London (HedgeNordic) – The claim that fund of hedge funds (FOHF) are dead is greatly exaggerated. Their headline assets of around $600 billion, per HFR, have been declining as a percentage of hedge fund industry assets (now around $3.5 trillion, according to BarclayHedge). But FOHF are highly influential in acting as consultants and advisors to some of the world’s largest pension funds, endowments, foundations, and sovereign wealth funds, which often invest via their own dedicated managed accounts, so that the assets do not appear under FOHF umbrellas.
FOHF aim to add value through one or more of: access, diversification, asset allocation, strategy allocation, manager selection, risk management, and negotiating fee discounts and structures.
Historically, when little public information existed about hedge funds, the funds of funds offered access to hedge funds as an asset class – and some of them, such as Dixon Boardman’s Optima Group, or Theta Capital’s Euronext-listed Legends Fund, do still offer some access to closed funds.
Funds of funds also allow smaller investors to obtain more diversification where minimum subscription sizes (which can range from $100,000 to $25 million or more) are too high for them to diversify by going direct. Even in the UCITS world, some UCITS hedge funds have minimums of $1 million or more.
Asset allocation and strategy selection bets are taken by managers such as SkyBridge Alternatives, which has allocated large percentage of its multi-manager product to specialist US mortgage managers.
“The biggest disadvantage of FOHF fees is arguably not the level of fees per se, but the absence of netting.”
Many FOHF claim that their manager selection due diligence routines have avoided frauds such as Madoff, and blow-ups.
Indeed, FOHF may add value through risk management. Risks may be reduced through portfolio construction that provides a range of uncorrelated factor exposures. Some managers use risk aggregation formats (such as the non-commercial Open Protocol Enabling Risk Aggregation, or the commercial RiskMetrics) to help with getting a handle on fund risks, while others FOHF invest only through managed accounts that offer total position transparency, and potentially instant liquidity. Tactical trading of funds can involve regularly buying and selling funds, redeeming those that overshoot risk targets or breach risk guidelines.
Fees: Double fees, Netting risk and First Loss Structures
Funds of funds are now competing with investment consultants in two ways. For clients who are large enough to muster minimum tickets, both may simply provide a regularly updated “buy list”, without actually managing the allocations. The business model here can be a fixed fee, as low as a few hundred thousand dollars a year, or maybe a few basis points of assets.
But the consultants do now manage money as well, through “implemented consulting”, “fiduciary management” or “outsourced CIO” services. For these mandates, fees can also be quite low: perhaps tens of basis points, with no performance fees.
FOHF add a layer of costs, which may or may not be offset by using their buying power to get fee discounts from underlying managers. Cost-conscious investors encourage many funds of funds, including Kempen of the Netherlands, to negotiate fee discounts. Other managers use managed accounts, or co-investments into specific deals, partly to get lower fees.
The biggest disadvantage of FOHF fees is arguably not the level of fees per se, but the absence of netting – so that investors are taking the netting risk. If half of a FOHF’s funds make profits that are equal to losses incurred by the other half, then the FOHF still pays performance fees to the profitable funds, even though FOHF investors received aggregate performance of zero (or even lost money after FOHF fees and costs). Even when the majority of investee funds are profitable, the effective performance fee percentage incurred by FOHF investors is higher than the headline fee, and sometimes markedly so.
Netting risk may be mitigated through an “internal FOHF” (which can also be dubbed a multi-strategy fund), where the same manager can offer multiple strategies, but this also greatly restricts the choice of funds. Some multi-strategy hedge funds that have hundreds of portfolio managers, each paid on their own P&L, have the same netting risk as most FOHF.
The most innovative fee structures include “first loss”, whereby the underlying managers have to put up significant amounts of their own capital, and bear the first 10% or so of losses, but get a higher performance fee, perhaps as high as 50%. These vehicles have been good at preserving capital, and maintaining very steady returns. When most or all of the managers are profitable, the expense ratio is high, but investors do not pay performance fees for flat or negative performance.
