Building a future

Fund of Hedge Funds

Funds of hedge funds are an increasingly accepted way for investing into hedge funds

According to a recently published report by Hedge Fund Research, the assets in the hedge fund industry continue to grow, with total assets estimated to have reached $665bn by the end of the first half of 2003.

The total number of funds rose significantly with the estimated amount around 5,655, up from 5,379 at the end of 2002.

Hedge Fund Research estimates 281 new funds were launched during the first half of 2003, of which 132 were fund of funds.

Funds of hedge funds have continued to attract investors and now represent over 40% of global hedge fund assets. Strong demand for these products has seen this segment grow from roughly $80bn in 2000 to almost $300bn by the middle of this year.

Fund of hedge funds benefited from increased acceptance by investors due to the prolonged bear market cycle and the renewed search for portfolio diversification. Hedge funds typically show low correlation to traditional asset classes and provide significant diversification benefits to portfolios.

Despite this recent strong growth, the fund of hedge funds sector will continue to attract a major share of institutional and retail assets worldwide.

Diversification
To some degree, funds of hedge funds resolve a lot of the issues around investments into hedge funds, including concerns about fund specific risk and the lack of liquidity. Furthermore, the minimum investment in a fund of funds may also be lower than that of an individual hedge fund or managed account and this widens the investor spectrum to a much broader group. In addition, many attractive hedge funds are closed to new subscriptions and are only accessible through a fund of hedge funds vendor.

Funds of hedge funds provide investors with diversification across various investment styles as well as professional supervision of the investments, including sophisticated risk management.

When individual hedge funds are pooled into a fund of hedge funds, the risk profile of the hedge fund investment tends to fall dramatically, reflecting the extraordinarily low correlation between the returns of individual hedge fund strategies. In order to achieve the desired benefits from diversification, diligent portfolio construction remains a key — if not the most important — element for success.

The specialised fund of funds managers can realise important economies of scale by collecting and processing information for a large investor base. By aggregating hedge funds, the research and identification of successful managers is highly scaleable, and facilitates efficient ongoing due diligence.

Smaller funds of hedge funds tend to have more concentrated portfolios due to their limited resources, which can be less than optimal as hedge fund investments are highly heterogeneous. An overriding axiom of modern portfolio theory is the principle of diversification which risk-aware investors understand and follow.

Yet, this is actually something that many investors have ignored at times. During the bull market, pension funds and life insurance companies were able to build up a large capital surplus and thus increase their risk levels. Portfolio volatility was high due to significant equity weightings and, in many cases, not reduced when equities started to tumble.

Today, institutional investors have again started to focus more closely on risk-adjusted returns.

Driven by the high cost of manager due diligence and the need for sophisticated portfolio and risk management expertise — an absolute pre-requisite for success in the hedge fund arena — the majority of institutional investors are likely to outsource this function. The growth in the industry is thus expected to continue if investors return and risk expectations, as well as other important factors like timely and detailed reporting, are met.

Also, the demand for structured products is likely to continue as principal protected products, which include profit lock-in features, are highly attractive to private investors. Of course, as with any other industry which is growing so quickly, we will see consolidation and further specialisation of some market participants.

In particular, the mid-sized providers will need to find differentiating factors that set them apart if they wish to remain independent.

At the moment, the 10 leading investment institutions which are active in the fund of hedge funds sector are estimated to represent more than half of the market. The success of the fund of hedge funds provider will not exclusively depend on their ability to produce decent returns but the risk-adjusted performance will always remain one of the key drivers for success.

Disappointing after-fee performance will most certainly hurt the ability of a fund of hedge funds provider to attract new money, and will eventually cause investors to question its continued existence. If performance levels remain below expectations for a prolonged period of time, investors will seek a replacement.

Thus, the dynamic of change in the industry will remain high. Over the past five years, the dispersion of returns between funds of hedge funds has substantially increased, so we can assume that the industry will continue on its consolidation path. Both single managers and fund of hedge funds managers will be targets for those institutions that have ambitions to expand on a global scale.

At the same time, distribution capabilities have become more important. Some providers have entered into strategic alliances with distribution partners, while a number of large and global investment banks have embarked on a strategy of their own. For many providers this will represent an issue, as they may find it difficult to operate with big distribution channels and the potential increase in assets this can bring.

Fees
Investors choosing the fund of hedge funds investment route face a unique cost structure. A typical fund of hedge funds charges a flat management fee plus an incentive fee based on the after-fee return of the individual fund product.

In most cases, the performance fee is tied to a high watermark which means that a manager may only charge an incentive fee from new profits. The fund has to make up for any losses before it can charge its incentive fee. So, a fund falling from 10 to five and then rebounding to 10 will not be able to charge an incentive fee on the 100% profit from five to 10.

Nevertheless, fees in the hedge fund industry remain high compared with traditional investment management, yet such fees are justified by the fact that hedge fund management companies strive for absolute performance and limit assets under management. Bluntly stated, there is no such thing as a free lunch and investors who wish to benefit from the favourable risk/return profile of hedge funds must accept cost structures which are not common to traditional assets, like equities and bonds.

Additionally, the fund of hedge funds represents a sophisticated approach to investment that, in the recent past, has achieved higher returns and lower volatility than equities. The typical performance-based fee structure provides a significant incentive to identify and focus on winning hedge fund strategies. The fund of hedge funds provider is compensated to ensure adequate risk management and effective portfolio management in order to continuously meet investors’ risk/return preferences.

Funds of hedge funds will continue to play an essential role in the hedge fund industry and demand should remain robust even beyond bear markets. In the US, institutional investors have already accepted hedge funds as a viable asset class some time ago. Nevertheless, current penetration rates remain very low, and the industry only represents a very tiny portion of less than 2% of the global financial markets.

Other markets are still far behind the US and most investors are still at the beginning of a steep learning curve. There are some countries, like Germany, where investment into hedge funds was almost impossible and is only now being liberalised slowly.

Capacity constraints might represent a limiting factor on the supply side in some cases, which will again support the growth of large fund of funds providers capable of reserving capacity due to their size and extensive network built over time within the industry.

There may also be spill-over effects in the future. It might be possible that traditional managers start to adopt capabilities and services from hedge funds in the long run. As hedge funds have the freedom to adopt investment strategies that are not currently available to traditional investment managers for regulatory and other reasons, this potential development might be reserved for the very long run. In the near-term future, the fund of hedge funds sector faces several challenges.

Apart from legal, regulatory and tax rule changes which might restrict marketing and distribution to some extent and also change auditing and registration requirements, the focus will be on enhancing reporting disclosure and meeting risk/return expectations.

Also, product innovation and distribution alliances will be key factors for ensuring the future success and prosperity of funds of hedge funds providers. Over the past decade, the industry has proved to be extremely flexible and dynamic and should be well prepared to meet these challenges.

The industry has a bright future and the best placed providers are likely to be those with in-depth experience and a long track record, capable of offering all the building blocks to their clients as we move away from essentially a cottage industry to a consolidated one.

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