Meanwhile, down on the farm…

For some institutional investors, the equivalent of buying the milk from the cow is becoming increasingly popular, even though it comes with its own brands of risks. More and more they are skipping the convenience store/consultant and heading right out to the country to check out the fund livestock on their own.

But going direct can and often does come with a different kind of price tag – a lack of understanding of what you’re getting–or not–as well as a lack of context and experience that having a salesperson or something in between the producer and buyer that vets for quality, reliability and even relevance can help mitigate.

Proponents of direct investing have long argued they don’t need to pay someone else an additional layer of fees to select managers and strategies for them; supports of the fund of funds model say it’s prudent for pension funds and others who don’t necessarily have the in-house ability to conduct the due diligence and oversight required to vet and monitor individual managers to retain someone else to do it.

A recent report by Citi Prime Finance suggests the direct investment proponents are winning, particularly in the wake of the global financial crisis as pensions and sovereign wealth funds choose to knock directly on managers’ doors rather than going through a fund of funds or other third party to make an allocation.

The report, entitled “Global Pensions and Sovereign Wealth Funds Investment in Hedge Funds: The Growth and Impact of Direct Investing” (click here to download) finds that global pension and sovereign wealth fund allocation to hedge funds currently totals about 3% of the pension and sovereign wealth fund asset pool of $31 trillion, or $820 billion.

Of particular interest is what the majority of those pension and sovereign wealth funds are now doing in terms of their hedge fund allocations. The broader good news is that more and more pensions and sovereign wealth funds are allocating to alternatives. As the chart below shows, the amount of capital allocated to alternatives including hedge funds has jumped to 19% from 5% back in the mid-1990s.

What the survey finds, however, is that most of those allocations are going directly to hedge funds, in large part because they feel that with a little bit of help they can better understand and control the types of investments they are making – better than a fund of funds.

The report further notes that while many pension and sovereign wealth funds began their hedge fund investing programs using fund of funds as a way to initially access the market and learn about the space, they later moved to direct investing, particularly as their knowledge of the space deepened.

“Many pension and sovereign wealth funds began their hedge fund investing program using fund of funds as a way to initially access the market and learn about the space,” notes the report. “As their education advanced, many chose to begin shifting toward a direct investing program. This was already occurring by 2006-2007, but the financial crisis and Madoff scandal accelerated this trend…”

Indeed, liquidity mismatches and “contagion risk”, already an issue by 2006–2007, hit warp speed by 2008, becoming a rising tide of discontent rightfully or not directed predominantly at funds of funds.

According to the report, survey participants spoke “passionately” about their frustrations with the traditional fund of funds model, noting pretty plainly their disdain for fund of funds portfolios being overly diversified, which was seen as having a “zeroing out” effect. The incentive to generate “1 and 10” was also viewed as a negative, with some pensions and sovereign wealth funds questioning fund of funds priorities.

On the flip side, respondents did note that traditional fund of funds continue to have a role to play in the market for institutions with smaller hedge fund programs that lack the resources or funding commitment to build out internal capabilities.

Meanwhile, the study also found that most pension and sovereign wealth funds still look beyond their own walls for some pretty important counsel: chief investment officers, consultants, or funds of funds advisoes to aid in their direct allocating. The chart below shows the average size, ticket size, allocation and turnover of both pension funds and sovereign wealth funds’ portfolios.

“The shift to direct hedge fund investing has been dramatic since the global financial crisis — particularly among larger pensions and sovereign wealth funds,” the report notes. “These participants have not settled on a standard model or approach as most still look to outsourced CIOs, consultants or fund-of-fund advisors to support their direct allocating efforts.”

The report goes into significant detail on different types of direct investments, and what pensions and sovereign wealth funds are looking for when it comes to making decisions about the types of hedge fund structures they’re most comfortable with and under what terms.

What seems evident, though, is what many in the industry have been saying for some time: that transparency and liquidity reign, and that constant monitoring, poking, prodding and the occasional strip-search request is all part of the new game of institutions investing in hedge funds.

The question for hedge funds, of course, is whether it’s worth it. Given that there’s another 97% of money in pensions and sovereign wealth funds that hasn’t been allocated to alternatives, our take would be yes.

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