Liquidity and 2008
A mismatch between FOHF liquidity, and their holdings’ liquidity, became apparent in the financial crisis of 2008. This was partly due to some FOHF offering monthly or quarterly dealing, and allocating to some funds that had one, two or three-year lock ups. It was also due to ‘style drift’ with some ostensibly liquid managers investing into private equity assets such as African diamond mines. Frauds such as that perpetrated by Weavering manager and Swedish national, Magnus Peterson, (who now receives free food and lodging in the UK) did not help.
But the reality is that the evaporation of liquidity in late 2008 came as a big shock to most market participants. Strategies that might have been liquid enough to meet redemptions in 2007 or before, were paralysed as certain financial markets froze up. Stricken banks needed to shore up their own balance sheets rather than providing liquidity in markets, and many leveraged investors became forced sellers as credit was withdrawn. Holdings that had been classified as “level 2” and valued using a broker quote, were reclassified as “level 3” and had to be valued using models. Asset-based lending and direct lending strategies often struggled to repay redemptions because their borrowers could not find alternative finance from banks, while life insurance premium finance funds became illiquid for a more benign reason: humans are living longer, due to advances in medical treatments and technology.
All of this – and the failure of counterparties such as Lehman Brothers – led to gates, and side pockets, some of which turned out to be surprisingly good long-term investments. Lehman Brothers exposures have generated strong returns over the past nine years, for instance.
“Funds of funds are now competing with investment consultants in two ways.”
There are persistent concerns about credit market liquidity, and a couple of long only credit mutual funds in the US suspended dealing in 2016, but we are not aware of any FOHF having had exposure. We have not heard of FOHF running into liquidity issues recently, but then overall financial market liquidity has been buoyed by central banks. We may only find out if there are liquidity mismatches, when and if investors make large redemptions.
A perceived disadvantage of FOHF is lack of transparency, where they do not disclose their holdings – fully or at all. When I started in the FOHF industry in 2003, some players were secretive but I think this is now increasingly rare. Where FOHFs act as consultants, the clients obviously need to know the names of funds, in order to invest in them directly. Where there are comingled funds, FOHF financial statements should normally disclose holdings at least annually, while public funds such as UCITS in Europe, and exchange-listed vehicles, do so more often. Investors who want a transparent FOHF should be able to find plenty. The general thrust of multiple regulations, including MiFID II, is for more transparency, not less.
For the past decade, post-crisis, FOHFs have been consolidating, to cut costs and build critical mass. For instance, Permal, which manages on of the oldest FOHF – Haussman Holdings, launched in 1973 – was taken over by Legg Mason in 2005; bought Fauchier Partners in 2013, and then merged with EnTrust in 2016. Even the largest FOHF seem to think it makes sense to merge: in 2017, PAAMCO and KKR Prisma, each of which runs over USD 10 billion, announced a tie-up.
This consolidation leads to the argument that the industry will become dominated by a few giants at one end of the spectrum, with niche specialists at the other end. Smaller and medium-sized managers must be doing something different if they are to survive and remain independent. Specialist funds of funds could focus on managed futures/CTAs (eg Sweden’s RPM), commodities, quantitative strategies, market neutral strategies (eg Sweden’s Merrant), emerging markets, UCITS funds, alternative credit and direct lending, or on seeding new and emerging managers (eg IMQubator, where I worked between 2011 and 2013). Like all specialists, they will claim to have more knowledge and expertise in their own area. But clearly, the performance fee netting issue is multiplied when investors have ten different specialist FOHF.
“This consolidation leads to the argument that the industry will become dominated by a few giants at one end of the spectrum, with niche specialists at the other end. ”
The real reason why many smaller FOHF may in fact survive is that they are often “friends and family” type vehicles, rather than hard-headed commercial businesses. The nature of the hedge fund industry is that some people like to invest with, and work with, those with whom they have forged strong personal relationships over many years.
This article was written by Hamlin Lovell for the Nordic Hedge Fund Industry Report 2018.