Investment consultants now control roughly $830 billion of the $2.5 trillion invested in hedge funds

Consultants control $830 billion of hedge fund AuM, according to Barclays study

28 Aug, 2013

Investment consultants now control roughly $830 billion of the $2.5 trillion invested in hedge funds, according to a study by Barclays Prime Finance. The Barclays study said the average investment consultants’ Assets under Administration (AuA) had grown by 30% since 2010. Albourne Partners, with $288 billion in AuA, was the largest consultant by a significant margin.Goldman Sachs prime brokerage revealed 65% of pension funds and 45% of insurers employed consultants when making hedge fund allocations, with 90% of respondents using them to help them with operational due diligence and 76% for investment research.  A survey by Deutsche Bank also confirmed consultants’ ascendency among allocators with 60% of investors stating they used them in 2013, an increase from 30% in 2011.

Nonetheless, consultants do face significant challenges, the Barclays report added. The consultancy space is highly concentrated and unlike most oligopolistic markets, it is unable to charge high fees. This was attributable to the flat fee model adopted by Albourne Partners and pressure from institutions, particularly pension funds, to keep costs low.

The Barclays report highlighted consultants with advisory mandates needed to gain scale as advisory services tend to produce lower margins, or vary their strategy and expand into different alternative asset classes such as private equity and real estate.

Another opportunity for consultants would be to offer discretionary services, which are higher margin, although Barclays adopted a cautious note. “Investment consultants have long attempted to break into the discretionary business on the long-only side with limited success,” it read.

Furthermore, consultants told the Barclays study they could struggle to convince clients of their expertise as money managers as opposed to advisors, while some acknowledged inevitable conflicts of interest between the advisory and discretionary sides of the business would need to be prevented.

Consultants have been criticised for their aversion to risk and their perceived bias towards larger, established hedge funds, many of which have failed to deliver genuine alpha. Some consultants, despite their inherently conservative client base, are though looking to allocate into emerging managers or niche strategies and markets, in what could be a serious challenge to funds of funds down the line.

Indeed, consultants have already snapped up a lot of business that historically would have gone to funds of funds, which suffered severe underperformance following the financial crisis. Funds of funds’ fall from grace was evident in the 2013 Goldman Sachs prime brokerage survey, where they represented just 35% of respondents, the lowest level ever recorded, and a far cry from 2008 when they accounted for 61% of all respondents.

“Small and some mid-sized funds of funds will continue to be challenged in a shrinking industry. They may need to consider all options to retain or grow assets including M&A options or re-positioning themselves as outsourced CIOs,” it read. Despite this, the Barclays study was confident the asset class will continue to survive, although the largest funds of funds were the ones best positioned to thrive going forward.

A number of funds of funds have reinvented their business model by focussing on niche managers, lowering fees, upping the ante on their operational due diligence and offering advisory services and customised accounts. Many of the underperforming funds of funds have also since liquidated or merged.

This turnaround is reflected in their recent performance numbers. Figures from the Chicago-based Hedge Fund Research revealed funds of funds made gains of 4.52% in 2013, marginally trailing the average hedge fund, which has posted returns of 4.76%. Data from Eurekahedge said funds of funds were up 3.83% in 2013 compared to single managers, which produced gains of 3.54%.

While Barclays predicts funds of funds will continue to see outflows, it doubts this decline will be fatal. Some funds of funds even reckon retail investors will start taking interest in the asset class. The Barclays study said 45% of large funds of funds surveyed were contemplating a launch of a ‘40 Act product over the next 12 to 18 months.

Others are less sure. A BNY Mellon and Casey Quirk survey of 23 funds of funds running $159 billion, said 55% offered a registered vehicle available to retail and mass affluent investors, although uptick had been low with these products accounting for a mere 8% of their overall sales in 2012. Eleven per-cent viewed retail funds of funds as a promising growth area although 32% doubted it would expand.

Distribution, operating, tax, legal and compliance challenges do remain for regulated funds of funds.  Subchapter M requirements when investing in US- domiciled partnerships are onerous and force funds of funds to conduct look-thru exercises on their underlying hedge funds to ensure they are in compliance. Furthermore, some hedge funds may not be overly transparent in disclosing their holdings, and this could lead to problems for registered funds of funds with their selection process.

“Investors value funds of funds most for their ability to provide access to premier or closed funds, investment ideas, product innovation and new talent. Funds of funds should play to their strengths and focus on the truly differentiated value propositions that cannot be delivered by consultants,” concluded the Barclays study.