Funds of Hedge Funds May Be Down, But Don’t Count Them Out

When was the last time you read some good news about the funds of hedge funds industry?  Judging by the tenor of most articles in the trade press and general business news outlets, funds of hedge funds (FoHFs) are losing assets, losing interest and losing relevance.  As trumpeted by a recent headline in The Economist, “Going, going, gone?” seems to be the prevailing view of their status. 
It’s certainly true that the industry’s numbers trace a downward trajectory.  In contrast to the strong rebound in assets under management (AUM) by single-manager hedge funds after the financial crisis, total assets managed by FoHFs fell from their 2007 peak of $798 billion to less than $644 billion as of year-end 2011, according to Hedge Fund Research.  Those counting casualties will find no shortage of FoHFs that have shuttered or are on the ropes and revenue-starved. Many fund managers are still working to recoup the steep losses they suffered in 2008, and those that have failed to hit their high water marks have not earned performance fees for three years.  
Most troubling of all is the widespread questioning of FoHFs’ fundamental value proposition. For some 40 years now, FoHFs have existed to provide greater expertise in hedge fund selection, due diligence, and risk management than many investors could muster or afford on their own.  Particularly for smaller and mid-sized institutions with limited experience, FoHFs have served as a gateway and training ground for hedge fund investing.  
Unfortunately, several years of lackluster overall returns, combined with FoHFs’ added layer of fees, have produced a growing trail of disgruntled investors.  News reports, and indeed data, indicate that institutions of varying size are increasingly choosing to go direct, managing their own hedge fund investments despite the learning curve and staffing costs involved.  Needless to say, consultants and single-manager hedge funds are quickly stepping up to offer FoHF-type expertise, in some cases even assembling portfolios of hedge funds themselves. Meanwhile, FoHF managers have been whittling down fees, sometimes going so far as to eliminate management fees altogether for their larger clients.

On the face of it, it’s not an encouraging picture. And yet, when you look beyond the headlines and broad-brush statistics, there are rays of hope. To paraphrase Mark Twain, it appears that reports of the FoHF industry’s demise have been largely exaggerated.

For one thing, some FoHF firms, particularly the larger shops, are not only retaining assets but attracting new allocations even as others are buckling under business pressures.  Indeed, as reported in Hedge Fund Intelligence, 47% of the FoHFs with more than $1 billion in assets saw positive asset growth in 2011, and the total AUM in this group increased by some 10% in the course of the year.

Industry dynamics also suggest some enduring role for FoHFs.  The universe of hedge fund managers and strategies has continued to grow in size and complexity.  Even among large institutional investors, few have all the internal capabilities needed to deal with the full spectrum of investment issues and possibilities. And even the most sophisticated investors still need advice in areas from manager selection and due diligence to risk management, performance attribution, and monitoring.  Seasoned FoHF managers remain a repository of specialized expertise few others can match.

The most compelling notes of encouragement come from FoHF investors themselves.  In a recent SEI survey, 72% of institutional investors and consultants agreed that “FoHFs still play a valuable role in institutional investment portfolios.”  Four out of five investors we surveyed said they see FoHFs as an ongoing portfolio component, not just a way station on the road to direct hedge fund investments. Moreover, 84% predicted that FoHFs will still exist in 20 years.

But that doesn’t mean a continuation of the status quo. Consistent with reports of industry-wide outflows, nearly 44% of investors we surveyed reported lowering their allocations to FoHFs over the past three years.  When the topic of FoHFs’ future is broached directly, two-thirds of investors and consultants we surveyed agree with the statement that “Funds of hedge funds must reinvent their business model if they want to survive.”

So how can FoHFs change their stripes and elevate their competitiveness?  Some trends are already taking shape.  More than a few FoHF managers are already shifting away from well known, name-brand hedge fund managers, positioning themselves as talent scouts who specialize in up-and-coming managers and interesting, little-known strategies.  Some go even further by seeding new funds for talented managers. 
Customization is another promising direction.  FoHF solutions have many elements—from manager selection and strategic advice to portfolio construction and risk management—all of which can be mixed and matched to clients’ specific objectives. Moving up the customization scale, FoHFs could work closely with clients to provide complete, fully customized hedge fund investing solutions, helping to answer investors’ growing concern with matching assets to their liabilities. To be sure, that level of customization is resource-intensive, but it may be a requisite for survival.    
In all, SEI’s exploration identified seven broad ideas for making hedge funds more competitive, augmented by investor, consultant and manager ratings of those concepts.  The report, Seven Ways to Reinvention: Evolving and Enhancing the Funds of Hedge Funds Model, can be requested by visiting www.seic.com/ReinventingFOHF.
Our study made two important things clear.  First, while institutional investors and FoHF managers see eye to eye on a number of issues, on some there is a marked disconnect.  For example, while 63% of responding managers said that “FoHFs have provided the level of transparency investors need,” only one-third of investors and consultants agreed with that statement.  These areas of divergence not only point to a need for more meaningful dialogue among managers and their clients, but also highlight opportunities for managers to differentiate themselves. 
The better news – point #2 –- is that institutional investors, the lifeblood of the FoHF industry, already have some clear visions of what a competitive FoHF looks like.  Moreover, they appear to be receptive to—and even looking for—–a radically reinvented business model that casts FoHFs as versatile solution providers, and trusted advisors. 
As one respondent put it, “The competitive FoHF of the future will be more of an alternative assets platform with different investment structures and an ability to invest across the spectrum of alternative assets.” Other respondents go even further, seeing the competitive FoHF as a partner equipped to offer a comprehensive array of hedge fund investment offerings, strategies and services.   
The FoHF industry’s story is still being written, with the potential for many more twists and turns along the way.  But the upshot is that FoHFs find themselves in a rare window of opportunity, an inflection point in the global hedge fund industry where innovation is welcomed. This is a time when key decision-makers and influencers are not only looking for meaningful and, potentially, even radical change, but are keenly interested in what develops next. That openness to possibility may be the best news the FoHF industry has heard for some time.