Ideal Hedge Fund Terms:

For a host of reasons, hedge funds have not offered the most investor friendly terms. The cynical view is that hedge fund managers will get away with as much as they can. The fees are high, the performance fees are charged and cannot be reclaimed if there is a subsequent loss, the manager is drifting into markets and strategies managers are unused to, liquidity is unilaterally suspended just when investors need to exit… the list is endless.

The more charitable view is that hedge fund managers have little idea how a fund should be structured; they are traders and portfolio managers and have little time or attention to spend on fund structure and terms. To be sure this is a major failing since any business needs management of liabilities as much as assets. It is telling that we refer to them as asset managers because liability management often faces neglect. And so, here is my attempt at constructing a set of fund terms and principles which are hopefully fair to manager and to investor.

Overriding Principle:

The money is yours. It is my privilege to manage your money. It is not your privilege to invest with me. Your interests come first. If that was ever violated then I am out of business. I will treat your money better than my own.

Side Pockets:

You may opt out of my side pocket class. If you choose to opt in, I will not charge you management fees on the side pocket assets under management. I will only charge performance fees on side pockets and then only when cash is realized. I will let you know when I side pocket an investment and I will provide details of each investment. If I retroactively side pocket an investment, I will charge you no performance fees. Performance fees are charged only if the investment is designated to a side pocket at inception of the position.

Gates and Suspensions:

Depending on the strategy there may be gates or not. If I run a liquid strategy, I will exclude gating in the PPM. I will restrict the right of the directors or the manager to suspend NAV and redemptions except in specific instances which will be set out in the PPM.

If I suspend redemptions, I will cease to charge management fees. I will exclude performance fees for the duration of suspension as well. That is, any NAV appreciation during the period of suspension will not be subject to performance fees.

During suspension, you are de facto a senior creditor. I will provide you with total transparency subject to non disclosure agreements.

It is ridiculous and utterly criminal and sinful for me to hold on to money against your will and then charge you management fees for the privilege.

Strategies:

I will specify my strategy with as much specificity as I can while retaining flexibility to act. This will not be easy to do, but I will to the best of my ability, specify in the PPM, what I can or cannot do. If I want to add a strategy, I will inform you and you will have the opportunity to redeem costlessly before I implement a new strategy. This restricts my ability to act quickly, or to be nimble in taking advantage of any new opportunities, but you know what you get. Alternatively, I may run the new strategy in a side pocket which you can opt into immediately or at a later date. (I am going to have difficulties finding an Administrator who can do this cheaply for all of you.)

Reporting and Transparency:

I will provide you with timely reporting. Depending on the systems I can afford, I will report to you in real time, otherwise daily, otherwise weekly, otherwise monthly. I will provide you risk and exposure reports. I will provide you position level reports only where it does not endanger the fund. I will provide high level exposure reporting and I will arrange for the fund Administrator to provide independent confirmation to you so that you can perform your own reconciliation.

I will speak to you all once a month in a scheduled investor briefing. I will take questions at the end of the call. The call will be recorded for replay. Beyond this, my head of investor relations will be happy to schedule ad hoc calls, bearing in mind that you want me to dedicate substantially all my time managing your money.

Fees:

I will charge management fees on a reducing sliding scale just like some mutual funds. I tell you that my management fees are to cover the running costs of my business, well, my costs do not rise as a proportion to my assets under management. As for performance fees, I will reserve half of my performance fees in each period into a subordination reserve. This reserve will vest (be payable to me) on a rolling basis equal to any lock up I may have but in any case no earlier than 2 years. That is, if I lose money for you, 20% of the loss will be taken away from the reserve to repay you.

Alignment of interest:

I will invest X USD of my money in the fund. I will pay full fees, and be subject to the worst liquidity terms I offer any investor. Capacity in my fund will be some fixed multiple of my investment. If I redeem from my own fund, I will disclose this and force redeem investors to maintain this fixed multiple. I am not forced to invest any fees I receive into the fund but to the extent that I do, it increases the capacity of the fund. I will be the last man standing. My capital will be the last to leave the fund.

Despite the events of 2008, many managers still violate the overriding principle: that they are looking after other people’s money. Fortunately, most managers are not like that. For too long, investor have tolerated asymmetric terms in their contracts with the fund and the fund manager. Its time to change that.

