Why institutions bypass hedge FoFs

More first-time investors in hedge funds are allocating to the strategies directly, rather than choosing hedge fund-of-funds (hedge FoFs), as investment talent circulates among institutions and investors observe the passive approach that many hedge FoFs apply to their portfolios. Simon Ruddick, managing director of hedge fund consultancy Albourne Partners spoke with Simon Mumme about this trend and the challenges of investing directly.

As skilled investment staff move among the internal teams of pension funds, institutional newcomers to hedge funds have become more assertive than their predecessors, choosing to pick managers right from the start instead of beginning with hedge FoFs before going direct, Ruddick says.

An investor that has already built a portfolio of direct hedge fund investments has “a better view of the skills to be a core holder of blue chip hedge funds,” he says, and can bring this knowledge to an institution that is drafting a hedge fund program.

But the level of risk the first-timers are exposing themselves to is not changing. Ruddick observes that they follow the pattern set by pension fund investors in hedge FoF managers, which usually choose one of three broad types of mandates: a conservative mandate that replaces part of their fixed income exposure; a riskier equities substitute; and a more balanced portfolio of hedge fund strategies.

“They invariably start with the conservative one, and the longer they’ve been invested the more they move away.”

As the newcomers favour direct investments, institutions running mandates with hedge FoFs were accelerating their transition to single managers, Ruddick says, after observing how passively the managers steered their portfolios during the worst of the financial turmoil.

“The world changed dramatically but hedge FoFs didn’t change their core holdings of hedge funds.”

“The clear trend now is going direct and there’s nothing surprising about it. The underlying managers would rather have the money directly, and there’s less fee drag, and there’s also been the passivity of core holdings.”

He says many hedge FoFs are “fighting a slow, losing battle” as their supply of first-time investors thins out, and existing investors pick managers themselves.

“They have gone from a ludicrously profitable business to a very profitable business. There was so much fat there, it could take a trimming.”

Once a pension fund chooses to go direct, they rarely, if ever, return to hedge FoFs.

“I’ve never seen an institution that has one direct ever go back to hedge FoFs.”

Having chosen this independence, and now that many hedge fund investors are beginning to be treated with the transparency they have demanded from managers, Ruddick says funds must implement a process through which they can manage the information they receive.

“Funds flooded by information don’t have the time to do anything reasonable with it. Developments should be on how to harness and make sense of it. We see this as three key components to risk management: measuring, monitoring and managing risk.”

To effectively manage risk, investors must monitor and accurately measure it, and these components of the process are the most important.

Some investors have bought managed accounts with hedge funds to better manage risk. But the operational workload accompanying this method  simply “replaces one set of challenges with another,” Ruddick says.

“If managed accounts became prevalent, they’d have a whole lot of things to learn about counterparty risk and best party execution.”

He adds that many hedge funds have cleaned up their operational procedures after the collapse of Lehman Brothers. Some that performed their own administration have outsourced this function to professional service providers and hold their assets in separate custody accounts to limit risk.

This is an instance in which hedge funds have improved their processes to appease investors. “But it’s not all rosy,” Ruddick says.

“A source of frustration on the investor side is that, for the funds they want to be in, they can’t negotiate better terms. The top funds didn’t have to change their fee structures because of supply and demand.”

Hedge funds have benefited from the long-term outlooks of institutional investors: these customers have provided managers with lasting sources of capital, which they rarely got from their traditional high-net-worth individual and family office clients.

“Some of the previous investors in hedge funds, like family offices, were always sceptical of institutional investment in hedge funds – that they’d swamp them with big amounts of money.

“Now we’ve seen the industry face some challenging times. Thank goodness there was a bedrock of consistent money.”