As hedge funds grow, funds of funds get clipped

With alternative investments more popular than ever, it's ironic that a channel originally designed to broaden distribution is struggling to keep pace. While the hedge fund industry now boasts a record $2 trillion in assets, following three straight months of inflows, the $469 billion funds-of-hedge-funds space has had just two months of net inflows in the past 24. “I predicted the demise of the fund-of-funds business coming out of the market crash, and by the end of the decade, my gut says they won't be much of a factor,” said Uri Landesman, president of Platinum Partners, a $1.3 billion hedge fund shop. The biggest challenge facing the fund-of-funds model, according to Mr. Landesman, is the added layer of fees that investors must absorb in order to participate in an asset class that is already infamous for fee structures that typically start by charging 1% on assets and 10% on investment performance. Funds of funds, which bundle alternative strategies by investing in multiple underlying hedge fund managers, typically tack on their own fees — which can amount to another 1% on assets and 10% on performance. A decade ago or more ago, when most investors had neither the assets nor the resources to access hedge funds directly, funds of funds flourished as a gateway into this otherwise exclusive community. But today, as more hedge funds expand their distribution efforts and the mutual fund industry continues to roll out registered alternative products, the fund-of-funds model is starting to make less sense. A survey of hedge fund managers and investors, released earlier this week by Greenwich Associates and Ernst & Young, found that 75% of hedge funds in Europe and North America are seeing an increase in direct investing and that they expect the trend to continue. “Direct investment continues to increase and is preferred by managers, with intermediation shifting away from funds of funds to investment consultants,” said Michael Serota, co-leader of Ernst & Young's Global Hedge Fund Services. “Some funds of funds are offering more advisory-like services in order to compete,” he added. “With returns likely to remain subdued, and investors finding access easier, there will remain a focus on the costs of intermediation.” Mr. Landesman said the shift away from funds of funds has been extreme. “Pre-crash, funds of funds represented about half of our business, but now I'd estimate it's between 5% and 7%,” he said. Beyond the extra layer of fees, funds of funds also are hampered by liquidity-related challenges. Part of the original appeal of a fund of funds was that investors would get better liquidity than they could typically expect from a hedge fund, which offer quarterly liquidity, at best. But as funds of funds have tried to maintain standards of offering monthly liquidity with 30 days' notice, they have effectively reduced their pool of hedge funds in which they could potentially invest because most hedge funds aren't interested in offering increased liquidity. “The liquidity issue limits where they can invest, and that in turn limits their size,” said Mr. Landesman. Of course, the funds-of-funds space isn't exactly rolling over and just waiting to die. Like the hedge fund industry, itself, a lot of fund-of-funds shops are trying to adapt to the changing dynamics in the alternative investing space. Aurora Investment Management, an affiliate of Natixis Global Asset Management, would be characterized by most as a fund-of-funds shop. Asked to describe what the $9 billion asset management firm does, Aurora president Scott Schweighauser said: “We invest capital in hedge funds on behalf of ourselves and our clients.” But when asked directly if Aurora is a fund-of-funds shop, he said: “We're a hedge fund solutions provider and an intermediary, although traditionally people probably would have described us as a fund- of-funds [provider].” Mr. Schweighauser's nomenclature reflects both marketing savvy and the realities of the evolution of the fund-of-funds business. In addition to helping clients invest in hedge funds through commingled funds and separately managed accounts, Aurora launched its first access point for retail investors in April with its own alternative-strategy mutual fund, Aurora Horizons (AHFAX). “We felt it was important to expand the breadth of our products to make them more available,” Mr. Schweighauser said. With just $153 million in assets, the mutual fund is still fledging, but Aurora sees potential in the current breakdown of its assets, which stands at 80% institutional and 20% individual investor. “I expect that in five years that breakdown will be closer to 50/50,” Mr. Schweighauser said. In essence, as the top end of the hedge fund industry pushes toward a more corporate model that includes layers of operational and marketing support to offer more direct investor access, there could still be hope for the fund-of-funds space. “We're definitely seeing more investors now going directly to hedge funds, as opposed to going through funds of funds, because hedge funds are becoming more institutionalized,” said Natalie Deak, a partner in the hedge fund practice at Ernst & Young. “But the fund of funds model is also changing to focus more on smaller institutional investors and servicing more of the retail market,” she said.