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Funds of hedge funds are being forced into a corner as investors withdraw billions of dollars from the sector every quarter, scared off by mixed results and high performance fees.
The number of funds of hedge funds has fallen steadily in recent years, according to figures from Chicago-based Hedge Fund Research, dropping from 2,462 in 2007 to 1,855 in the first quarter of this year. While outflows have eased since the haemorrhaging seen in 2009, they persist. More than $22bn was removed from funds of funds in 2012 and another $5bn in the first quarter of 2013.
But some managers are staging a comeback.
First, investment houses are turning their fund of funds businesses round by embracing the job of financial adviser and building bespoke funds for clients. Second, they are throwing away the rule book whereby they simply sold a utilitarian array of portfolios of preselected hedge funds.
With the aid of managed accounts, investment houses are tailoring their offerings to suit the precise needs of their investors. They are also creating “best idea” versions of selected hedge funds. This strategic shift involves being smarter, as well as adopting hands-on management.
Suppose two hedge funds in a portfolio make similar trades, then the position in one of those funds might be dropped, depending on the wishes of investors. It is also less likely that money will be held in a commingled fund or even in a fund structure.
A survey of 23 funds of funds with assets of $159bn conducted in May by BNY Mellon, a hedge fund administrator, and Casey Quirk, the research consultancy, backs up the anecdotal evidence. It revealed that customised separate accounts constituted 56 per cent of funds of hedge funds’ gross sales in 2012; commingled funds, once the industry’s bread and butter, accounted for just 30 per cent of sales.
“The big houses are essentially managing a portfolio of customised best ideas from a number of different managers,” reports Ken Heinz, president of HFR. “They are making these tactical portfolio adjustments. There’s more hedging activity and leveraging and the reducing of certain positions. It’s all becoming very customised and strategic.”
Europeans are keener on funds of hedge funds than North Americans and Asians, according to the BNY Mellon study. Of the $30bn of gross inflows into the sector last year, 52 per cent came from Europe and another 35 per cent from North America. Asians contributed just 6 per cent to the total.
Interest from retail investors remains lukewarm at best. Last year, retail products comprised just 8 per cent of funds of hedge funds’ sales, according to the study. But efforts are being made to woo these investors, with some houses offering SEC-regulated vehicles and others bringing in distribution specialists to create game plans to attract their money.
“People would love to have retail money again. And I think that market could come back,” said one industry executive. “But trying to raise that money is difficult. Retail clients were quite burnt by their experiences in alternatives when markets imploded a few years ago.”
Fund houses continue to place aggressive bets on institutional money. About 80-90 per cent of the money Switzerland’s GAM now runs is for institutions. And though it may sound like marketing hogwash, this switch to selling big pension funds “solutions” and not “products” is succeeding.
“This is an adaptation for survival,” says Anthony Lawler, a portfolio manager in GAM’s multi-manager team. “The industry consolidation will continue.”
He adds: “Demand from investors is more nuanced. People are saying, ‘If I’m going to pay you a fee, I want a thoughtful manager who can offer a portfolio with twenty good funds. That requires people who understand all strategies.”
This change in priorities is necessary to compete. The leading cause of the $41.5bn in gross withdrawals BNY Mellon and Casey Quirke identified last year was investors opting to switch to direct stakes in single-manager hedge funds.
Mr Lawler argues that large players such as Blackstone, Grosvenor and Mesirow fare better than small ones in this Darwinian environment. “The largest funds of funds have the resources to provide solutions-based products to people while smaller ones are being found out for not having the resources,” he says.
Fund of funds managers also acquiesce more when clients demand a reduction in the 1 and 10 per cent fees for management and performance respectively, once the norm in the sector.
“There is pressure on funds of hedge fund to reduce fees and we’re putting pressure on hedge funds and having some success there,” says Mr Lawler. He estimates that fund houses charge about 80-100 basis points without incentive fees for a multi-million dollar hedge fund portfolio. The fees go down if investors offer more than $1bn.
The U-turn in business models is proving productive. Though gains are modest, anecdotal reports suggest 53 per cent of the fund of funds in the survey have succeeded in growing their assets and top-line revenues since 2010.
“The business is not dead,” claims Dixon Boardman, founder of Optima Fund Management, a US fund of funds group, triumphantly. “There are 9,000 to 10,000 hedge funds out there and when I started out 25 years ago, there were just 600. But the list of those you still want to invest in is very short.”
Cynics disagree, but optimists such as Mr Boardman still think there is money to be made in this line of work And their entrepreneurial spirit is evident. To drive revenues higher, more funds of hedge funds and consultants such as Towers Watson are entering the advice business and offering themselves as consultants in areas such as asset allocation, manager sourcing and research and due diligence.
Traditional US mutual fund managers, who now compete against low-cost exchange traded funds, want to get in on the act too. At the end of 2012, Wells Fargo Asset Management took a minority stake in Rock Creek, a private fund of funds group in Washington with about $7bn in assets that specialises in selling institutional investors bespoke portfolios. This follows the move by Franklin Templeton, the US mutual fund manager, to take a stake in K2 Associates last year, and Legg Mason’s purchase of Fauchier Partners, a European house with a fund of funds business, which it merged with its alternative asset management business Permal.
Mr Boardman concludes that funds of funds still make considerable sense for institutional investors.
“When I started out, a hedge fund was almost avant garde. Now people are more sophisticated and some want a bespoke product. They’ll set the risk parameters, but they want the managers to watch their money very, very carefully.”
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