This topic is open for discussion on our forum. Please click here to express your views.

2008 was a traumatic year for investors in pretty much any asset class or strategy. In 2009, I’ve been reading a number of investor surveys seeking to discover what investors want. I am as usual focusing in particular on the hedge fund industry.

 

Key findings:

 

1. Investors continue to favour larger hedge funds in the 1 to 5 billion USD range.
2. There is a decided preference for managed accounts.
3. Investors are against leverage of any sort.
4. Investors require better risk management and transparency from their managers.
5. Performance remains the number one factor in assessing a hedge fund manager.
6. Investors expect global macro, CTAs and equity long short to perform best going forward.
7. In terms of what they intended to invest in, investors preferred global macro, distressed credit, CTAs and credit long short.

 

It is difficult to comment on these findings without knowing the history and context of the investors. One can make a couple of simplistic observations.

 

1. If larger investors favour larger hedge funds, you will end up with the larger investors having more hedge funds in common. Also, you will end up having more hedge funds with investors in common. This creates a very interesting and amusing correlation through instrument variables. The investors are each others’ hidden instrument variables with the dual situation that the hedge funds are each others’ hidden instrument variables.
2. The case for and against managed accounts is best dealt with in more detail in another article. With a managed account one gets validation of assets, better liquidity, better transparency, no gating, independent valuation, ability to be the sole investor. Yes, maybe, yes, yes, yes, and yes. Validation of assets is unparalleled in a managed account especially if the managed account is established by the investor. Independent valuation is available through appropriately structured hedge funds. Better transparency is also unparalleled through a managed account but can be available through an appropriately structured hedge fund. No gating is definitely a plus. But better liquidity is not so clear. If the underlying assets are illiquid, the ability to sell them is really the ability to fire-sell them. Then it becomes, I want a managed account where I am the only investor who can fire-sell assets but I want everyone else in the fund to be gated or suspended. Not really feasible. If the assets are indeed liquid, a managed account means that the investor has full benefit of the liquidity of the underlying market. On the other hand, there are costs associated with managed accounts that require a minimum size which can be quite sizeable. The performance of the managed account may not track the performance of the commingled fund for all sorts of reasons. Some assets are not divisible. Timing issues can result in managed accounts not having the same portfolio compositions as the commingled fund. And there are a host of other issues which may be neither good nor bad but complicate the implementation and analysis of managed accounts.
3. See my article on Leverage on 17 March 2009: Leverage: Nothing is Good or Bad… 
4. Investors require better risk management and transparency from their managers. Transparency is one of the most important factors in the investment decision because at its heart is the ability to verify the representations made by a manager pre-investment. It allows investors to see if managers are doing as they say they would. Transparency goes beyond mere position level reports. Position level reports are useful to prove the assets and the strategy. Risk reports are useful and reduce the complexity of the position level reporting to a more manageable form. Having access to the manager and to the various people in the team are important elements of transparency as they provide not just the static snapshot of risk, or the historical trading behaviour but they also provide an insight into the views and intentions of the manager on a forward looking basis.
5. Performance is a difficult one. Everyone loves a fund that is generating good returns whether they are high or stable. But how does one distinguish between skill and luck? Track record is but one measure.  (See my article 22 Jan 2008 about The Importance of Track Record in Hedge Fund Investing)  See also my articles Skill and Luck 1, and Skill and Luck 2.
6. I find it quite interesting that investors expect global macro to do well going forward. At risk of being circular, the call that global macro should do poorly or well in a given year is a global macro call in itself. Thus, the only people who can claim that macro will do well at any particular point in time is someone qualified enough not to need to outsource macro to some guys who charge 2 and 20 to take your money to have a go at Roulette. If you don’t know whether macro will do well or not then you outsource to a macro manager whose head of marketing will tell you that macro will do well this year.
7. It is interesting to note that investors want to increase their allocations to credit hedge funds, a strategy which they do not have a strong opinion about in terms of returns.

 

Obviously there are more interesting things going on behind these findings and my comments are on the output without the benefit of the underlying data.

 

 

For those of us who have lived through major bear markets there is significant skepticism about the current equity market rally.

 

Reasons to be optimistic:

 

·          Economic data is improving. The extreme inventory destocking in late 2008 is being reversed. Housing prices are stabilizing. Housing transactions are rising.

