We must have struck a nerve: letters in response to Charles J. Gradante's July 22 Other Views commentary, "Fund of hedge funds imprudent for fiduciaries," continue to pour in.
Hewitt Investment Group is a general investment consultant that advises on direct hedge funds as well as fund of funds. While direct funds represent a significant opportunity set, we do not believe that any one approach is right for all clients, and we certainly do not believe that funds of funds are imprudent.
The specificity in relation to hedge funds that Mr. Gradante attached to Whitfield vs. Cohen probably is excessive. One of the supposed requirements he inferred from the case was to "become familiar with the various hedge fund strategies in order to improve ongoing monitoring." The Whitfield case involved a trustee who allocated capital to a manager without ever reviewing any financial statements or other documentation of the manager, who also was an unregistered investment adviser. According to the ruling, the manager never provided a description of the nature of investments it made. Also, the monthly statements from the manager consisted of nothing more than the amount of the original investment, an accrued interest figure, and the sum of the two figures. The trustee never requested more information than what the manager provided.
The supposed requirements to investigate fund-of-funds investments at the fund level flies in the face of the modern interpretation of the prudent person rule. Mr. Gradante conspicuously leaves out one element of prudence: the principle of diversification. For properly diversified portfolios, designed to limit the loss from any one investment, potential litigants may not isolate individual investments as being imprudent within the context of the entire portfolio, even when that investment is Long Term Capital Management.
Finally, it is worth noting the specific reason cited in the Whitfield case for the trustee's liability. The court held that the manager did not meet the definition of "investment manager" under ERISA because the manager did not acknowledge in writing a fiduciary status, and was not a registered investment adviser. This is quite inconvenient for Mr. Gradante's argument because the vast majority of hedge funds are not registered. Interestingly, many funds of funds are becoming registered investment advisers, which is great comfort to some investors. It is easy to see why a trustee would want to select a registered fund of funds, rather than build a portfolio of unregistered vehicles.
Mike D. Smith
director of research
Hewitt Investment Group
Due diligence monitoring
Charles J. Gradante is inaccurate in stating that "fund sponsors might be breaching their fiduciary duty by investing in hedge funds through a fund of funds." He incorrectly assumes that under the Employee Retirement Income Security Act the due diligence and monitoring functions fiduciaries must perform apply in all cases to the underlying funds in which a fund of funds invests. This is simply not true.
ERISA would not require a plan fiduciary to perform due diligence and monitoring with respect to the underlying funds in which a fund of funds invests if either (a) the underlying assets of the fund of funds are not considered to be "plan assets" under Department of Labor regulations or (b) the manager of the fund of funds is registered with the Securities and Exchange Commission as an investment adviser.
If the underlying assets of a fund of funds are considered to be "plan assets," an ERISA plan investing in such a fund would be treated as holding an interest in each of the underlying hedge funds in which the fund of funds invests. If, however, the manager of the fund of funds is a registered investment adviser, the manager will qualify as an "investment manager" under ERISA, provided the manager is properly appointed and acknowledges in writing that it is a plan fiduciary. As a result, the fiduciaries that invest in the fund of funds will be liable only with respect to their decision to retain the manager as a fiduciary to invest in hedge funds and generally will not be liable for the acts and omissions of such manager. Plan fiduciaries do not have to monitor each investment made by such a fund of funds in order to discharge their fiduciary duties.
In fact, investing in a fund of funds may provide additional opportunities for a plan. A fund of funds permits a plan to gain exposure to hedge funds that because of minimum investment requirements may not be possible if the plan were required to invest directly in hedge funds. Also, the plan benefits from the expertise of the fund-of-funds manager in selecting appropriate hedge funds and allocating assets between them. Lastly, a fund of funds permits the plan to have an expert (the manager), who is also an ERISA fiduciary to the plan, perform due diligence with respect to hedge fund investments.
Beth J. Dickstein
Sidley Austin Brown & Wood
Intermediaries' vital role
Fiduciaries regularly pay intermediaries to build portfolios of private equity, venture capital, real estate and even commingled stock. Why they do this is clear - unless the plan has a properly trained staff to execute these highly specialized investments, the plan threatens to breach its fiduciary responsibility by investing without the requisite experience and skill sets. In response, many of the most sophisticated investors, including the largest public pension funds, have embraced investing in the hedged sector through multimanager vehicles.
The numbers and facts well document this trend. At $100 billion, global multimanager hedged strategies account for roughly one-fifth of total assets managed by hedge funds, and this percentage is increasing.
A multimanager approach can be achieved through a consultant or multimanager fund. Of great importance, in contrast to consultants, the principals of multimanager funds often invest significant capital alongside the capital of outside investors, which truly aligns their interests with the interests of their investors.
Well-formulated multimanager hedged organizations have deep skill and experience in comprehensive due diligence, fund selection and monitoring, from both a quantitative and qualitative standpoint. Further, multimanager funds allow the greatest degree of flexibility and scalability - highly relevant for today's volatile investment climate.
Carrie A. McCabe
McCabe Advisors LLC