Confusion and the confusing things that cause it

“The future ain’t what it used to be.”

American baseball player and patron saint of confusion had an obvious knack for making ironic, contradictory and logically self-referential observations about daily life.  Had he been in the hedge fund industry, he might have really enjoyed this week.

Several recent hedge fund stories seem strangely inconsistent with each other.  First Euromoney’s EMII.com website ran a story called “FoF Assets Lead Hedge Fund Growth“.  And at the same time, Investment News ran a story titled “Funds of hedge funds losing their luster“.  So which is it, the best of times or the worst of times?

A closer read of both articles reveals that both stories are more similar than the headline writers have let on.  EMII was referring to a Finalternatives piece that acknowledges the recently-acquired taste for single-manager funds displayed by investors:

“While many investors can and have chosen to bypass FoHF structures in order to invest ‘direct’, for the past 10 years assets under management under the FoHF structure grew faster than AUM for all hedge funds combined.”

Investment News seems to agree, with the caveat that this trend is actually coming to an end rather quickly.  They cite data from Morningstar that indicates single manager hedge funds had a net inflow of over US$10 billion in June while fund of funds said sianora to $9.7 billion.  Says Investment News:

“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…”

“…’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.”

For better or worse, larger investors are essentially “rolling their own” fund of funds using single manager funds.  But keep this in mind: Funds of funds must eventually allocate all their capital to single-managers.  Imagine a world where funds of funds manage, say $100 billion and single funds manage $500 billion.  Let’s say investors put a further $200 billion into hedge funds overall – allocating half to funds of funds and half to directly to single managers.  The funds of funds would double in size and the single managers would increase by only 40%.  Even if investors placed all of the money in funds of funds, then the funds of funds would triple and the single managers would still grow by only 40%.  So comparing growth rates is a red herring.  At the end of the day, all the money goes to single managers.  Funds of funds are more akin to financial advisers than they are to single-manager hedge funds.

Here’s another couple of stories this week that seem to conflict with each other.  Bloomberg reported earlier in the week that “States Double Down on Hedge Funds as Returns Slide“, while Pensions & Investments said yesterday that Middle Eastern and European hedge fund investors were “Jumping off the bandwagon“.

Bloomberg cites data showing that the average allocation to alternative investments by state pensions doubled from 2003 to 2007 and now sites at around 5.7%.  Meanwhile, P&I quotes Casey Quirk’s David Bauer and Ennis Knupp’s Keith Black (see guest posting) as reminding us that alpha decay and industry concentration are starting to make some investors take pause.

In fact, in “Managers hungry for cash infusion” P&I also reports that:

“In the face of their worst collective performance in years — compounded by a 76% drop in net inflows in the first half of the year and redemptions from high-net-worth investors — hedge fund managers anxious to replenish their coffers are visiting institutional investors and their proxies, institutionally oriented fund-of-funds managers, with caps in hands, sources said.”

So what are we to make of all these seemingly contradictory developments?  Yogi Berra, hedge fund commentator, summed it up better than we have ever done so.  Said Berra:

“Nobody goes there anymore. It’s too crowded.”

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