Race for Returns

Yale University endowment manager David Swensen launched a blistering broadside at the practices institutional investors use to select hedge funds in an interview last year with the Wall Street Journal.

Swensen described fund of hedge funds as "a cancer on the institutional investor world. They facilitate the flow of ignorant capital." His argument was that such funds are self-defeating; investors need to be in the top 10% of hedge funds to succeed and, with a fund of funds, they are likely to be excluded from the best managers.

He was equally withering about the practice of fund managers and consultants only channelling funds to a short approved list of hedge funds: "Consultants make money by giving advice to as many people as possible. But you outperform by finding inefficiencies most of the market has not yet uncovered. So consultants ultimately end up doing a disservice to investors."

But was Swensen's criticism justified? And if so, is there anything that schemes can do to avoid these pitfalls?

If his critique of fund of hedge fund (FoHF) managers was the complete story, there would be little point choosing this route to investment. However, these managers, offering investors access to a portfolio of hedge funds in a single investment fund, represents a wholly different risk profile to investing with a single hedge fund manager and may be more suitable for some schemes.

By contrast, a diversified FoHF delivers returns in the region of 7-10% and carries a lower risk profile. Although the underlying components are the same, they are entirely different investment propositions. The main practical difference is that FoHFs hold a hugely lower governance burden.

Harry Wulfsohn, director of FoHF firm Stenham Advisors, says: "If an investor wants to get access to hedge funds, they will ultimately have to pay someone to do all the necessary research. A very substantial process is required to build a hedge fund portfolio and monitor the risk in it."

He says that schemes need to be able to understand and select from the available hedge fund strategies, of which there are around 15, before selecting and performing due diligence on individual managers that follow these strategies. "And these days, especially post-credit crisis, the due diligence requirements have grown substantially," he adds.

Indeed, nearly 80% of respondents to the Beacon Consulting Group and Advent survey of risk management practices by hedge funds reported a marked increase in operational due diligence requests in 2010 over the previous year.

Such due diligence entails investigating both the investment itself and the operational risk of the manager. And once the portfolio has been built, "you've got to monitor the risk and monitor the managers, make sure they aren't doing anything stupid and are doing what you want," says Wulfsohn.

Going Solo

One alternative to hiring a FoHF manager is for the scheme to construct its own hedge fund selection and monitoring capability internally. Unfortunately, it is reasonable to assume that only the very largest pension funds will have the resources to attract and retain a team experienced and knowledgeable enough to build and manage – from a field of around 8,000 in the global market – a portfolio of hedge funds.

Wulfsohn says: "It is a very substantial process to source and filter down to some good ones and it's not just simply done on a database. A database is, in fact, the worst way to do it. We've been doing this for 15 years and the best names you get without fail come from asking around."

Greg Knott, co-CIO and founding partner of Hermes BPK Partners, a FoHF, says that many schemes are ultimately put off going it alone. "It should not be surprising that traditional investors who have started along the self-selection route frequently are reverting to specialists and that those who are debating the question for the first time elect one or more FoHF once proper analysis of the choices has been conducted.

"Often, it will be a combination of the two approaches which works best," says Knott. "Direct investments for certain allocations of risk," which the scheme can handle analysing, "and FoHF for other exposures such as specific asset classes, themes or geographies where resources don't allow for detailed enough due diligence."

Rather than seeking to reduce risk through a FoHF manager, a pension fund may opt to make a single large investment with one of the bigger multi-strategy hedge fund managers, such as Eton Park Capital Management or Bridgewater. Craig Stevenson, senior investment consultant, Towers Watson, says this halfway-house will work for some schemes.

"These firms employ large numbers of staff, and investors equate size with safety. In some cases, fees can be 3% annual and 30% of performance, but you would expect a similar type of risk and return profile – perhaps a little lower on the risk side – as a FoHF."

Stevenson says that a good multi-strategy return would be Libor plus 4-6% net of all fees: "If you had a limited governance budget and had to allocate to one manager, this might be the first natural first step." It should be noted, however, that choosing one multi-strategy manager leaves the pension scheme exposed to a higher degree of operational risk than a FoHF.

Running with the Pack

Even if a scheme has successfully set up a portfolio of hedge funds without a FoHF manager, it is still left with a significant ongoing governance challenge to cope with economic events. It is this dynamic aspect where FoHFs perhaps have most to offer.

Adam Singleton, senior vice president at Financial Risk Management (FRM), emphasises that returns from any particular hedge fund strategy are cyclical. He says: "The relative strength of different hedge fund strategies changes over time. By holding exposure to many different hedge fund strategies and also shifting exposure to concentrate on higher performing strategies, an investor can attempt to increase returns and avoid underperformance."

