The hedge fund of funds marketplace has experienced net redemptions four years in a row, and that trend is expected to continue in 2012. However, Agecroft Partners has observed some hedge fund of funds have thrived during this time period by focusing on a specific niche in the marketplace.
There will always be a place for hedge fund of funds within certain sectors of the hedge fund investor community, and those hedge fund of funds that can change with the evolving landscape will be the most successful going forward.
We will examine some of the major trends in the industry along with three niche areas that some hedge funds of funds have leveraged to successfully raise assets. These three areas are: Strategy Focus, Fund Structure, and Investor Segment.
Over the past decade, most of the flows into the fund of funds industry have come from large institutional investors. In the past, this group of investors has been more focused on the perceived security provided by the size, brand and infrastructure of a firm as opposed to pure performance. Many of these larger institutions invested in multiple fund of funds in an attempt to diversify their exposure, however, they did not realize that many of the largest fund of funds may have had a significant overlap in underlying managers. In addition, investment performance from some of these large organizations has not always met expectations.
As large institutional investors continue to increase their knowledge of alternative investments, two major trends are developing within the fund of fund industry.
The first trend is for multi-billion dollar pension funds to save on fees by moving away from multi-strategy fund of funds and invest directly with funds utilizing the help of a hedge fund consultant. This trend is the primary reason why industry fund of fund assets have been declining, but it typically only effects the largest fund of funds organizations that were able to raise significant capital from the large pension funds. These large fund of fund organizations will continue to bring in significant business, but not necessarily enough to replace the assets that are being redeemed.
The second trend we are seeing within the pension fund industry is the growing utilization of a hub and spoke approach to fund of funds investing. This approach involves a hub investment in one of the largest fund of funds as the core hedge fund allocation, with the spokes being made up of niche fund of fund strategies. These niche fund of funds will also be tapped as best-in-breed managers in other parts of institutional investorsâ€™ portfolios in addition to the hedge fund allocation. The growth of niche fund of funds investing should have the effect of increasing the number of fund of funds, with a larger percentage of assets flowing to mid-sized firms.
Although the largest pension funds will more frequently bypass fund of funds, a majority of pension funds will continue to get their hedge fund exposure through fund of funds. In addition, we expect strong flows from retail investors into fund of funds.
Strategy Focus Niche
It is very difficult for investors to differentiate between fund of funds unless there is a clearly defined advantage to adding them to the portfolio. Some managers have been very successful in raising assets by focusing on niche strategies with limited competition. Billions of dollars have been flowing to firms that focus on:
Global Macro/CTA – After the significant drawdown in performance for investors during the 4th quarter of 2008 and early 2009, investors took notice of the lack of correlation of these two strategies relative to other hedge fund strategies as well as long-only benchmarks. In order to increase downside performance protection and protect against â€œtail riskâ€?, investors have significantly added to these strategies. While industry-wide hedge fund assets today are slightly above 2007 levels, assets dedicated to the Global Macro/CTA space have increased from $288 billion to $433 billion at the end of the third quarter 2011, based on Hedge Fund Research data.
Commodities – There is growing concern among many investors that the purchasing power of their investments will be eroded by rising inflation. This concern is driven by two primary factors, including the weakening of the dollar and increased competition for commodities. The weakening of the dollar stems from growing trade and federal deficits. At some point these pressures could be greatly enhanced if other countries lose faith in the dollar. Large selling by China and Japan would be devastating to the currency. Global competition for commodities is steadily increasing as developing nations like China and India modernize their economies, which will put upward pressure on commodity prices. A strong trend by institutional investors is to allocate a portion of their portfolio to real assets, including commodities. A few fund of funds dedicated to commodities have greatly benefited from this trend.
Seeder/Accelerator Funds – Many hedge fund investors require a hedge fund to have a minimum of $100 million in AUM before they will consider investing in that hedge fund. This has caused significant demand by smaller hedge fund managers for seeder or accelerator capital. Seeders/Accelerators agree to invest a large amount of assets into the hedge fund, and in return, they receive both the performance generated by the fund on their investment and a quasi-equity position in the firm, usually by sharing in the revenues on all assets of the fund. Seeders can generate significant returns if they pick a fund that performs well and significantly grows its asset base. Many fund of funds that allocate a percentage of their assets to feeder funds have generated good returns and seen positive asset flows.
