 per cent and 1.72 per cent returns in the last two months of the year, against 2.09 per cent and 1.43 per cent for the Fund Weighted Composite, and 1.9 per cent and 1.4 per cent for the S&P 500 (plus dividends).
Indeed, according to Mr Godden, 2007 looks set to be a promising year for hedge funds, not least because of suggestions that it will be difficult for equities. “Globally, we are moving into a more interesting phase for hedge funds to extract added value,” he explains. “More volatility, more of a gap between good and bad companies, rising rates, inflation picking up – all these create opportunities.”
Nor does HFR itself predict a rush out of fund of hedge funds into single strategy products. “I don’t think there is a meaningful decline in assets coming into fund of funds,” says the firm’s president, Ken Heinz. “I don’t think the data indicates that investors in those products are not getting the returns they are interested in.”
That is not to say that the fund of funds industry is guaranteed an easy ride. As Mr Godden puts it: “There are too many fund of funds in the world, a lot sub-standard. But the smart ones have repositioned themselves. They have become an outsource for all the things you have to do in investing in a boutique business – analysing, due diligence, allocating across strategies. So while you will get very big well resourced investors like Hermes who can do it in-house, anyone much smaller doesn’t have that resource.”
Cutting out the hassle
Florence Duculot, portfolio manager at EIM, which has $10bn (€7.7bn) under management, agrees. “Especially for institutional investors, there is still a strong interest in funds of hedge funds,” she says, “because it is very difficult to go directly to the funds themselves, do the due diligence work and find the right strategies that will perform well.”
Instead, Mr Godden predicts polarisation: “The big players, for example Man, will be attracting more and more money, and smaller players, sub $2m, will struggle.”
The obvious deterrent for institutions contemplating fund of hedge funds is the double layer of fees. “If investors feel they are getting value added they will continue to utilise funds of funds,” says Neil Ebers, chief operating officer at Lionhart, which manages three hedge funds with a total of $650m.
“But a number of institutions, including pension funds, have increased their allocation to hedge funds, and what you will find is that, after a period of time, they start to produce their own mandate and go directly to the hedge funds. We see the value added that funds of funds bring for certain investors. For others, it is clear they don’t add the value they are purporting to.”
Paamco’s Mr Oxley defends fund of funds against concerns about fee layering. “Identifying, monitoring and constructing a portfolio requires a lot of resources,” he points out. “Yes, you can do it yourself but you would need to create a team with the same type of resources that a good institutional fund of funds would put into it.” For Paamco, that means employing 30-40 investment professionals. As Mr Oxley remarks, it is “still not inexpensive”.
On top of this, he says, the size and investment timing of a big fund of funds means being able to drive a harder bargain on fees with individual hedge funds. The figures generally thrown around are two-and-20 per cent fees for a hedge fund, with an additional per cent or two for the fund of funds, and perhaps a performance fee as well. But Mr Oxley claims that Paamco has been able to negotiate a discount on 90 per cent of the funds it invests in, reducing the overall fee.
“We are a fund of funds managing $8bn,” he explains. “When we invest – and there are fewer than 100 hedge funds that we invest in – our investments on average are relatively large. Also, a fund of hedge funds is usually in a position to make a much earlier decision about investing in a hedge fund. If you are coming earlier to the market you can often get some kind of recognition, often a fee discount.”
Ms Duculot adds that it comes down to whether funds of funds can deliver what they have promised: “It is about diversifying, not just about return, for institutional investors. So long as they can provide this service and help the institution overall in asset allocation decisions, picking the right hedge funds, and the right product, investing in fund of hedge funds makes sense.”
Multi-strategy appeal
According to Mr Oxley, not even multi-strategy funds – single hedge funds which diversify returns by using a variety of investment strategies – represent a major threat to funds of funds. Going back to basics, he stresses: “If you are an institution or any kind of investors and you want to invest in hedge funds, you have to start from the point of view that these are dynamic investments in small companies.”
The point is that it makes sense to diversity, and most investors would be shy of putting all their financial eggs into one hedge fund basket, even a multi-strategy one. Says Mr Oxley: “I know multi-strategy funds give strategy exposure, but you are still not diversifying business risk.”
That is not to say that there is no place for multi-strategy, or even some single-strategy funds. But it is as a complement to a fund of funds, not as a replacement. “They are not mutually exclusive,” says Mr Oxley. “And our experience is that a number of larger institutions are using both.”
Such an institution would combine a fund of funds, to make the difficult choices between newer managers, with “satellite” investments directly into multi-strategy funds. These would be funds with which the institution can feel relatively comfortable – “because they are well known names and the institution has a good understanding of the business”.
The last two years have seen a dramatic shift, strategy-wise, towards “alternative alternatives” – notably energy plays and emerging markets, according to Mr Godden at IGS. But will 2007 see a return to more traditional forms of hedge fund? The jury is out.
Emerging markets have had, as HFR’s Mr Heinz puts it, “a couple of really strong years”, with the HFRI Emerging Markets (Total) returning 24.29 per cent year-to-date to December 2006, and 21.04 per cent in 2005. Ms Duculot expects strategies favoured last year, especially emerging markets, to stay in favour, while Lionhart’s Mr Ebers predicts that they will “continue to garner investments coming in over the next couple of years”.
He explains: “Looking at some of the Eastern European or Asian countries, with the changes in Malaysia, Singapore, the Philippines, Taiwan, Korea, these are market places which have continued to produce opportunities. Everyone wants non-correlated returns and they want the alpha appreciation, and you have to go looking for that.”
But Mr Oxley warns that emerging market hedge funds may not always be ideal for institutions, for all their appeal to high-net-worth individuals: “The hedge fund investor world is bifurcating into those who are purely seeking return – in general, more private clients – and institutional investors, who are looking to risk adjusted returns and to diversify.”
Direct investments
Investors in this second class are, he points out, likely already to have direct investment in emerging markets. Investing in them again via hedge funds may just mean additional fees for little extra risk-adjusted return. “Emerging market hedge funds,” he argues, “tend to have high beta as they tend to be difficult to hedge – it is difficult to identify true hedge funds in that market. Why pay high hedge fund fees for a market exposure when you can buy it for a lot less?”
Moreover, Ms Duculot cautions, the dangers of overcrowding can be intensified in “alternative” hedge fund markets. “Some niche markets, including emerging markets in some instances, saw some crowded trades, for example in Brazil,” she says. “We keep watching constantly and, when we go to niche markets, we try to measure the risks.”
Either way, it is too soon to give up on more vanilla hedge fund funds. Even Mr Ebers predicts a return to more traditional products, which he sees as growing in popularity alongside the increased interest in more unusual ones like emerging market hedge funds. “Everyone,” he says, “likes a mainstream product, something which ticks away and produces good performance on a low risk adjusted basis.”