For example, FRM has historically invested with hedge funds of all sizes, but it has shifted its focus to smaller and mid-sized managers, believing that in the current uncertain environment, these managers bring a mix of nimbleness, liquidity and performance delivery. Also, Singleton says, "there is a great deal of capital being concentrated with a small number of large managers, and we want to avoid that concentration of assets."

However, while it may be possible for FoHFs to benefit from implementing such strategies, it is certainly not the case that there is universal agreement on who the best hedge fund managers in the market are, even at one particular moment in time. Stenham recently bought Montier, a smaller FoHF provider, because Stenham perceived it operated on the same philosophy as itself. However, while Stenham has 70 hedge funds on its approved list and Montier 40, Wulfsohn says it turned out that only three funds were on both lists.

One way in which a FoHF can potentially add value is by using its scale, the promise of future inflows from its clients, to drive down the fees it pays to underlying managers.

Chris Manser, global head of FoHF at AXA IM, explains: "We deploy sizable chunks of money to our individual managers and that usually gives us a good leverage point into these negotiations, which are around fees, transparency, liquidity and governance."

He adds, "Obviously, if a fund is not very successful, it's not going to have very many inflows and then there is a lot of room to negotiate fees."

However, as Manser acknowledges. "Sometimes, fees will be the most difficult point to negotiate, especially when you're trying to get into a fund that is quite successful. [Likewise] if you're taking, for example, the last £100 million capacity out of a manager, then often, the concessions that manager is willing to make are relatively small."

Flexing Muscles

Some consultants contend that there are only a handful of FoHF managers worth their salt. Towers Watson's Stevenson says: "From a research perspective, there is only a limited range of FoHFs we think offer sufficient skill or levers of return that are able to offer a decent scope for added value. Most of the industry, we would say, struggles to make a decent value proposition."

Towers Watson forms its view of managers net of all fees, assessing what proportion of alpha – returns generated through skill rather than rising markets – is paid to the manager in fees. In total, Stevenson considers it fair for a manager to take 30% of the alpha generated (including annual and performance fees).

Towers Watson splits FoHF research into two main types: core and niche. Niche research focuses on accessing returns and risk premia that are difficult to access directly, such as catastrophe bonds or Nordic power markets, which can add a layer of diversification.

Consultant Aon Hewitt also favours a core-satellite approach which combines two or three FoFs as the core with a handful of satellite single-strategy managers focusing on tactical opportunities.

Guy Saintfiet, senior hedge fund researcher at Aon Hewitt, says the consultancy employs a dedicated fees team to drive down these "destroyers of value". The fees team negotiates with managers before they can go on Aon Hewitt's approved list, which contains seven FoHFs, including two niche managers. Saintfiet says: "When it comes to FoHFs, the original 1.5% annual charge and 10% of performance is definitely going out of fashion and we're looking on average at fees below 1% all-in."

Saintfiet also identifies a trend for pension funds to go down the delegated consulting route.

New Game in Town

At its inception, the proposition of the FoHF industry was to provide investors with access to big name hedge fund managers that they could not access directly.

Aon Hewitt's Saintfiet says that FoHF providers received a lot of bad press following the crisis of 2008 and not without reason. Looking forward, he adds: "A lot of the providers out there were sub-par. I think 2008 proved that it is extremely important to select the right provider, and you are seeing a bifurcation in the industry where the good and successful FoHFs will become bigger. The small and less sophisticated FoHFs will leave the industry because they just erode value with the fees they charge on top of the lack of alpha they generate."

In the wake of the crisis, FoHF managers were able to negotiate hard with underlying managers, resulting in reduced fees, increased transparency and better liquidity terms.

The losses sustained by hedge fund investors in 2008 also brought the alignment of the investor's interests and the manager's fees into question and significant strides have now been made. For example, Hermes BPK has created a three-year fee structure which allows reimbursement to the client of performance fee overpayment in poor performance years. Knott at Hermes BPK Partners says: "Taking a long-term approach to performance fees fosters a true partnership which extends beyond investment into true alignment of interests. Such innovation, combined with new levels of institutional style transparency, meaningful risk aggregation and high levels of governance underpin the new FoHF model."

FRM's Singleton concurs in this area of governance. He says: "Especially since 2008, there is a real opportunity to work with managers to put in place structures and terms that are better for investors. Mid-sized and smaller managers especially are open to working with us on these issues."

Another positive change is that FoHFs have become more flexible in how they work with institutional clients, with some acting on almost a full advisory basis; advice is not necessarily just related to hedge funds but also to temper biases in the client's equity and fixed income exposures.

This article first appeared on on 25 November 2010.