Firms managing hedge funds of funds have spent the years since the recent financial crisis focusing on the wrong things. Many hedge funds of funds managers have spent their time deflecting criticism, pondering consolidation options, or simply have been paralyzed, while the hedge fund rebound since 2008 has largely bypassed them. Instead, funds of funds managers should draw attention to their increased relevance for investors in today’s complex investment environment.
Firms clinging to the legacy hedge funds of funds business model will continue to suffer from static asset growth and shrinking fees. But less discussed and understood is how some funds of funds managers have been able to remain relevant to investors.
Winning hedge funds of funds managers are focusing resources around three activities that are not commoditized and that investors value highly. These are: tactical asset and strategy allocation; disciplined portfolio construction and true customization of portfolios; and access to scarce managers and strategies.
In a 2011 survey Casey Quirk completed with Bank of New York Mellon, we found that hedge funds of funds managers evolving their model as described above were able to grow assets faster since 2008, and were subject to less fee pressure. This analysis offers evidence of what will succeed in the future. The survey included 17 firms, managing a total of $126 billion in assets as of year-end 2010, or approximately one-third of all assets overseen by hedge funds of funds.
To us, this emphasizes that moving away from the legacy hedge funds of funds model is imperative if the industry is to thrive again. The legacy funds of funds construct was built around exhaustive manager research, including operational due diligence and post-investment risk monitoring. The major output of the legacy model was a manager buy list that served effectively as one portfolio: a diversified, low-turnover fund that was tweaked along the margin over time, increasingly complemented by hard-to-scale “advisory” services.
For the reinvented hedge funds of funds manager, the buy list of legacy models represents the beginning, not the end, of the process. Winning funds of funds managers focus their efforts and resources on asset allocation and portfolio construction to create clearly distinct portfolios: those tailored to evolving client and channel specifications, highly concentrated completion portfolios, and tactical opportunistic portfolios that respond rapidly to changes in macro themes. This requires clearly segregating the manager-research hurdle course from portfolio management.
Why does any of this matter, other than to funds of funds managers themselves? It matters because investors’ need for key hedge-fund-of-funds skills is greater today than it was before the crisis, when asset owners had a nearly totemic faith in strategic asset allocation. Since 2008, however, investors have been migrating to a more tactical mindset. This emerging focus requires two things: the ability to look across asset classes constantly for risk and opportunity, and to position risk measurement and management as the primary inputs in the investment process.
Hedge funds of funds managers are well-placed to help guide investors in this new world because they already look across most of the capital markets, even if indirectly. A focus by investors on top-down decisions should imply less direct manager relationships, another argument in favor of assemblers such as funds of funds.
Finally, successful institutional hedge funds of funds already have consultative, customized relationships, at least with large investors, indicating skills in multiasset-class portfolio construction.
To shift toward this business model, funds of funds managers must redeploy their resources to highlight key competitive differentiators, such as:
Manager research remains important, but should be redirected. Instead of “finding the best managers,” hedge funds of funds firms should think of their manager buy list as a toolbox, with managers being selected for their potential portfolio role. Rather than disproportionately covering the “super-class” of very large, fully institutionalized hedge fund managers that investors already access directly, funds of funds need to shift their focus to uncover new talent and novel investment strategies. To that end, why not consider expanding the opportunity set to include strategies beyond hedge funds?
Operational due diligence remains essential, but today this is table-stakes; it is no longer the key differentiator it once was.
Risk management becomes an input (pre-investment), rather than being post-investment risk monitoring, even if the same tool (risk analytics system, likely commoditized) is employed in both approaches.
Asset allocation and portfolio construction need to be elevated in importance, with dedicated senior resources representing a clearly separate process and skill set relative to the manager research function.
To thrive in the long run, hedge funds of funds managers should view themselves not as a product, or as a service, but as platforms delivering asset allocation and portfolio construction solutions to clients.
Daniel Celeghin is a partner at management consultant Casey, Quirk & Associates LLC, Darien, Conn.