Consultants Eating Up Funds of Funds?
Funds that invest in a range of hedge funds are facing a battle to win new business, as the same consultants they court to win money from pension firms are grabbing a chunk of an industry that was already struggling to grow.In December 2008, I warned that funds of hedge funds face extinction. Fast forward to 2014 and we see why. Not only are funds of funds not able to charge that extra layer of fees, they now face increasing competition from useless investment consultants that are marketing geniuses able to bamboozle their clients into believing pretty much anything.
So-called fund of hedge funds are designed to give investors an easy way of putting money into hedge funds, offering to spread their risks and do research into the individual hedge funds for them.
But sliding asset prices during the financial crisis and the fallout of the Bernie Madoff fraud scandal saw billions of dollars exit fund of hedge funds, leading many to close or merge.
Over the past few years, those that remain have found consultants - who have built up expertise after years of vetting fund of hedge funds for institutions - are now investing directly into funds on behalf of some large-scale clients.
Trade publication InvestHedge found three consultants - Mercer, Cambridge Associates and Towers Watson - were among the 10 biggest fund of hedge funds by assets as of the end of 2013, representing 12.6 percent of the $728 billion held by fund of hedge funds with assets worth at least $1 billion.
"In new allocations to the industry ... consultants are active in gaining mandates," said Joachim Gottschalk, chairman and chief executive of hedge fund firm Gottex.
The increased competition is particularly significant, because the industry is struggling to grow.
The value of assets held by fund of hedge funds worth at least $1 billion has risen by just 16.5 percent since 2009, according to InvestHedge, and remains well below the peak of just over $1 trillion hit in 2007.
The hedge fund industry on the other hand is booming - total assets under management are at historic highs after rising by almost two thirds over the same period, data from industry tracker HFR showed.
Fund of hedge funds have voiced concerns over a potential conflict of interest in cases where they pitch strategies to consultants that are also in competition with them.
But consultants argue they have internal measures to prevent the sharing of confidential information.
"Those individuals responsible for researching hedge fund of funds and the research they conduct is Chinese walled off from the rest of the business," said Dan Melley, UK head of fiduciary management at Mercer.
INDUSTRY RESHUFFLE
Fund of hedge funds have traditionally relied on high net-worth individuals. But in recent years, institutional investors have become a bigger part of the industry's client base, handing an advantage to consultants, many of which have long relationships with pension funds and other institutions.
Deutsche Bank's Alternative Investment 2014 Survey found the proportion of respondents from the fund of fund industry - of which fund of hedge funds are a part - who said more than half of their assets under management in 2013 came from institutions was 63 percent, up from 53 percent in 2008.
Many fund of hedge funds have adjusted to the new landscape, increasing the services they offer instead of simply selling fund of hedge fund portfolios.
"Before it was very formatted," said Nicolas Rousselet, managing director at Swiss investor Unigestion. "They had fund of funds or direct hedge funds ... Now it's much broader."
Many fund of hedge funds now provide co-management services for investors looking to play a more active role in their portfolio, fiduciary services for clients who want to keep their investments at arm's length, and advisory offerings for clients investing directly.
This has made the traditional fund of fund compensation structure - a 1 percent management fee and a 10 percent performance fee - a thing of the past.
"Increasingly any fund of fund that has any institutional business is in effect changed into a consulting firm," said Peter Douglas, founder of Singapore-based hedge fund consultancy GFIA.
"The idea that any capital owning institution is going to pay 1+10 for a commingled portfolio of hedge funds is yesterday's story."
However, while most funds of hedge funds are struggling, the largest firms in the stricken industry keep getting larger. The top 50 firms in Institutional Investor's Alpha annual Fund of Funds 50 ranking control some $494 billion combined, and the top 10 of those firms manage $224 billion:
That’s no accident, if there is any truth to the old maxim that it takes money to make money. The top firms, like No. 1-ranked Blackstone Alternative Asset Management, have the cash to branch out into newer, more lucrative areas beyond the traditional funds-of-funds model of investing in hedge funds on behalf of clients. This once-hot strategy has suffered significantly since the financial crisis of 2008, when funds of funds lost money and clients fled en masse. Now, cutting-edge funds-of-funds firms are getting into areas such as staking hedge fund firms with start-up capital and offering supervisory services for institutional investors who want to invest in hedge funds directly but still need a guiding hand.If I had a choice to go with a Blackstone or a Mercer, I would definitely choose the former and sign an air-tight co-management agreement with them to train my internal staff so they can invest directly. That's what a very smart guy like Rick Dahl, CIO at MOSERS, did when he started investing in hedge funds. He needed a reputable fund of hedge funds to get into the space but he also wanted to train his small staff to become good at direct hedge fund investing.
These moves, while innovative, cost money and require connections — two things that many smaller firms do not have in abundance. With more and more institutional investors looking to go it alone, firms that have the money to innovate are best placed to survive the new climate.
As far as consultants getting into this space, it's fraught with potential conflicts of interests. Consultants are branching out into fund investments because they realize that their traditional (low margin) business model is dead and the real money is in asset gathering. Everyone wants to collect fees through asset gathering but the problem is there is no alignment of interests and the focus isn't on performance where it should always be.
One area where funds of hedge funds still dominate is in seeding new hedge funds. They have the network and expertise to identify talented managers and seed the funds with the highest probability of success. Even here they face stiff competition from hedge fund gurus like Julian Robertson whose accelerator fund is burning bright (but that is not a seed fund).
I'm actually amazed that hedge fund inflows are booming. Despite hedge funds having suffered the worst performance start to the year since 2011, industry assets hit a new peak of $2.7 trillion thanks to healthy net inflows. And who is leading the charge? Who else? Dumb public pension funds getting raped on fees, ignoring the hedge fund curse.
Below, Troy Gayeski, senior portfolio manager at Skybridge Capital, talks with Tom Keene about asset allocation and market risk for hedge fund managers in “This Matters Now” on Bloomberg Television’s “Bloomberg Surveillance.”