·          China as an engine of growth. For now domestic consumption is muted and savings rates are too high but the infrastructure spend will boost growth.

·          Emerging Asia and Lat Am is replete with healthy companies at distressed valuations.

·          Markets have overshot on the downside and are exceedingly cheap.

·          Equity earnings yield gap is supportive of equities.

·          Government policy is extremely supportive of risky assets. And will continue to be until asset prices recover. TARP, TALF, QE, PPIF and so on.

·          The legacy loans program

·          Markets turn a good 12 months before the real economy recovers.

·          The market panic is over, investors are recovering from the initial panic.

·          Inflation will be positive in diminishing the real value of debt and encouraging consumption.

 

Reasons to be pessimistic:

 

·          TARP. TALF, PPIP, et al won’t work, or at least not as well as intended. The plans are short on detail but long on principles. There are a number of ways the plans might fail, some high probability ones. The government has now provided the capacity to purchase distressed assets from banks. They have not addressed the propensity for banks to sell. The market will likely remain thin and illiquid. The process will take too long.

·          Credit markets may be functioning again but the demand for credit is also diminished. There are mixed signals here. Companies are looking for credit to refinance existing debt and the recovery in credit markets is positive for them. Households will benefit from the Legacy Loans Program. The propensity to consume, however will take time to recover.

·          There is a crisis of unemployment which will take longer to resolve. The problem is global and likely to be protracted.

·          Economic problems become social order problems. Pockets of unrest have arisen in France, Eastern Europe, China.

·          The perma bears are waiting to short at around current levels.

·          Inflation may become a problem. So far expectation for deflation have not come true. In fact there are incipient signs of inflation.

 

It is always too early to tell if the market will recover. It is only knowable when the market has already recovered.

Most analysts are graduates with a straight ruler. They are quick to connect the line between two points and extend it indefinitely.

Different analysts have rulers of differing lengths.

 

My best guess is that the current rally may continue for another month but runs out of steam (1^st quarter results are not going to be pretty), equity markets make new lows in 2H 2009 and then we have a real recovery. Why? I think we have had the panic selloff and it lasted from September 2008 until March 2009. We are currently experiencing a relief rally. Such rallies can be quite strong. However, I do believe that the real economy still faces considerable problems which will take time to resolve. Equities are forward looking and should price a recovery a good 12 months ahead. I simply don’t see a sustained economic recovery before the latter half of 2010 or early 2011. This would put a sustained recovery in equity markets at late 2009 to early 2010.  Remember, this is a best guess. Would I trade on it? Ask me every 3 days.

 

Now equity markets lead recoveries but credit markets don’t. So, now, what was that about wanting to invest in distressed credit again?

 

 

We begin in the past:

Aggregation of capital to provide access to hedge funds. Most hedge funds accept minimum subscriptions of 1 million USD. For the smaller sized investor, this is too much to construct a diversified portfolio.

 

Aggregation of investors for hedge fund managers. Funds of funds also serve an intermediary function for hedge funds who would otherwise incur investor acquisition costs of their own. Fund of funds incur costs of acquisition of investor capital.

 

Risk management. Investing in hedge funds involves analyzing complex risk profiles and aggregating them into a portfolio in such a way as to optimize the return to risk characteristics.

 

Manager sourcing and due diligence. As hedge fund investing is all about identifying skill and talent, as it is widely held in the investor community that the majority of hedge funds are of poor quality, there are high search costs. These search costs involve analysis of complex strategies, identifying talent and skill, assessing the non-investment risks such as operational integrity, corporate governance and resource adequacy of a manager.

 

What has been achieved:

 

Using data from January 1990 to February 2009, we have a look at hedge fund returns and fund of funds returns. We use the HFRI Index to represent hedge fund performance, and the HFRI FOF Index to represent fund of hedge fund performance.

 

First of all, an interesting chart showing the correlation between hedge funds’ and fund of funds’ returns. Starting at around 0.75 in 1994, it has climbed steadily to 0.97 in 2009. You would expect to see high correlation since one is contained in the other. The explanation for lack of correlation is that funds of funds are somehow not tracking the performance of the underlying funds as closely. This can be good and bad. If one argues for the value added by a funds of funds, one would expect the correlation to be less than 1. The closer to 1, the less the value added since funds of funds then become a mere conduit. That the correlation has grown over time is an indication that the value added has fallen over time.

