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Alternatives

Hedge funds of funds are back, but this time with a few twists

Patrick Ghali sees funds of funds being used mostly for niche strategies or a geographic focus.

Consultants and money managers are seeing a resurgence in interest for hedge fund-of-funds allocations across continental Europe and North America, but with a repositioning or enhancement of relationships.

Unlike previous surges of interest, sources said there are new motivations for searches, new demands from clients and different structures in place.

"They've been declared dead many times," said Toby Goodworth, London-based managing director, head of risk and diversifying strategies at consultant bfinance. "I started out in hedge funds in 2004 and I've seen it evolve quite significantly over that time."

Mr. Goodworth said over the past 12 months, there has been a "very substantial increase" in hedge fund-of-funds searches through Europe and North America, vs. the previous year. He declined to release exact numbers but said searches are more than 50% higher.

Consolidation and turnover in the market is a big driver, he said. "The fund-of-hedge-funds landscape has changed markedly the last few years with the closure of some smaller firms and mergers of smaller and midsized firms. Investors respond to that and in some cases may decide to re-tender."

Assets under management in commingled and customized fund-of-funds were largely flat at $414 billion as of June 30, 2017, vs. $416 billion a year earlier, according to Pensions & Investments' 2017 survey. Further, 61% of the managers reported growth in assets for the year ended June 30, 2017, with 29% reporting a decline. However, the number of hedge fund-of-funds managers that responded to the survey fell to 31 from 44 the year before.

Michael Turner, CEO at London-based Man FRM, said of the current period: "I would go so far to say (it is) maybe the busiest I can remember."

Mr. Turner said the firm, which had $17.5 billion in assets under management as of March 31 — up 20% year-on-year — is seeing less demand for the traditional commingled-type strategies of a decade ago, but there is "increasing demand for bespoke solutions for clients."

Requests range from tailoring an allocation to a specific requirement to building a managed account platform for an investor, he said. "We see a growing demand for our services, and it really is very much more focused on how can we help clients as opposed to taking something off the shelf."

Mr. Turner added that this surge in interest is global.

Alternative risk premiums

One new angle to searches is the incorporation of alternative risk premiums, bfinance's Mr. Goodworth said.

Man FRM also is seeing demand for the incorporation of risk premiums, with a number of allocations mixing the approach with more traditional funds-of-funds investments. Executives started doing so in 2013, with a view that the risk utilization of portfolios could be increased without attracting higher fees or damaging liquidity. Executives initially made use of sister unit Man AHL's macro quantitative research capabilities to help build strategies, and after the 2014 acquisition by Man Group of quantitative firm Numeric Holdings LLC, now Man Numeric, built out equity quant strategies too.

"We have been allocating to in-house risk premia strategies since January 2014 … and we are seeing clients want and like what risk premia brings, and also (want the) alpha of traditional hedge funds. We have a number of mandates in progress on that front," Mr. Turner added.

Diversification also is a draw for investors looking at hedge funds of funds. "In general I would say we have always continued to see demand for fund of funds," said Patrick Ghali, managing partner, co-founder at Sussex Partners in London.

"What has changed is that investors have become more discerning," he added. "For more plain-vanilla strategies, many have decided to go the single-manager route instead. But for niche strategies or geographically focused investments, investors are often still interested in using a FoF to get a more diversified exposure as it often makes sense to minimize risks" such as operational or strategy-specific risks. "Where a (fund of funds) is offering no discernible differentiation and middling returns, demand has fallen away sharply. But where a clear value-add can be shown, interest continues to be robust," Mr. Ghali said.

Jeffrey A. Levi, principal at Casey Quirk, a practice of Deloitte Consulting, in Darien, Conn., sees another change among hedge fund-of-funds firms and their relationships with clients.

He said hedge fund-of-funds returns have been strong over recent years, but flows had been largely moderate to negative. "We have seen a slowdown in outflows — I wouldn't say we are seeing a big resurgence in that category, but a tempering of redemptions."

But what he has seen is a repositioning of offerings from hedge funds of funds and also private equity funds of funds.

"Managers are increasing the amount of advice they are delivering on a product, so more of a consultative delivery, with more bespoke offerings for the larger clients and more customer tailoring," he said. "Increasingly a lot of these fund of funds are competing directly with the consultancies, which has been an interesting conversation."

There has also been increased focus on fees, with hedge fund-of-funds structures largely viewed by investors as simply adding another layer of cost.

However, pressure has brought fees down — a study by bfinance published in May 2017 showed quoted hedge fund-of-funds fees for a €25 million ($29.4 million) allocation fell 20% globally for the period January 2015 to March 2017, vs. the period January 2010 to December 2014. The median quoted fee fell to 80 basis points from 100 basis points over that period.

In Europe, "where investors fell out of love with the sector more severely than their counterparts elsewhere," bfinance said in the study, the average quoted fee was down about 30% to 69 basis points for the period.

Borne out of that focus on fees is another type of relationship.

"There has been a shift over the last seven years (from commingled products) toward more managed accounts, fund of ones, and increasingly more advice. Some of that has led to things like multimanager subadvised relationships and efforts to create new, scalable offers, all of which has continued to place downward pressure on fees," Mr. Levi said.

More attractive

Mr. Goodworth of bfinance agreed. "The multimanager hedge funds have made themselves more attractive — we have seen the emergence of funds of subadvisers, so rather than the classic fund-of-hedge-funds setup where one allocates directly to external underlying funds, a subadvisory relationship sees the constituent managers allocated a sleeve of the capital directly," he said.

That means performance fees are netted-off, and in some cases there is also no fund-of-funds fee. "The economics are split between the fund-of-hedge-funds manager and the underlying manager of each of the (allocations). We have seen them making themselves more attractive from an economics point of view and from the ability to accommodate smaller ticket sizes," Mr. Goodworth said.