The nature of funds of hedge funds, their scale and, more specifically, the added value they offer to their investors have all evolved over time, and will continue to evolve.
In an interview, Brian W. Chung, senior vice president,senior portfolio manager for SSARIS Advisors, a Hedge Funds of Funds affiliate of State Street Global Advisors, spoke of that evolution thus: “There was a time when the value proposition of [fund of hedge funds] was a matter of gaining access. FoHFs were the gatekeepers to the underlying hedge funds, but the added value here was most beneficial to high net worth and non-professional investors. After all, the managers of, say a $100 billion pension fund don’t need to pay an extra layer of fees for access to managers – hedge fund managers are happy to talk to these institutions.”
Today, FoHFs offer to add value in another way: or, rather, in two other ways. Chung says that very large funds of hedge funds “play a role simply because they are large and can exert a lot of influence on the underlying funds, on fees, transparency, and other issues, for the benefit of their clients. Smaller FoHFs who don’t have this sort of leverage play a very different role, as specialists in tactical allocation or in a particular strategy – in CTAs, or credit-oriented funds for example. The middle tier of FoHFs is fading out, so the industry looks like a barbell.”
The barbell isn’t growing as quickly as are the underlyings. In August, State Street published a white paper, “Hedge Funds: Rebuilding on a New Foundation,” and reported that in the first quarter of 2011, hedge fund assets under management reached and exceeded $2 trillion for the first time. The previous record had been $1.93 trillion, in the second quarter of 2008. As our readers may have heard, the third and fourth quarters of 2008 were … not so hot. State Street says that the new record suggests “the hedge fund industry is moving beyond the financial crisis and rethinking its future.”
“[U]nderlying trends such as aging populations and chronic pension underfunding, which drive the need for absolute returns, suggest huge opportunities for the hedge fund industry to play a larger role,” the paper said.
As for FoHFs: before the crisis, they peaked at $826 billion in assets under management. They have not returned to that level since. They were only at $673 billion at the end of the first quarter of this year. “In the next phase of hedge fund evolution,” the paper says, “successful FoHFs will be those that develop an innovative, more flexible business model geared to providing client-focused portfolio solutions.”
These solutions might include, for example, developing and marketing managed accounts, so that FOHFs may evolve into FOMAs.
Elements and Administrators
Five critical elements will help hedge funds in the near future distinguish themselves from one another, and thus attract investors: Investment strategy and performance; liquidity management; portfolio transparency; pricing and lock-ups; operational due diligence.
1) Performance has always been important, of course, but “days of no-questions-asked performance are gone….owners today want to know how returns were achieved, the strategies that drive them….” In short, they do ask questions.
2) Liquidity likewise has always drawn its share of questions, but of late a chasm has separated managerial and investor perceptions in this area. Managers want to be allowed the time for their strategies to work – or, at worst, the time to wind down positions in an orderly way. Investors want to be more active at modeling their own “liquidity profiles, and disaggregating the liquid from the less liquid components….” Various means of reducing the width of that chasm have emerged. For example, “administrators are … being called upon to provide bridge financing as part of their comprehensive mix of services.”
3) Investors want not only transparency/information; they want the data presented in a way that helps them understand it. Third-party administrators are well-positioned to serve as mediators.
4) As for pricing and lock-ups, it is as yet unclear, the report says, whether “competitive market forces are driving a long-term divergence in fees and terms between different types of hedge funds, resulting in more varied terms and compensation structures across the industry.”
5) Finally, as to operational due diligence, new laws are reshaping this aspect of the industry: the Dodd-Frank Act in the U.S., and the Alternative Investment Fund Managers Directive in Europe. Each imposes new reporting and operational requirements. Here, too, third-party administrators “will play an essential role in facilitating compliance with the evolving supervisory and regulatory landscape.”