 

 

*reconstructed from data compiled by HFR

 

 

In the period, HFRI has returned an average of 11.8% per annum with a volatility of 7.10%. HFRI FOF has achieved an average 8.1% per annum with a volatility of 6.1%. It is possible to explain some of the differences by the fees that funds of funds charge for their services. Let us apply those funds of funds fees to the HFRI and see where we get. Lets assume that on average, a fund of funds charges 1% management fees and 10% performance fees. Funds of funds have a variety of fee structures but this one is quite representative. If a fund of funds simply invested in the HFRI and charged those fees, they would return 9.7% per annum with a volatility of 6.4%.

 

 

*reconstructed from data compiled by HFR

 

One is tempted to argue that funds of funds have been a failure. It is more interesting to analyze than to criticize, however, and funds of funds are a rich area for research. Let us make a simplistic start. Of the 4 main arguments for funds of funds, lets see which ones of them have failed, and what other problems have not been covered.

 

The first two purposes, I think, are easily fulfilled. Funds of funds have fulfilled their roles as intermediaries with benefits for both investors and fund managers. There are more tricky issues here which we will revisit.

 

Portfolio and risk management are functions where by and large funds of funds have been successful at. A few funds of funds run concentrated portfolios and may be underdiversified, if anything too many funds of funds run portfolios with overdiversification where the marginal diversification is tiny. Strategy specific funds of funds exist but their mandate is precisely to be concentrate by strategy. There are issues of correlation introduced laterally through the equity base which we will deal with when we revisit the intermediary functions.

 

It is i
n due diligence where many funds of funds have fallen down. There are two types of failures in due diligence. The first is where the fund of funds was unaware of a problem and the problem was thus unavoidable, and the second is where the problem is apparent but the fund of funds took a view. Madoff falls into the latter category. (See my earlier post on Madoff on 16 December 2008).

 

Problems faced by funds of funds:

 

Its not easy running a fund of funds. Some fund of funds managers have been careless, some have had poor judgment, some have are not all that bright, but for the most part, funds of funds are run by well trained professionals working within tough constraints in turbulent markets.

 

Size. This is one of the biggest problem with funds of funds. They are victims of their own success. Let’s be clear about this, not even the smallest fund of funds can always be nimble and shift allocations from one strategy to another, or from one manager to another. That just makes life difficult for everyone. As a matter of risk management, funds of funds rightly have concentration limits. Their capital often cannot represent more than 10% of the capital of a hedge fund they invest in. Thus a fund of funds can allocate no more than 10m to a hedge fund with 100m assets under management. In order for the allocation to be meaningful, a fund of funds does not want to invest with 1000 hedge funds, providing each one with 0.1% of their capital. So, funds of funds will have at the back of their minds, a target allocation of say between 3% to 6% of their capital per manager on average. This means that on average, a 1 billion USD fund of funds needs to deploy say 50m USD per manager, requiring that the average size of the manager themselves must be at least about 500m. For a 10 billion USD fund of funds, just multiply by 10. There are about 10 funds of funds managing between 15 billion to 30 billion USD last year. Not surprising, in a nod to our symbiosis hypothesis, there are about 10 hedge fund management groups managing between 20 billion to 40 billion USD.  Both numbers are smaller now. Still, there are not so many hedge funds out there with 5 billion USD under management. And so the larger funds of funds are forced into a smaller and smaller set of hedge funds to choose from.

 

Asset liability mismatches. This problem really came under the spotlight last year. Funds of funds usually give monthly or quarterly liquidity to their investors. They do this to attract investors, to make their products more palatable to their target investors. This, however, limits the type of funds that a fund of funds can invest in since they should match the duration of their assets to their liabilities. Some strategies are liquid, like equities, fixed income, macro. But others like credit, distressed, event driven and small caps and derivative strategies are not liquid. Some funds of funds take a view, limit their allocation to such strategies but invest all the same. It is hard to say what is the right limit, 10%? 20%? 30%? In a crisis, 10% is too much. In normal times, 50% is too little.

