Funds of hedge funds, after enjoying steady growth since the beginning of the decade, are now seen by some in the industry as victims of their own success.
Funds of hedge funds, after enjoying steady growth since the beginning of the decade, are now seen by some in the industry as victims of their own success.
As performance has leveled off throughout the hedge fund industry, funds of funds, which add an extra layer of fees to package several dozen hedge funds into a single portfolio, are finding it more difficult to stand out in a crowded marketplace.
"Most of the large funds of funds these days have many of the same positions, and investors are realizing the duplication," said Rachel Minard, president of Cogo Wolf Asset Management LLC, a San Francisco-based fund-of-hedge-funds firm with $100 million under management.
According to Hedge Fund Research Inc. of Chicago, at the end of 1999 there were 3,102 hedge funds and 515 funds of funds.
From 1999 through the end of June, the number of hedge funds had jumped 147% to 7,662, and the number of funds of funds grew 413% to 2,642.
The most recent data from Morningstar Inc. in Chicago shows that individual hedge funds had net inflows of $10.7 billion in June, while funds of funds suffered $9.2 billion in net outflows.
"Generally speaking, I think a lot of people are starting to look at the funds-of-funds model, wondering what they're getting for the added layer of fees," said Ryan Tagal, director of hedge funds at Morningstar.
Morningstar, which already divides individual hedge funds into categories and assigns star ratings, will do the same for funds of hedge funds by the end of the year, Mr. Tagal said.
The fund-of-funds fees, which typically include a 1% management fee and a 10% performance fee, are applied on top of the fees charged by the underlying hedge funds, including an average management fee and a 20% performance fee.
Increased pressure from the deep-pocketed institutional-class investors, as well as some basic principles of supply and demand, are driving signs of change in the funds-of-funds industry, which could bode well for financial advisers who are looking for investment opportunities in the space.
The handwriting is on the wall, said Ms. Minard of Cogo Wolf, a firm that has flipped its hedge fund research from bottom-up to top-down macro in an effort to stand out from the crowd.
"There's an adaptability one has to have in this market because investors are looking for something to complement their existing portfolios, and they want funds of funds with an opinion," she said. "The institutions are seeing the similarities in the fund-of-funds models, so we literally turned it on its head."
BUILDING THEIR OWN
As the larger institutional investors have gained experience in the hedge funds space, more of them are opting to bypass the fund-of-funds route in order to build their own hedge fund portfolios.
"Some large investors that have been using funds of funds for a while now have the scale and the infrastructure to go it alone by building their own hedge fund portfolios," said Lee Schultheis, founder and chief investment officer of Alternative Investment Partners LLC, a White Plains, N.Y.-based firm with $800 million under management.
Funds of funds are also seeing more competition from multistrategy hedge funds and investible indexes, which have come onto the scene over the past few years.
There is even pressure coming from registered mutual funds that apply certain hedging strategies.
"There are a number of mutual funds that now claim to offer market-neutral strategies, and last year we did an exercise to narrow that field for some of our clients," said Mark Willoughby, principal at Greenbaum & Orecchio Inc., an Old Tappan, N.J.-based firm with $480 million under advisement.
Individual investors, in general, still favor the added levels of due diligence and advice that has be-come the trademark of funds of funds.
"High-net-worth investors believe the need for advice today with regard to alternatives is very high," said David Bailin, president of the alternative investment solutions group for Charlotte, N.C.-based Bank of America Corp.
A bank-sponsored survey of 403 wealthy individual investors found that 79% think that it is important to work with an adviser when investing in alternatives.
In response to a related question, just 24% said that the additional level of screening isn't important.
"There is no tidal wave of people who want to go it alone," Mr. Bailin said.
As the market has gotten more crowded, some funds of funds have tried to compete by offering more customization, better liquidity, more transparency and even lower fees — an issue of near-constant debate within the hedge fund space.
NO MANAGEMENT FEE
"Some fund-of-funds managers that charge no management fee at all have done quite well at attracting assets," said Kenneth Heinz, president of Hedge Fund Research.
With regard to pressure from investors to cut fees, he said that "most managers are more likely to make concessions on things like transparency than on fees."
The best advantage for funds of funds is the ability to be flexible by offering customized portfolios, according to John Van, Nashville-based chief compliance officer for Greenwich (Conn.) Alternative Investments LLC.
"Some investors aren't looking for exposure to the entire hedge fund industry, but might want a certain type of exposure," he said. "It's still a great big world and there are still plenty of pockets of money out there."
E-mail Jeff Benjamin at jbenjamin@investmentnews.com.
