Does shift away from funds of funds mean diversification is dead?

4 May 2008

On Friday, Bloomberg reported that the proportion of hedge fund assets invested in funds of funds has decreased over the past 5 years while the proportion of assets invested in single manager funds has increased.  For a long time, fund of fund investors have defended the practice of paying “fees on fees” by saying they were actually paying the second layer of fees in exchange for “knowledge transfer”.  

Now it appears they weren’t kidding.  Bloomberg cites Pensions & Investments data that shows the proportion of US pension assets invested in funds of funds fell from 57% to 49% over the 2002-2007 time period.

Meanwhile, Euopean funds of funds seem to be doing just fine - this according to Global Pensions.  The magazine reported back in March that:

“European fund of hedge funds (FoHF) are increasingly being used by institutional investors, because confidence in FoHFs investments has risen, according to a report by Fitch Ratings…”

“Fitch expected continued growth in FoHFs, largely driven by increasing participation of institutional investors, and an evolving European regulatory environment trending towards quasi-retail onshore status for FoHFs.”

The Fitch study to which Global Pensions refers does points out that non-investors in funds of funds have avoided them, in part, due to the second layer of fees.  But the study also predicts overall growth for funds of funds in Europe (although it is silent with regard to the proportion of hedge fund investments made via funds of funds).  So it would appear that European institutions may still be interested in picking up a few tips from their fund of funds supplier before they send them packing. 

While it’s easy to think that hedge fund investors have grown tired of diversification and are now placing bets on their favourite horses, that’s not necessarily the case.  Many of the converts to so-called “direct investing” in hedge funds are now essentially running in-house funds of funds themselves (effectively with one client).

Which begs the question, with more stand-alone funds of funds considering IPOs, how long can such in-house operations resist spinning out their funds of funds into separate operating companies, bringing in other investors and extracting tangible value from all the “knowledge transfer” they paid for with all those double fees?   

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One Response to “Does shift away from funds of funds mean diversification is dead?”

1. Monday links: emotion and innovation « Abnormal Returns Says:
   May 5th, 2008 at 10:59 am

   […] The upshot of a shift away from fund of hedge funds. (All About Alpha) […]