 

The industry is a cliquish and fashion driven one. The main centres of fund of funds management are Geneva, New York, London, with some up and coming centres like Hong Kong and Singapore. Everyone knows everyone, everyone is exchanging notes, seeing the same hedge fund managers and developing an industry wide Groupthink. In any industry, not just the fund of funds one, trends are often driven by the loudest voices. I can see no intuitive reason why decibels and IQ should correlate well.

 

Lets us return to the points about aggregation of capital by funds of funds on behalf of investors, and on the other side, on behalf of hedge fund managers. There are lots of interesting things going on here. The size issue overflows into the concept of funds of funds being aggregators. By construction, the larger funds of funds must invest in the larger hedge funds. This implies a high level of overlap in their portfolios. Large funds of funds have higher numbers of hedge fund managers in common. (It makes little sense therefore to diversify between large funds of funds.) Conversely, large hedge funds must have higher numbers of exposure to funds of funds in common. This dual overlap can and has been a toxic combination as investors seek to exit from their exposure to hedge funds as a whole.

 

The Future of Funds of Funds:

 

We have heard anecdotal evidence that funds of funds had redemptions of 30% of their assets in 2008 and that redemptions have continued in 2009 albeit at a much reduced rate. We hear about funds of funds redeeming from their underlying hedge fund investments in expectation of further redemptions. All the news is bad.

 

But funds of funds serve a very important role. The 4 functions they serve, risk management, diversification, aggregation of managers, aggregation of investors, continue to be valid. What has gone wrong is a problem of implementation. The devil has been in the details.

 

The asset liability mismatch has to go. This means that funds of funds will have to pass on the liquidity terms they receive to their investors. Some strategies such as distressed credit will be off limits to the existing funds of funds by reason of the monthly or quarterly liquidity that the funds of funds offer to their investors. More longer lock up funds of funds will emerge to service both the funds offering these less liquid strategies and the investors who want to invest in them.

 

Liability management will become as important as asset management. This means a bigger role for marketing, investor relations, for structuring of fund offerings and vehicles, for a greater variety of structures, for better analysis and management of investors. In asset management, liability management means the analysis of hedge funds’ investor bases, funding terms and requirements and stability of counterparties and counterparty arrangements.

 

The size issue is uncertain. Smaller funds of funds don’t suffer from the problems highlighted. Investors who cotton on to the size issues will adjust their allocations accordingly and help to smooth out the size distribution of funds of funds. On the other hand, some investors will demand size and scale as proxies for adequacy of resources. It is really not clear which side
is right or will dominate.

 

Standards of due diligence will be raised, whether or not this makes sense. For the most part it makes sense, but there will also be new optical embellishments. The hedge fund industry is not immune to image. With the new chassis, engine and suspension will come a new coat of paint. Too long has the industry been dominated by jargon, by assumption, by the signaling of a brand name. Investors will likely return to the roots of good due diligence – no question is too stupid to ask. And they will ask this of their funds of funds intermediaries as well.

 

Much faith has been lost in the funds of funds industry. Much money has been lost. The average fund of funds lost 20% in 2008. But many of the better ones, smaller ones, lost between 9% to 12%. Those have done well against any other alternative save cash and treasuries. But how will the industry organize itself going forward? What investor class will it target? I argue that retail investors need hedge funds in their portfolios but don’t have the means and resources to do so. What improvements will funds of funds bring to their processes and products?

 

These questions I invite you to answer on my Forum. What is the Future for Funds of Hedge Funds?

This topic is open for discussion on our forum. Please click here to express your views.

 

We begin in the past:

 

In the financial market collapse of 2008, one area of particular decline has been the fund of funds industry. Many fund of funds run to a greater or lesser degree, an asset liability mismatch. That is, they provide better liquidity terms than they receive from the hedge funds they invest in. The reasons for the existence of funds of funds include:

 

1.        Aggregation of capital to provide access to hedge funds. Most hedge funds accept minimum subscriptions of 1 million USD. For the smaller sized investor, this is too much to construct a diversified portfolio.

 

2.        Aggregation of investors for hedge fund managers. Funds of funds also serve an intermediary function for hedge funds who would otherwise incur investor acquisition costs of their own. Fund of funds incur costs of acquisition of investor capital.

 

3.        Risk management. Investing in hedge funds involves analyzing complex risk profiles and aggregating them into a portfolio in such a way as to optimize the return to risk characteristics.

