How is the FoHF Industry Evolving?

If you believe the trade press, then you probably think that the fund of hedge funds (FoHFs) industry is in its death throes. We are all familiar by now with the headlines (covered in a recent post) as well as the statistics:

1. the number of FoHFs has fallen by a quarter since 2007 with 800 liquidations (28%) vs 9% for HFs (efinancialnews)

2. the value of FoHF total AUM has fallen 30% from $799bn to $564bn (HFR)

3. direct investments in HFs by DB plans, among the largest 200 U.S. retirement plan sponsors, was up 75.6% to $77.8 bn compared to FoHFs which were up 20.8% to $31.9 bn (P&I survey)

4. the HFRI Fund Weighted Composite Index was up 10.32% in 2010 (5.22% over 5 years) while the HFRI FOF Index was only up 5.68% (1.79% over 5 years) (HFR)

5. more state pensions invest directly in HFs than FoHFs (a turnaround from 2006) – with the change from FoHFs to direct HF investing coming from new allocations (Cliffwater)

Things however are not nearly as clear as the statistics might lead us to believe. SEI/ Greenwich Associates’ October 2010 survey found for example that nearly half of the respondents say they invest exclusively in FoHFs (50% were F&Es, 21% public, 14% corporates and 13% consultants). Among institutions investing both in HFs and FoHFs, 60% of assets are directed to FoHFs. Unsurprisingly there are a higher proportion of corporates and smaller plans allocating to FoHFs compared to F&Es and other large investors (>$5bn).

There is little doubt that the industry has evolved significantly from the days of FoHF businesses built simply upon an off-the-shelf highly diversified portfolio of 30-100 managers for 1 and 5 or 1 and 10. Due diligence failures, increased competition, fee compression, the renaissance of multi-strategy firms and increasing investor sophistication, have radically remade the shape and business model of the typical FoHF. The old selling propositions: access to scarce capacity; expert research and soucing; diversification; and quantitative risk management techniques no longer provide firms with an edge.

The sharp end of the industry has been allowing investors to access their managers directly for many years. Co-investments, early stage co-seeding opportunities, the creation of customized or completion portfolios and managed accounts have been the stock-in-trade of the industry leaders for well over a decade. These firms have developed long-term partnerships with their investors and in the process their firms have become truly client-centric and performance focused. Long-term compensation and incentive arrangements, focused portfolio offerings and tight controls of their cost-base have created firms with cultures and structures that are in alignment with investors’ interests.

Investors and their consultants are increasingly working with their FoHF providers and HFs to build customized or completion portfolios. Since the financial crisis in 2008, several large institutional investors for example, have been persuaded that part of the solution to their long-term funding challenges is to substitute some equity beta with equity hedged, global macro and managed futures strategies. These hedge fund strategies are liquid and transparent while significantly reducing left-tail risk within the portfolio (managed futures are uncorrelated to equities).

While investors should – and will – continue to reduce traditional beta factors in their portfolios, they will also increasingly require their asset managers to deconstruct the traditional FoHF value chain. Since Madoff, the balance of power has shifted significantly in the direction of investors, who will continue to pressure asset managers to price and provide individual components of the investment process on a tailor-made basis. Rather than buy an off-the-shelf portfolio for 1 and 5, the investor may, for example, wish to access on a stand-alone basis (or in combination):  individual managers (e.g. via managed accounts), the portfolio construction and analysis team, independent risk management services, thought leadership, hedge fund due diligence, multi-level reporting services, or technology solutions.

This represents a blurring of the line between asset managers and the traditional investment consulting industry. This will lead to greater industry consolidation – and eventually – investors will receive better services for a fairer price.

References
1. My last post about FoHFs: http://jeremy-king.com/?p=38
2. efinancial news article 09.20.2010: http://bit.ly/g0zuzK
3. Cliffwater report 01.24.2011: http://bit.ly/fi6lx6
4. SEI/ Greenwich Associates white paper:http://bit.ly/eWfppc