Under Pressure, Funds of Hedge Funds Evolve

Now More Consultative, Customized

Asset managers are revamping their fund-of-hedge-funds (FoHF) strategies as public pension funds become pickier within the asset class. With many investors pushing for lower fees, higher returns and more transparency, managers are adjusting funds and offering customized strategies.

Total FoHF assets under management worldwide dwindled to $811 billion as of Aug. 31, down from a peak of $1.2 trillion in 2008, according to data firm Preqin. As a result, some managers have exited the space altogether: Preqin recorded 158 new FoHF launches in 2010, 87 in 2011 and 77 in 2012. Only 45 new funds had been launched through August of this year.

Managers that have continued to deliver FoHFs have been forced to refurbish their strategies in order to retain clients and draw interest from prospects. “I think managers are trying to get more creative and find unique opportunities,” said Mike Mikytuck, director of business development at FoHFs manager Benchmark Plus. Firms such as Benchmark are now offering advisory and risk management services to complement investment strategies, he said, while others are marketing new, nichier strategies.

Push From Pension Funds

Much of the pressure on FoHF managers is coming from pension funds. Many pension funds are either shifting to direct investments or axing their hedge fund allocations altogether, albeit for different reasons.

Fees are the cause of contention for many. The $16.7 billion Los Angeles Police & Fire Pension System recently slashed its hedge fund bucket, primarily because of fees. The pension plan’s FoHFs portfolio made up just 3.77% of its assets, but accounted for 17% of its investment management fees, according to documents from a May 2 board meeting. The fund has since decided to reduce its hedge fund allocation to 2% and is keeping just a single investment with Bridgewater Associates.

The $2 billion Oklahoma Police Pension & Retirement System also dropped its FoHF investments because of fees. Last year, the pension fund terminated a $74 million contract with Attalus Capital and began looking to directly invest approximately $100 million in 10-15 hedge funds. Previously, it had invested in 25 hedge funds through Attalus. “It’s going to save us a large amount of money—over a million dollars in fees,” Executive Director Steve Snyder told GMMQ earlier this year. “We’re reducing [the amount of hedge funds], but we think we’re going to get more bang for the buck now.”

Other funds that have already shifted to direct investments or are in the process of doing so include the Massachusetts Pension Reserves Investment Management Board, the Fort Worth Employees’ Retirement System, the Kern County Employees’ Retirement Association, the Kentucky Retirement Systems and, most recently, the Teachers’ Retirement System of the State of Illinois. Many funds either hire more internal investment staff or a specialist consultant to assist with the transition. Both Kern County and Fort Worth selected Albourne America as their consultant; Fort Worth also added a new staff member to its internal team. MassPRIM brought on Eric Nierenberg, a former portfolio manager at Lee Munder Capital Group, to serve as a senior investment officer for hedge funds and low-volatility strategies. And Illinois Teachers’ is in the process of searching for both a hedge fund consultant and risk management advisor.

Returns also play a role. L.A. Fire & Police found that as of March 31, its FoHFs portfolio underperformed the S&P 500, the Barclays U.S. Aggregate Bond index, and its benchmark, T-Bills +4%, in all periods except for the one-year period, according to fund documents. The $10.3 billion New Mexico Educational Retirement Board recently cut its FoHFs allocation from 8% to just 3% of its portfolio and is adding direct investments because of underperformance. “We just found that it did not perform very well in up markets or down markets,” said CIO Bob Jacksha. “We said, ‘Okay, we’re not getting the performance we want and we’re paying more than we want.’”

Mikytuck said this kind of disillusionment is common. “Everyone is looking at returns, and when you compare the three-year S&P return to the three-year hedge fund return, hedge funds appear lacking,” he said. “So people wonder why they are taking on the extra risk, fees, and headline exposure of hedge funds for low returns. While investors still like the attributes of hedge funds, they want products with a higher return.”

Takin’ Care Of Business

To adapt to investors’ changing demands, many FoHF managers are taking on new roles and working with clients on a case-by-case basis. “We’re seeing more of an advisory role for the asset manager,” said Peter Hill, global head of fund-of-hedge-fund services at Citi. “They’re not necessarily sticking to the core commingled vehicle—it’s more of a discussion, where they’re sitting down with their clients and designing a strategy that works for them.”

Grosvenor Capital Management adopted this kind of a relationship with Oklahoma Police when it decided to invest directly in hedge funds. Although the pension fund terminated Attalus, it kept a $214 million account with Grosvenor. As the fund scoured the market for hedge fund managers, Grosvenor provided back office work and research, Snyder said. Oklahoma Police also looked at Grosvenor’s “stable” of more than 600 hedge funds when it was determining where to invest. Grosvenor did not return phone calls for comment.

This type of relationship can be appealing to many pension funds, which are looking for more leeway and control over their investments. “Investors are looking for flexibility, and you definitely have more flexibility if you’re going out of the commingled vehicle and into a managed account,” Hill said. Accessibility is another plus: “The level of transparency that investors are demanding these days is definitely a lot higher than it was in the past,” he said. “Investors are getting more data from their managers.”

Some asset managers are letting others take on advisory services and are instead focusing their efforts on new products. Benchmark Plus is rolling out its Singulus Fund, which Mikytuck described as a “best ideas” strategy. “It’s going to comprise not a dozen hedge fund managers, but a dozen hedge fund-like trades,” he explained. “So we’re working with managers to source individual investment opportunities—we’re hiring the hedge funds and using them for just one trade.”

Benchmark Plus has also launched so-called “tracker funds,” which achieve exposure to long/short equities by mimicking hedge fund indices. As funds consider different ways to invest in hedge funds, these replication strategies have proved popular as well. MassPRIM’s Nierenberg recently said that he is considering the space because it is less volatile, in addition to “uncorrelated, even esoteric, trading strategies.”

As investors search for new types of FoHF strategies, managers say the asset class will undergo changes but will not go away completely. “Investors like that hedge funds have flexible mandates and are able to access unique sectors of the market,” Mikytuck said. “There’s also this pervasive hope that hedge funds will be able to avoid the next downturn, like 2008. Fund-of-hedge-fund managers are starting to see more interest in long/short equity strategies,” he added. “Investors like their ability to be flexible and to moderate exposure in case the market turns down.”


Article originally appeared in Money Management Intelligence and Global Money Management Quarterly. Link here (paywall).


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