 

4.        Manager sourcing and due diligence. As hedge fund investing is all about identifying skill and talent, as it is widely held in the investor community that the majority of hedge funds are of poor quality, there are high search costs. These search costs involve analysis of complex strategies, identifying talent and skill, assessing the non-investment risks such as operational integrity, corporate governance and resource adequacy of a manager.

 

 

 

What has been achieved:

 

Using data from January 1990 to February 2009, we have a look at hedge fund returns and fund of funds returns. We use the HFRI Index to represent hedge fund performance, and the HFRI FOF Index to represent fund of hedge fund performance.

 

First of all, an interesting chart showing the correlation between hedge funds’ and fund of funds’ returns. Starting at around 0.75 in 1994, it has climbed steadily to 0.97 in 2009. You would expect to see high correlation since one is contained in the other. The explanation for lack of correlation is that funds of funds are somehow not tracking the performance of the underlying funds as closely. This can be good and bad. If one argues for the value added by a funds of funds, one would expect the correlation to be less than 1. The closer to 1, the less the value added since funds of funds then become a mere conduit. That the correlation has grown over time is an indication that the value added has fallen over time.

 

 

 

 

*reconstructed from data compiled by HFR

 

 

In the period, HFRI has returned an average of 11.8% per annum with a volatility of 7.10%. HFRI FOF has achieved an average 8.1% per annum with a volatility of 6.1%. It is possible to explain some of the differences by the fees that funds of funds charge for their services. Let us apply those funds of funds fees to the HFRI and see where we get. Lets assume that on average, a fund of funds charges 1% management fees and 10% performance fees. Funds of funds have a variety of fee structures but this one is quite representative. If a fund of funds simply invested in the HFRI and charged those fees, they would return 9.7% per annum with a volatility of 6.4%.

 

 

*reconstructed from data compiled by HFR

 

One is tempted to argue that funds of funds have been a failure. It is more interesting to analyze than to criticize, however, and funds of funds are a rich area for research. Let us make a simplistic start. Of the 4 main arguments for funds of funds, lets see which ones of them have failed, and what other problems have not been covered.

 

The first two purposes, I think, are easily fulfilled. Funds of funds have fulfilled their roles as intermediaries with benefits for both investors and fund managers. There are more tricky issues here which we will revisit.

 

Portfolio and risk management are functions where by and large funds of funds have been successful at. A few funds of funds run concentrated portfolios and may be underdiversified, if anything too many funds of funds run portfolios with overdiversification where the marginal diversification is tiny. Strategy specific funds of funds exist but their mandate is precisely to be concentrate by strategy. There are issues of correlation introduced laterally through the equity base which we will deal with when we revisit the intermediary functions.

 

It is in due diligence where many funds of funds have fallen down. There are two types of failures in due diligence. The first is where the fund of funds was unaware of a problem and the problem was thus unavoidable, and the second is where the problem is apparent but the fund of funds took a view. Madoff falls into the latter category. (See my earlier post on Madoff on 16 December 2008).

 

Problems faced by funds of funds:

 

Its not easy running a fund of funds. Some fund of funds managers have been careless, some have had poor judgment, some have are not all that bright, but for the most part, funds of funds are run by well trained professionals working within tough constraints in turbulent markets.

 

Size. This is one of the biggest problem with funds of funds. They are victims of their own success. Let’s be clear about this, not even the smallest fund of funds can always be nimble and shift allocations from one strategy to another, or from one manager to another. That just makes life difficult for everyone. As a matter of risk management, funds of funds rightly have concentration limits. Their capital often cannot represent more than 10% of the capital of a hedge fund they invest in. Thus a fund of funds can allocate no more than 10m to a hedge fund with 100m assets under management. In order for the allocation to be meaningful, a fund of funds does not want to invest with 1000 hedge funds, providing each one with 0.1% of their capital. So, funds of funds will have at the back of their minds, a target allocation of say between 3% to 6% of their capital per manager on average. This means that on average, a 1 billion USD fund of funds needs to deploy say 50m USD per manager, requiring that the average size of the manager themselves must be at least about 500m. For a 10 billion USD fund of funds, just multiply by 10. There are about 10 funds of funds managing between 15 billion to 30 billion USD last year. Not surprising, in a nod to our symbiosis hypothesis, there are about 10 hedge fund management groups managing between 20 billion to 40 billion USD.  Both numbers are smaller now. Still, there are not so many hedge funds out there with 5 billion USD under management. And so the larger funds of funds are forced into a smaller and smaller set of hedge funds to choose from.

