Funds of hedge funds are under the microscope

Institutional investors are examining every aspect of their fund-of-hedge-funds portfolios and the managers in charge of them in the wake of the performance debacle of 2008, liquidity problems and the seismic shock of Bernard L. Madoff's massive Ponzi scheme. That's according to a group of experts at a round table on the state of funds of hedge funds, held by sister publication Pensions & Investments. The Aug. 18 discussion focused on the quality of operational due diligence and transparency; the need for better portfolio construction and risk management, and a related move back to more concentrated portfolios of underlying hedge funds. The panel also discussed the limitations and pitfalls of separate-account hedge fund management.
“What do investors demand from their funds of funds?” asked Kent Clark, managing director and chief investment officer of hedge fund strategies and global manager strategies, alternative investments and manager selection at Goldman Sachs Asset Management LP. “One of the things that we never thought we'd actually have to say, but we have to now, is that the expectation is that when investors call and ask for the money back, they actually get the money back,” he said.
Joining Mr. Clark were Andrea M. Bollyky, managing director for business development and client relations in the absolute-return strategies unit at Aetos Capital Management LLC; Daniel Celeghin, director at Casey Quirk & Associates LLC; Peter M. Gilbert, chief investment officer of the Lehigh University endowment; Alan Kosan, managing director and head of alpha research at Rogerscasey LLC; and Jim Vos, chief executive officer and head of research at Aksia LLC.

CHANGE OF FOCUS

The panelists stressed that institutional investors will seek fund-of-funds managers that are focused on both superior investment management and appropriate liquidity matching, rather than on asset gathering. “I think it was pretty easy to raise a shingle and become a fund of funds in the early part of the decade. I think investors feel a little bit betrayed by all the packaging that went into the fund-of-funds business by new product launches, by liquidity mismatches, by aggressive documents — statements about investment process that weren't necessarily fulfilled,” said Mr. Vos. Aksia's consulting team looks for fund-of-funds managers that are “running a real investment organization, so a separate CEO and CIO is must for us,” he said. “We'd like to see a firm that has one or two strategies and lives and dies by those programs, and fairness between investors. I think that after 2008, people are very focused on avoiding any kind of product packaging that gives one class of investors any advantage over another.” Much of the deeper scrutiny faced by fund-of-funds managers is focused on the quality of operational due diligence, driven to some extent by the Madoff fraud. “Sophisticated investors are still going to look for a gatekeeper of sorts to provide oversight,” said Mr. Kosan. “I think the No. 1 demand is going to be in the area of transparency and in risk management. If anything, while Madoff wasn't a hedge fund per se, if anything, emotionally what it created was a huge response and as a result, I think hedge funds of funds may actually see an increase in business.” Round-table participants noted that successful funds of funds already have given operational due diligence a much more prominent role in manager selection and portfolio construction. “I think one of the things that differentiates [funds of funds] now after Madoff is the focus on due diligence and the ability of funds of funds to have operational accounting, auditing and people involved with that due diligence,” Mr. Gilbert said. “I think in the past there was more of an emphasis on performance and access to funds. Now, processes are much more driven by analysis — historical analysis — of prior performance of funds as opposed to operational and back office. That's a major difference in terms of what institutional investors will be looking for going forward.” But to be effective, due diligence by hedge fund managers must be relentless, Ms. Bollyky stressed. “Constant re-underwriting of the manager selection is crucial because these hedge funds are meant to take advantage of anomalies in the marketplace. So if the only time you've done your operational due diligence is prior to making that investment and you're not performing very systemic, rigorous due diligence on a regular basis, then you're missing possible changes or alterations that might occur at the firm,” Ms. Bollyky said. Mr. Kosan predicted that funds of hedge funds will continue the evolution of their investment models and will develop more customized funds, separate accounts and specialized single-strategy funds of hedge funds in response to institutional investor demand.

PRESSURE'S ON

As for hedge funds managed as separate accounts, he said, “the growth of hedge fund separate accounts is putting pressure on fund-of-funds fees on some level.” Still, Mr. Kosan acknowledged that there are some barriers to widespread institutional adoption of separate accounts, including the requirement for a large minimum investment — typically between $50 million and $100 million — along with the unsuitability of illiquid strategies in a separate-account format, and custodial and security issues. Mr. Kosan's fellow panelists were more pessimistic about the prospect of separate accounts becoming more widely used among institutional hedge fund or fund-of-funds investors.
“I think separate accounts [are] viewed as this silver bullet by a lot of groups, but if you look at the attributes that they believe the separate account will give them, a lot of those qualities can be gotten in other ways more efficiently, and cheaper,” Mr. Celeghin said. Mr. Vos said that even with the advantages of owning a separate account, in the end, the institutional investor will find that “their return is really not going to be much different than the commingled funds'. So the package is a great package, but it's not really a different investment choice.” One big advantage offered by separate accounts in the past was transparency, but “the whole industry is changing to a great degree and you're beginning to get the kind of transparency that that a separate account would have. That's a tremendous change,” Mr. Gilbert said. “I think the industry as a whole now understands what institutional investor needs are and particularly after this last year, there's a much greater move toward more transparency. Government will probably be requiring registration, more transparency, and you see much more proactive change with a lot of underlying funds of funds that are willing to be more transparent now,” he said. Separate accounts notwithstanding, the panelists concurred with Mr. Clark that fund-of-hedge-funds managers must navigate rampant change in the hedge fund industry. “Frankly, what we see is an industry in tremendous change and it's still changing and I argue it probably will continue to change through the end of this year. In the last couple of weeks we've seen very large, presumably still viable, hedge funds just pack it in. And it's not even yearend yet, when things could get really interesting,” Mr. Clark predicted. Christine Williamson is a reporter for sister publication Pensions & Investments.