Funds of hedge funds recast dismal model

October 30, 2013 12:34 pm

Funds of hedge funds recast dismal model

By Sam Jones

How many investments have yet to recover from 2008? Many major equity markets are approaching or have moved beyond their pre-crash peaks, at least in absolute terms. Most investment strategies too, have bounced back. Five years on, the idea that anyone should have failed to recover from the collapse of Lehman, and its attendant crises, is almost absurd, even given the volatile and difficult conditions in the years since.Spare a thought, then, for the fund of hedge fund managers of this world. And spare some tears for their clients.

Funds of hedge funds, funds which themselves invest in groups of hedge funds on behalf of investors, were once the principal way people put money to work in the hedge fund industry.

The business still accounts for a huge chunk of hedge fund assets under management today. By current measures, funds of funds, with $650bn of client money, make up a quarter of the hedge fund industry’s total assets.

And yet, their performance, on average, has been dismal.

A $100 investment in the average fund of funds manager made at the beginning of 2008 (were it possible to make such a small bet) would currently be worth just $96, according to HFR, the hedge fund industry data provider.

For reference, the same amount invested in either global bonds, equities or – heaven forfend – private equity (according to S&P) would currently be in the black.

Funds of hedge funds have been nothing if not consistent. In each of the past five years, the average fund of funds has underperformed both markets and the average hedge fund itself ($100 invested in the average hedge fund would now be worth $114, according to HFR).

Institutional investors, those who have dominated new money coming into the hedge fund industry since 2009, are already wising up to the problem.

Unless a fund of funds manager can offer them a genuinely unique investment proposition – perhaps by targeting only small, emerging managers, or else by focusing on a specific sector – few institutions will opt to use them as their main conduit into the hedge fund world. Many pension funds now prefer the option of paying a consultant to do their fund selection for them for far less money.

All of this would appear to point towards a healthy shrinking and retooling of the fund of funds business model.

But, late last year, a new vista opened up for some funds of funds that offered a compelling alternative to change and cheaper fees: retail.

In the US, the JOBS act now makes it possible for hedge funds to advertise themselves to the wealthy, a development which, combined with a rapidly growing trend ofshoehorning hedge fund products into mutual fund structures, has the potential to create a huge new client base for fund of funds managers.

Retail investors make for something of a captive audience. There is no way to invest a small sum of money into a hedge fund – and no reason for a hedge fund to take such a sum – but funds of funds make for a neat solution by being able to pool small investors’ capital, diversifying their risks, and magnifying their opportunity for access.

Big funds of funds have seen a highly attractive opportunity to repackage their wares.Blackstone and Permal – two of the biggest and most reputable – have mutual fund versions of their funds of funds businesses, for example. Dozens of other, smaller firms across the spectrum are looking to follow suit.

As far as the further growth of the sector is concerned, Cerulli Associates, an asset management research firm, estimated in a recent paper that as much as 14 per cent of hedge fund industry assets – over $300bn – will soon come through such retail-oriented structures.

In a universe where the underlying hedge funds in these were making big double-digit returns, this would probably be a justifiable line of business.

But if funds of funds have failed by institutions and the super-wealthy in the past half decade – still down 4 per cent as they are from 2008 – there is little reason to imagine that they will do well by retail investors in the next.

It hardly helps that many of the products on offer, or being designed, have enough layers of fees to make a French pastry maker blush.

For starters, there are the underlying management fees of 2 per cent of assets and 20 per cent of investment returns. Then there may be the fund of fund fees of one and 10. And then there will at least be a 1 per cent management fee for the mutual fund, potentially topped up with arrangement and brokerage costs.

For an underlying hedge fund that made a gross 20 per cent gain on its portfolio in this situation, the end mutual fund investor would see a gain of roughly 10 per cent – perhaps considerably less.

And in an environment where the underlying hedge fund made a gross gain of just 10 per cent, still better than the reality for the past five years running, then the end retail investor would see a gain of just over 3 per cent. The retailisation of funds of hedge funds is rentier capitalism at its worst.