Funds of funds in good graces of investors again

Hedge funds-of-funds managers are experiencing a modest renaissance as institutional investors look for better ways to manage their hedge fund portfolios and increase their allocations.

In an era when once-thriving, prominent institutional hedge funds-of-funds firms such as Aurora Investment Management LLC are sold, and Diversified Global Asset Management is sold and swiftly closed by its new owner because of diminishing assets, the small cadre of the largest managers are sought after by investors for hedge fund solutions.

Managers report a lift in the number of clients adding more money to their existing portfolios, as well as the number of asset owners that managed internal hedge fund-of-funds portfolios with unsatisfactory results.

Hedge funds-of-funds shops also are accommodating a rising number of institutions that are continuing their direct hedge fund investment programs, but need an external expert to design, build and source managers for niche, specialist or capacity-constrained portfolios that can't be easily managed internally.

And new hedge fund investors, both large and small, still are turning to hedge funds-of-funds managers.

The most notable first-time search running right now, according to sources, is that of Japan Post Bank, Tokyo, which is interviewing hedge funds-of-funds managers, seeking two or three firms to run a $10 billion portfolio for the ¥205.5 trillion ($1.71 trillion) postal deposit pool. JPBank internal investment staff plans to make manager selections as early as March or April, said sources with knowledge of the search who requested anonymity.

A JPBank spokesman did not respond to an e-mail request for comment.

Another large first-time allocation to hedge funds of funds was made in October by Illinois State Universities Retirement System, Champaign. Investment staff there hired Pacific Alternative Asset Management Co. and KKR Prisma to split management of $500 million for SURS' $15.9 billion defined benefit plan.

“Direct investors in hedge funds currently are getting hedge fund-of-funds-like returns. It might be better and simpler just to use a hedge fund of funds,” said James C. McKee, senior vice president and director of hedge fund research, Callan Associates Inc., San Francisco.

“It's easy to build up (an internally managed) hedge fund-of-funds portfolio in a relatively benign environment, but in a tough market like the one we're in now, managing that portfolio will require a lot more resources than most institutions likely budgeted for,” Mr. McKee stressed.

Among other institutions that have turned to or are searching for a variety of hedge fund portfolio solutions from hedge funds-of-funds managers:

nThe $3.9 billion Fresno County (Calif.) Employees' Retirement Association is expanding its relationship with Grosvenor Capital Management LP, moving its current $156 million investment from a commingled hedge fund-of-funds and splitting it between a customized separate account managed by Grosvenor and a portfolio of direct investments in hedge funds on which the money manager will advise.

nPlymouth County (Mass.) Retirement Association is considering increasing its allocation to hedge funds by $10 million to $20 million from the current $25 million and is searching for at least one more hedge funds-of-funds manager. The $830 million pension fund splits the existing allocation evenly between Aetos Alternatives Management LLC and ABS Investment Management LLC.

nThe $47 billion Los Angeles County Employees Retirement Association, Pasadena, increased its hedge fund allocation to 5% from 3% of plan assets for 2016. LACERA will increase the allocations of existing hedge funds-of-funds managers Grosvenor and Goldman Sachs Hedge Fund Strategies LLC to put part of the nearly $1 billion increase to work. In November, investment staff extended the pension fund's relationship with Grosvenor by awarding a $300 million mandate for a customized opportunistic credit strategy to the firm.

The largest, most institutional tier of hedge funds-of-funds managers is coming in for the bulk of portfolio changes from institutional investors, including BlackRock Inc., Blackstone Alternative Asset Management, Grosvenor, Mesirow Advanced Strategies Inc., J.P. Morgan Alternative Asset Management Inc., Pacific Alternative Asset Management and UBS Hedge Fund Solutions LLC.

“The bigger managers are growing as institutional investors return to or invest for the first time in hedge funds of funds, getting institutional pricing through investing in separate accounts,” said William J. Ferri, group managing director and head of UBS Hedge Fund Solutions, New York.

Investors are coming back to hedge funds of funds because “they have found out how hard it is to handle the top-down calls needed to balance the portfolio effectively,” Mr. Ferri said.

UBS' hedge funds-of-funds business managed $34 billion as of Jan. 1.

BlackRock's New York-based alternative investment platform, for example, saw a $2 billion surge of net inflows into its hedge funds of funds in 2015, said Joshua G. Levine, managing director and head of business development. Much of the flow — which is continuing this year — was from increases from existing hedge fund-of-funds clients, as well as from new investors returning to hedge funds of funds from direct hedge fund investment programs, Mr. Levine said.

But he stressed that both types of investors increasingly are eschewing traditional commingled hedge funds of funds in favor of customized separate accounts that offer more control, better pricing and improved transparency.

BlackRock managed $21 billion in hedge funds of funds as of Dec. 31.

Customization is a hot global trend among institutional investors, sources said, as investors like Fresno County seek better returns and to gain experience in managing internal hedge funds of funds from an existing manager, and large asset owners look for management of strategy-specific funds of funds.

The Florida State Board of Administration, for example, in January 2015 invested $300 million in a customized version of J.P. Morgan Alternative Asset Management's Elan strategy, which is focused on investing in the commodity trading adviser niche (Pensions & Investments, Jan. 12, 2015).

The Tallahassee-based board, which oversees $169.3 billion, had a total of $3.8 billion invested in hedge funds directly and through hedge funds of funds as of June 30.

Fully 70% of New York-based J.P. Morgan Alternative Asset Management's business is customized now, said John R. Anderson, managing director and president.

JPMAAM managed $12.7 billion as of Dec. 31.

Morgan Stanley Alternative Investment Partners benefited from “a decent amount of 2015 inflows coming from increases by existing clients. The majority of these inflows have been in customized mandates,” confirmed Jarrod R. Quigley, managing director, who is based in the firm's New York office.

Morgan Stanley AIP managed $22.4 billion in hedge funds of funds as of Dec. 31.

Blackstone Alternative Asset Management, New York, has seen existing clients steadily increasing their investments in the firm's hedge funds-of-funds solutions, said J. Tomilson Hill, president and CEO.

The pipeline for new business also is “very strong,” Mr. Hill said, noting that “washing out the backlog has been taking time,” more time than it might have a couple of years ago, given investor nervousness after 2015's choppy markets.

“It's a tale of different markets and preferences depending on where the institution is located,” said Gideon Berger, senior managing director and head of risk management for BAAM.

“In Asia, for example, where the stock market was obliterated, hedge funds look really good right now. In the Middle East, where oil price problems are top of mind right now, there's not as much appetite for hedge funds at the moment,” he said.

BAAM managed $69 billion as of Dec. 31.