A family dilemma
How best for a family office to engage with the hedge fund industry will require careful consideration
Taking a funds-of-funds approach to hedge fund allocation, rather than the traditional separate account method, presents a potential advantages and disadvantages for a family office and its clients.
With this in mind, the decision of the appropriate approach should be made only after considering carefully the balance of maintaining theoretical investment ideals and maximising operational efficiency, within the practical framework of hedge fund investing.
Furthermore, factors such as the number of clients and the overall commercial objectives of the family office are also crucial.
Key to the discussion is the fact that many hedge funds (and particularly the higher-quality funds) are closed to new investment, limiting inflows, or may close in the future. This has two significant implications.
Firstly, harmonising separate portfolios, although theoretically possible, may be considered as inequitable due to the fact that it would involve certain clients seeing their allocations to closed hedge fund managers diminish. Any harmonisation is further complicated by the fact that hedge funds trade monthly, quarterly or even less often.
Secondly, it gives clients a tendency to prefer owning their own allocations outright rather than through a fund of funds so as to avoid dilution risk: risk that ownership of hedge funds with limited availability is diluted by inflows from other clients.
Separate AccountS…
The main benefit of managing clients' hedge fund allocations as separate accounts is that it has traditionally allowed family offices to provide clients with fully tailored portfolios designed to meet their specific investment objectives and liquidity constraints.
The family office can employ a holistic approach over the entire client portfolio, blending hedge fund allocations with traditional asset classes (for example, by looking at factor exposures across the whole portfolio).
From a more practical perspective, a client with its own managed account has undisputed ownership of each investment and hence has no dilution risk.
Another important aspect of the separate-account approach is that, providing that the family office is set up to offer the flexibility, it can give the client the opportunity to choose between a discretionary or advisory service. This can be particularly valuable in the hedge fund space where certain clients enjoy participating in the hedge fund investment process.
However, while the advantages to the client are numerous, there are disadvantages for a family office with more than one family and/or beneficiary. The most significant problem is that many hedge fund positions are not replicable in the future (as described above).
Should accounts begin or account flows occur at different times, applying the same investment process to numerous accounts can yield results that are quite different.
Consequently, from the perspective of the family office, the administrative burden of managing multiple portfolios is significant and is compounded as the number of portfolios increases.
… OR Fund of Funds?
Much of this administrative/operational burden is mitigated through a fund of funds approach. Indeed, managing one pool of assets, to one set of investment objectives, and one pre-defined set of liquidity constraints within a formalised fund of funds structure provides benefits to the family office on a number of different levels.
The operational efficiencies of managing one pool of assets rather than several are obvious, (one portfolio to consider/review, one custodian, one set of orders, and so on).
Additionally, reporting is also vastly simplified with one monthly or quarterly report usually enough to satisfy an entire investor base. In addition to potentially freeing up personnel, these efficiencies allow the family office to take on additional clientele more easily.
From a business-development perspective, the setting up of a formalised fund of funds will provide the family office with a marketable track record. Providing performance meets expectations, this could be valuable in marketing to the existing client base, while the potential for new client segments is enormous.
While the operation might ultimately have to change significantly, a good track record provides a family office with an option of broadening its horizons to include the institutional and pension fund world and the potentially bigger allocations that those areas could involve.
Strategy VS Client NEEDS
Considering these hugely positive implications, why do we not see all family offices converting their businesses from multiple managed accounts into funds of funds?
While explanations may include a lack of desire to become 'more public' and to change the existing organisation, the over-riding reason is, of course, the fact that most private clients (and particularly the larger ones) typically prefer their own tailored account to a fund of funds.
There are indeed some benefits for a private client in using a fund of funds over investing directly, such as lower investment minima and having liquidity managed on a pooled basis. However, these benefits are relatively small, diminish as client size increases and hence are outweighed by the reasons why clients prefer separately managed accounts.
From an investment perspective, the benefits of separately managed accounts listed above are extremely valuable. Additionally, dilution risk is an important consideration for clients. However, an important issue often overlooked is that, for many clients, investing in hedge funds carries with it more than simply the good risk-adjusted returns that they hope to derive.
For many private clients, investing in hedge funds is a passion, and they associate significant satisfaction from being directly invested in the highest-quality hedge funds. Some clients do not simply look at risk as investing in a bad hedge fund, but also as missing out on the next Medallion!
Despite the fact that hedge funds report their performance weekly or monthly, and that decisions can typically be implemented only monthly, many clients review their portfolios daily. As a result, they feel the need to be constantly in touch with their hedge fund portfolio and events in the space.
These problems are more significant for a family office trying to move existing clients into a fund of funds. Experienced hedge fund investors tend to baulk at the idea of moving a mature portfolio that includes a significant proportion of closed high-quality hedge funds into a fund of funds where those legacy allocations could instead benefit other clients.
As a result, although the benefits for the family office in employing a fund of funds approach are clear, this is not necessarily what the client wants. Consequently, family offices that wish to pursue the commercial benefits of having a fund of funds, and the opportunities that it may allow tend to run both a fund of funds and bespoke account service.
The former can help the family office take on smaller clients, while providing a marketable track record that could lead to significant commercial opportunities. The latter ensures that the family office is able to continue to service its larger clients and attract those significant clients for which a bespoke managed account is the only option.
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