 

Asset liability mismatches. This problem really came under the spotlight last year. Funds of funds usually give monthly or quarterly liquidity to their investors. They do this to attract investors, to make their products more palatable to their target investors. This, however, limits the type of funds that a fund of funds can invest in since they should match the duration of their assets to their liabilities. Some strategies are liquid, like equities, fixed income, macro. But others like credit, distressed, event driven and small caps and derivative strategies are not liquid. Some funds of funds take a view, limit their allocation to such strategies but invest all the same. It is hard to say what is the right limit, 10%? 20%? 30%? In a crisis, 10% is too much. In normal times, 50% is too little.

 

The industry is a cliquish and fashion driven one. The main centres of fund of funds management are Geneva, New York, London, with some up and coming centres like Hong Kong and Singapore. Everyone knows everyone, everyone is exchanging notes, seeing the same hedge fund managers and developing an industry wide Groupthink. In any industry, not just the fund of funds one, trends are often driven by the loudest voices. I can see no intuitive reason why decibels and IQ should correlate well.

 

Lets us return to the points about aggregation of capital by funds of funds on behalf of investors, and on the other side, on behalf of hedge fund managers. There are lots of interesting things going on here. The size issue overflows into the concept of funds of funds being aggregators. By construction, the larger funds of funds must invest in the larger hedge funds. This implies a high level of overlap in their portfolios. Large funds of funds have higher numbers of hedge fund managers in common. (It makes little sense therefore to diversify between large funds of funds.) Conversely, large hedge funds must have higher numbers of exposure to funds of funds in common. This dual overlap can and has been a toxic combination as investors seek to exit from their exposure to hedge funds as a whole.

 

The Future of Funds of Funds:

 

We have heard anecdotal evidence that funds of funds had redemptions of 30% of their assets in 2008 and that redemptions have continued in 2009 albeit at a much reduced rate. We hear about funds of funds redeeming from their underlying hedge fund investments in expectation of further redemptions. All the news is bad.

 

But funds of funds serve a very important role. The 4 functions they serve, risk management, diversification, aggregation of managers, aggregation of investors, continue to be valid. What has gone wrong is a problem of implementation. The devil has been in the details.

 

The asset liability mismatch has to go. This means that funds of funds will have to pass on the liquidity terms they receive to their investors. Some strategies such as distressed credit will be off limits to the existing funds of funds by reason of the monthly or quarterly liquidity that the funds of funds offer to their investors. More longer lock up funds of funds will emerge to service both the funds offering these less liquid strategies and the investors who want to invest in them.

 

Liability management will become as important as asset management. This means a bigger role for marketing, investor relations, for structuring of fund offerings and vehicles, for a greater variety of structures, for better analysis and management of investors. In asset management, liability management means the analysis of hedge funds’ investor bases, funding terms and requirements and stability of counterparties and counterparty arrangements.

 

The size issue is uncertain. Smaller funds of funds don’t suffer from the problems highlighted. Investors who cotton on to the size issues will adjust their allocations accordingly and help to smooth out the size distribution of funds of funds. On the other hand, some investors will demand size and scale as proxies for adequacy of resources. It is really not clear which side is right or will dominate.

 

Standards of due diligence will be raised, whether or not this makes sense. For the most part it makes sense, but there will also be new optical embellishments. The hedge fund industry is not immune to image. With the new chassis, engine and suspension will come a new coat of paint. Too long has the industry been dominated by jargon, by assumption, by the signaling of a brand name. Investors will likely return to the roots of good due diligence – no question is too stupid to ask. And they will ask this of their funds of funds intermediaries as well.

 

Much faith has been lost in the funds of funds industry. Much money has been lost. The average fund of funds lost 20% in 2008. But many of the better ones, smaller ones, lost between 9% to 12%. Those have done well against any other alternative save cash and treasuries. But how will the industry organize itself going forward? What investor class will it target? I argue that retail investors need hedge funds in their portfolios but don’t have the means and resources to do so. What improvements will funds of funds bring to their processes and products?

 

These questions I invite you to answer on my Forum. What is the Future for Funds of Hedge Funds?