Pension funds and other fund sponsors might be breaching their fiduciary duty by investing in hedge funds through a fund of funds. While direct investing in hedge funds by pension funds and other trusts is acceptable, a fund of funds potentially compromises a fiduciary's duty of delegation and prudence in selecting and monitoring performance of a service provider, as defined by the Employee Retirement Income Security Act and the Uniform Prudent Investor Act.
Direct investing at the hedge fund manager level, not the fund-of-funds level, is more in line with established and proven practices in place for traditional investing. Indirect investment through funds of funds is an imprudent option for fiduciaries and can be characterized as "delegation with abdication of fiduciary duty." Consequently, the risks to the trustee and, in turn, the beneficiaries far outweigh the "turnkey" benefit of a fund of funds.
ERISA's and UPIA's "prudent investor" doctrine and other principles of trust asset management suggest it is imprudent, and not in the best interest of the beneficiaries, to depart from the traditional portfolio investment process of direct investing with the use of a consultant, preferably one whose core competency is in hedge funds.
While fiduciaries that use a fund of funds satisfy the "obligation to delegate" as stated in UPIA, funds of funds create fiduciary risk in three broad areas.
First, as mandated by UPIA, fiduciaries must:
* Establish the scope and terms of the delegation consistent with the trust objectives;
* Ensure ongoing compliance of investments to plan documents;
* Influence the investment process (asset allocation, manager selection, etc.) when scope and terms of the delegation are not being met; and
* Minimize cost.
Second, as ruled in Whitfield vs. Cohen, 1988, fiduciaries also must:
* Perform prudent, ongoing monitoring;
* Become familiar with the various hedge fund strategies in order to improve ongoing monitoring;
* Know and inquire about the nature of their manager's investments; and
* Avoid unnecessary counterparty risk (i.e., general partner/manager of the fund of funds), which is also mandated in UPIA.
Third, in my view, fiduciaries must maintain the ability to represent themselves and to take direct legal action against a hedge fund manager.
ERISA and UPIA eliminated all restrictions on investments (including hedge funds) under the "prudent investor" rule. As UPIA states, "The trustee can invest in anything that plays an appropriate role in achieving the risk/return objectives of the trust." Both UPIA and ERISA go on to state that fiduciaries are "obligated to delegate" their investment management duties if they do not possess the requisite knowledge and expertise. In United States vs. Mason Tenders, 1988, the U.S. District Court for the Southern District of New York held that "where the trustees lack the requisite knowledge, experience and expertise to make necessary decisions with respect to investments, their fiduciary obligations require them to hire independent outside advisers."
The duty to delegate, however, imposes two key responsibilities that present risks to trust fiduciaries when using a fund of funds: the duty of due diligence and the duty to monitor. The duty of due diligence, as ruled by UPIA, states that when investment management responsibilities are delegated, "The trustee shall exercise reasonable care, skill and caution in ... selecting an agent ... (and) establishing the scope and terms of the delegation, consistent with the purposes and terms of the trust." Accordingly, Whitfield vs. Cohen found a trust fiduciary liable because the fiduciary "did not know nor inquire as to the nature of the manager's investments" made on behalf of the plan. When investing directly in hedge funds, the act of knowing and inquiring is a functional part of the trustees' investment process. This is not the case when trustees invest in a fund of funds.
Many funds of funds invested in Long-Term Capital Management. But the Whitfield vs. Cohen decision some 10 years earlier pointed to the risk of investing in a fund like LTCM through a fund of funds. As the decision in that case states, the fund of funds' general partner "did not know nor could it inquire as to the nature of the (hedge fund) manager's investments."
The fiduciaries who invested in that fund of funds may have breached their duty of due diligence. Trust fiduciaries would not have chosen to make a direct investment in LTCM, given that LTCM would not be in compliance with most fiduciary investment plan documents. Yet funds of funds, partly to attract new capital, took advantage of their opportunity to invest in the highly sought after LTCM, which was otherwise closed to new investors.
This investment in LTCM resulted in one of several conflicts between trust fiduciaries' objectives and that of the funds of funds. The objective of a fiduciary has nothing to do with a fund of funds' product marketing, yet fiduciaries become bystanders to this mission, which can cause a trust to be invested in hedge fund managers that are "not compatible with the terms of their trust," according to the Whitfield vs. Cohen ruling. Direct investing greatly improves the trustee's ability to verify compliance and avoids unnecessary fiduciary risk inherent with a fund of funds.
The duty to monitor begins once the duty of due diligence has been completed. This duty requires the fiduciary to monitor the performance of the selected investment manager and periodically review the agent's actions in order to "ensure compliance with the terms and scope of the delegation," according to UPIA. This can be extremely difficult for a fiduciary invested in a fund of funds - and in many cases impossible.
"The duty to monitor carries with it, of course, the duty to take action upon discovery that the appointed (managers) are not performing properly,"noted the decision in Liss v. Smith, 1998.
The Whitfield vs. Cohen ruling emphasizes this ongoing responsibility of fiduciaries by finding that "the fiduciary had a duty ... to withdraw the investment if it became clear or should have become clear that the investment was no longer proper for the plan."
Once again, a fund of funds investment in LTCM (or any other hedge fund manager with problems) presents a risk to the fiduciary's duty to monitor. Direct investing in hedge funds mitigates this risk. Just as important, direct investing better reflects what the beneficiaries of the trust expect and require from their fiduciaries.
Charles J. Gradante is managing principal of Hennessee Group LLC, New York, a consultant to hedge fund investors. Parsa Kiai, a Hennessee associate, contributed to this article.
