The growth of the funds of hedge funds (FoHFs) sector has been unstoppable for the last few years, but recent industry figures show inflows into the asset class are now slowing down.
Declining money inflows, disappointing returns and high fees seem to be putting investors off this type of investment vehicle, and recent studies paint a quite depressing picture of the sector. According to data from Chicago-based Hedge Fund Research (HRF), inflows into FoHFs fell almost 40 per cent during the first half of the year, compared to figures registered during the same period of 2004. However, an analysis of the causes for this decline affords a less grim outlook for the sector.
First, it is important to highlight that the decline in investors’ interest in FoFHs does not mean the sector has been losing assets over the recent past, but that the amount of new assets coming in has been smaller than before, something that happens in every industry sector when products move from being the latest must-have to become an established investment option.
However, the significance of a 40 per cent drop in inflows cannot be underestimated, especially when one takes into account that FoHFs are still the preferred choice for investors seeking exposure to the hedge fund sector without the risks of investing in a single manager strategy fund. So why are investors putting less money into FoHFs?
Disappointing performance could have been one of the triggers, as returns in the sector are now considerably lower than they were a couple of years ago. The HFRI Fund of Funds Composite index, for instance, returned 11.61 per cent in 2003 and 6.8 per cent in 2004, and by the end of third quarter of 2005 returns only added to 3.58 per cent.
Joshua Rosenberg, president of HRF, says that clearly this challenging performance environment has led to a slowdown of inflows into these types of funds this year. “That said, we are still seeing inflows into funds of funds that indicates that despite the challenges from the performance perspective, there are still investors interested in hedge fund investments through fund of funds,” Mr Rosenberg says. “I think in single hedge fund strategies there is clearly an opportunity to generate stronger returns simply because it is a more focused type of strategy, but on the other hand there is more risk involved.” Furthermore, he adds, FoHFs are supposed to have a high level of expertise and the ability to spread large amounts of assets over a number of hedge funds, which limits risk. “So in exchange for slightly lower returns, you are getting and entirely different risk profile.”
However, still focusing on performance, what investors are facing at the moment is not just lower returns in FoHFs but, more importantly, they are seeing that other asset classes are now performing better. Given that the markets are rising at the moment, investors are finding attractive return opportunities outside the alternative assets classes, with straightforward equities and bonds offering more potential than they did in the recent past. Taking into account that most institutions turned to hedge funds in search of extra alpha-generating opportunities, the fact that conventional markets are now performing better may be putting them off following the alternative route.
“Last year was the first year that investors started to gain some confidence but they were still a bit worried,” says Christopher Aldous, chief executive at Absolute Fund Management (AFM). “In 2005 we suddenly have some good earnings forecasts so I think a lot of money came into conventional [investments].” Mr Aldous adds that recently investors have also seen returns in hedge funds declining, putting them off of committing more money to the asset class. “At the end of the first half of the year we saw that a lot of the money that had been promised was suddenly being withdrawn,” he says. Institutional investors are also becoming more informed about hedge funds and therefore they are more likely to buy single strategy funds, he adds.
“Anecdotally we are finding among some of the best funds which we know well and would like to add more money to, that they prefer to take money from institutions than from funds of funds. As they are getting more demand from institutions than before, they can turn away funds of funds and wait for institutional money to come directly,” Mr Aldous comments.
Decreased demand for FoHFs is also one of the drivers behind the discussions about fee structures. Declining inflows might well force managers to lower fees that are currently perceived as being too high by many investors, especially now that returns have been disappointing.
With this in mind, AFM has just launched a performance fee only FoHF, the Absolute Focus Fund, a concentrated version of the firms already well-established Absolute Fund that operates under a conventional fee structure. Mr Aldous believes the performance only fee structure of the new fund will help them to differentiate themselves in what he considers to be an overcrowded market.
“You see many complaints about the layering of fees within the fund of funds industry, and in particular the funds of hedge funds, because the underlying hedge funds fees are so high,” he says.
Investors in this new fund will be charged a 15 per cent performance fee on net gains on a monthly basis. Therefore, if the fund returns 10 to 12 per cent, the annual investment management fee will be between 1.5 and 1.7 per cent, which is similar to that charged by most other fund managers regardless returns are positive or negative.
Mr Aldous has seen a lot interest from clients in this new product at a time where new inflows into their existing fund have been declining. “We haven’t lost any assets but we have certainly had lower inflows. Personally, I think we will continue to see very slow growth in the existing fund, which has a standard fee structure,” he says.
Mr Aldous explains there are strong indications to believe that this performance fee only structure fund will be very attractive for investors, but he doesn’t expect many competitors following the same route. “Not everyone would do this because there is a business risk. Our main fund runs our business very happily but clearly if you only have a performance fee-based fund and you get bad performance for three months your business can go bust.”
Analysing the FoHFs sector as it stands at the moment, it seems that despite fees and performance pressure, investors will still buy into these vehicles for years to come. It might be true that some sophisticated institutional investors have the high level of expertise and dedication needed to invest in single managers hedge funds, but this is not the case for the vast majority of institutions. FoHFs will continue being the favourite vehicle to gain hedge fund exposure among many institutions across the world.
 Randy Shain, BackTrack | “Fund of funds still serve an extremely important function and, unless pension funds are going to take over the function of funds of funds, I don’t understand why they wouldn’t continue with that model,” says Randy Shain, co-founder of due diligence specialist firm BackTrack Reports. Mr Shain explains that FoHFs perform an extremely important task that consists in firstly meeting and speaking to potential managers and doing all the operational due diligence and “trying to figure out whether the manager’s story makes any sense”. |
“The second thing they do is to hire people like us to look at those running the companies because that’s something they don’t do that well as we can,” he says. “The idea is that the research they’ve done on the operational side combined with the people side, which what is what we do, will allow them to do a much better job than any individual investor could ever do.”
The FoHFs sector is suffering the same problems as the hedge fund industry as a whole. What was a one-time exclusive alternative to traditional investments, has now become part of the portfolios of more and more institutional investors across the world. As the markets become more crowded, return opportunities are set to decrease and pressure to reduce fees will be greater in the near future.
As with equities, investors investing in hedge funds know that some of the performance figures registered in the past will no longer be the norm, but they will still be an important part of investors’ portfolios. Single fund strategies might have been favoured over the recent months but that doesn’t mean asset inflows into FoHFs will not continue growing.
Mr Rosenberg at HFR is positive about the future of the FoHFs sector. He explains that over the last year or so investors have showed more interest in the most diversified single manager strategies such as event-driven and relative value funds. “Those two categories are where we’ve seen the strongest growth in assets, but they have also been decent performers,” he says. “However, our data is telling us there is still money flowing into funds of funds.”
