Despite recovery, long-term misalignments remain in fund of funds sector
Oct 18th, 2009 | Filed under: Hedge Fund Industry Trends, Today's Post
By: Dr. Bob Swarup, CAIA, AllAboutAlpha.com Editorial Board.
Last month, I talked about the painful journey the hedge funds of funds industry has endured over the last 18 months, with an unceasing barrage of criticism over the complacency of past years and the poor returns of 2008 only compounded by the unfortunate timing of Bernie Madoff’s decision to finally explain his three card trick to the audience. The result was a watershed moment for the industry, emphasizing how detached it had become from the investor community and its changing needs.
In many ways, one could term this an adolescent phase typical of any industry moving past its ‘cottage’ roots. The onus is now on funds of funds to demonstrate that they have learned from experience. Although the rally in recent months has alleviated the pressure somewhat, it should not be taken as an excuse to postpone the inevitable growing up that the industry has to do. Correcting the long-term misalignments between investors and funds of funds will be key to the recovery and future prosperity of the latter.
The rewards are potentially high. Many institutional investors are still committed to increasing their alternatives allocations and a recent survey by Bank of New York Mellon and Casey Quirk predicted that hedge funds could expect some $800bn in net inflows over the next four years. Funds of funds were predicted to capture almost 60 per cent of these net inflows – if they adapted to what investors want.
Like driving a Motorbike through a minefield, blindfolded
So what needs to change? In short, hedge funds of funds need to re-examine and reaffirm their value proposition to the end investor. The old adages of aggregation of capital, careful risk management and due diligence will need to be rethought and understood in a wider context.
Funds of funds need to appreciate that notwithstanding the oft-touted strength of their due diligence and the caliber of their portfolio construction, they are always an exercise in asset-liability management like most financial institutions – a point amply illustrated by the below schematic of the archetypal hedge fund from the BONY Mellon / Casey Quirk report… More…
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A few legitimate themes cascade from this article. Among them are:
A – What were the resources that the fund of funds deployed to filter throughout the hedge fund universe? did these resources really understand the mechanics of deriving absolute returns? and for those who relied on the quantitative filters, did they apply or discount the liquidity premium to the “attractive” return profiles?
B – The liability mismatch sure indicates that the “hedge fund” universe should be categorized in two buckets: (1) the liquid and nimble ones that deploy a strategy within the most liquid assets and able to offer the liquidity and (2) the less liquid, quasi private equity (shareholder activist, distressed debt, etc) with longer term horizons.
After speaking with, and following the developments, of so many in the universe of hedge funds: those in the first bucket (liquid and nimble) are more prone to derive the absolute returns and dislocate from the broad equity draw-downs (referring to those that deploy real hedge fund strategies); and those in the second bucket require the short-term pain (including in liquidity dry-ups) for the benefit of the long term gain.
Perhaps the fund of funds should distinguish themselves within the two to better match investors’ liquidity and return profile expectations.
A useful summary of a number of key themes. Over the last year or so a few things have become crystal clear:
1. The classical fund of fund business model is likely to need to change significantly in the coming years to respond to new market conditions and investor preferences
2. There is still a clear need for a fund of funds (or asset aggregator) in the investment structure as most true end investors still do not have either the scale or expertise to invest directly
Clearly the fund of funds/intermediary business is evolving quickly and we are seeing a large interest in the development of fund of managed account structures as one way of meeting the new breed of investor expectations. There are obviously other ways and my clear feeling is that the industry will stratify, either in terms of firms or products, into buckets of liquidity or risk (very much agreeing with the comment from Rene above). In the past, we all know there was very much a one size fits all approach for many.
Another key point to consider is fiduciary responsibility and how dis-intermediation of the fund of funds alters this: it is a big question and one that can have significant implications if not fully understood.