HEDGE FUNDS OF FUNDS: Holding the aces

Institutional investors will continue to be the biggest determinant of the future of hedge fund-of-funds managers in the next five years, said a group of observers who shared their predictions with Pensions & Investments.

And the shape of the fund-of-funds industry will have an equally profound impact on hedge funds themselves, given that an estimated 80% of annual inflows into hedge funds comes via funds of funds, said Charles Biderman, chief executive officer of TrimTabs Investment Research, Santa Rosa, Calif.

The $745 billion of assets managed by hedge fund-of-funds managers at the end of the second quarter accounted for 44% of the $1.7 trillion of hedge fund assets tracked by Hedge Fund Research Inc., Chicago. That’s up from 36% in 2005, 17% in 2000 and just 5% in 1990, according to HFR data.

Most sources interviewed said funds of funds will remain the primary way for institutional investors to invest in the complicated hedge fund arena.

“We definitely believe that institutional investors will continue to use hedge funds of funds,” said Kevin P. Quirk, partner at strategic consulting firm, Casey, Quirk & Associates LLC, Darien, Conn.

Jaeson Dubrovay, senior consultant and head of the hedge fund group at New England Pension Consultants Inc., Cambridge, Mass., agreed: “Given the blowups we’ve seen, it’s very doubtful that you’ll see many pension funds moving to a direct hedge fund program from hedge funds of funds.”

Mr. Quirk noted that funds of funds likely will become generally more consultative in their relationships with institutional investors and likely will be pressured to bring their total fees down to between 50 and 80 basis points per year from today’s standard of 1% management fee and 10% performance fee.

Other sources agreed funds of funds will remain an important vehicle for institutional investment in hedge funds, but said the investment model is beginning to change.

Eric C. Weber, principal and chief operating officer of boutique investment bank Freeman & Co., New York, said the new hedge fund investment model is a core-satellite approach.“We look at history, specifically from the mutual fund industry, to predict the development of the hedge fund industry. Similar to the mutual fund industry, which quickly moved away from its early emphasis on equity funds to all kinds of other strategies, the hedge fund-of-funds industry is beginning to get more specialized,” Mr. Weber said.

Institutional investors are moving from investing in three or four core hedge funds of funds — such Ivy Investment Management, Grosvenor Capital Management LP and Blackstone Alternative Asset Management LP — that have much overlap in their underlying portfolios and similar performance, Mr. Weber said. “Institutions are replacing one or two of those core managers with specialty niche managers. They might add an emerging markets, emerging manager, fixed income or Asia-only fund of funds to diversify and improve performance.”

Given the nature of institutional client demand, sources generally agreed on three big-picture predictions for hedge fund-of-funds managers in the next half decade:

• The industry will bifurcate, rewarding the most institutional and the largest of fund-of-funds managers that manage a minimum of $5 billion. Small, highly specialized managers that invest in niche strategies — with a geographic focus, in emerging managers or in a particular asset class such as commodities or certain kinds of credit instruments — also likely will thrive;

• Managers in the middle, with less than $5 billion or more likely $10 billion under management, that are unable to distinguish themselves with exceptional performance, investment process, strong infrastructure or the ability to offer customized, consultative strategies, likely will languish or close. Formation of new hedge fund-of-funds firms is unlikely, given ever-increasing barriers to entry; and

• To remain successful, even the most institutional of managers will be forced by client demand to innovate in developing new investment strategies. The funds of funds with the closest and longest relationships with the top-tier hedge fund managers will be most successful in exploiting those ties to produce the best-performing, most institutional new investment approaches.

“The survivors among hedge fund-of-funds firms will be those that really ‘get it’ when it comes to institutional investors. These firms would pass muster if you put them in front of any sophisticated investor — an endowment, foundation or pension fund,” said NEPC’s Mr. Dubrovay.

Mr. Dubrovay characterized firms of institutional quality as having deep, experienced investment teams; global coverage, including satellite offices all over the world; a fully developed infrastructure that captures information from every area of the company and facilitates the flow of that information; and the willingness to plow capital back into the firm in ways that truly enhance the investment process.

Scale — in the form of very large asset pools — also will be critical, said Philip Maisano, head of alternative investments at Bank of New York Mellon, New York. BNY Mellon ranked 10th in P&I’s ranking of hedge fund-of-funds managers, with $19.8 billion as of June 30.

“Critical mass will become very important, especially with regard to being able to build and maintain the apparatus needed to perform even better due diligence on hedge funds. The days when two guys working above a garage somewhere could be credibly managing a hedge fund of funds are really over,” Mr. Maisano said.

Mr. Dubrovay agreed, noting the most institutional of hedge fund-of-funds managers have the ability to invest a great deal of new inflow with the best-performing hedge funds because of the kind of assets they represent.

“Hedge fund managers recognize and appreciate institutional hedge funds of funds,” Mr. Dubrovay said. “When I talk to hedge fund (managers), they often mention that they have as investors some of the most institutional of funds of funds like it’s a seal of approval.”

Hedge fund managers express a strong interest in attracting more endowment, foundation and pension fund money and recognize that they can do that through certain hedge fund-of-funds managers, when surveyed annually by Deutsche Bank’s hedge fund capital group, said Maarten Nederlof, managing director and co-head of the group, who is based in the bank’s New York office.

“Hedge funds like institutional money because it’s long-term. The most extraordinary of hedge funds are much more likely to accept institutional hedge fund of funds as a source of these assets for that reason. Working with a hedge fund of funds can be favorable for many hedge funds, because it’s an easier way to service these clients, through one point of contact,” Mr. Nederlof said.