Emerging and Mid-Sized Manager Focus â€“ This is an area that is beginning to see increased investor focus because some studies have shown that smaller managers consistently out-perform larger managers. These mangers are much more difficult to identify and perform due diligence on than the largest, most well-known managers. Those fund of fund managers with a particular skill in this space should see increased demand. These type of funds also add diversification to pension fund portfolios since most pension funds are investing either directly or indirectly into the largest hedge fund managers.
Other niche strategies – There are many other niche strategies in the marketplace today that we expect to see large flows going forward. Some of these include focuses on long short equity, credit, and emerging markets.
Fund Structure Niche
Being a first mover in adopting a new fund structure can lead to significant asset flows with little competition. Over time these structures are adopted by more and more funds, increasing market competition, but still providing the first movers a sustained advantage due to their market share. While the fund of fund marketplace as a whole has seen assets decline, funds with the following structures have seen their assets surge. Each of these structures has strengths and weakness for investors. These structures include:
Managed Account Platforms – After the Madoff fraud and the proliferation in 2008 of hedge funds putting up gates and suspending redemptions, the demand for managed account platforms has exploded. Many of these platforms offer daily liquidity, full transparency of underlying investments and sophisticated risk analytics. Several of the hedge fund platform providers offer not only their own fund of funds, but allow investors to customize their portfolios.
Undertakings For The Collective Investment Of Transferable Securities (UCITS) – These funds can be sold within all the European Union countries, provided that the fund is registered within one of those countries. Like managed account platforms, these fund structures saw a significant increase in popularity after the market meltdown of 2008. These funds typically offer daily liquidity with low minimum investment requirements, opening up the hedge fund marketplace to many retail investors.
â€˜40 ACTâ€™ Funds – These are mutual funds that comply with the US Investment Company Act of 1940 and are often sold by leveraging the retail client base of large broker dealers. A few firms have raised billions of dollars in assets over the past few years. However, the number of new players into the marketplace is increasing exponentially.
Tax Advantaged Structures – These are hedge funds with insurance wrappers that allow US taxable investors to defer paying taxes on gains well into the future.
Fund of One – This business model creates a feeder fund into a large hedge fund. This feeder fund typically has a low investment minimum that provides some high net worth investors an opportunity to invest in a hedge fund for which they would not ordinarily meet the minimum. Investors are given a choice of which hedge funds they would like to participate in.
Investor Segment Niche
Some hedge fund of funds have developed very focused marketing strategies that target specific market segments. This approach allows them to develop strong brands within targeted investor segments. Certain investor segments find it reassuring that other investors of their type are also investing with the manager:
Insurance Companies â€“ The assets in this market place are huge, and many of the companies are increasing their allocations to hedge funds in order to increase the return on their investment portfolios, which have declined over time due to the reduction in interest rates. Knowing the regulatory issues faced by insurance companies and having a fund that is structured to address this industry specific need gives a manger a strong advantage over its competition. A successful marketing campaign also requires the fund of funds to identify which companies to call on and who the correct contact is at each company. While this includes a significant investment in time and research, the payoff can be large. This is a market where many people know each other and share ideas between companies, which can magnify a focused marketing campaign.
Regional Focus – Some firms have developed strong brands by focusing on a specific country or region. In a specific country these firms have the advantage of similar language and culture that provide a feeling of trust. Other firms in the US focus on the cities they are located in and build strong networks with local accounting firms, trust attorneys and local advisory firms. Many less investment knowledgeable high net worth individuals like to keep their money locally. This business model is beginning to see increased competition from the proliferation of endowment model managers and hedge fund of fund wholesalers.
Retail Financial Advisors – The largest brokerage firms dominate the wealth management space, but independent regional firms are catching up. Most of these firms have an approved list of fund of funds that their advisors can recommend to clients. In order to effectively gain assets from this distribution source, fund of funds must get on the approved list of the individual firm and then provide a very focused â€œwholesaleâ€? sales approach whereby they are continually traveling to the brokerage firmâ€™s larger offices and meeting with top producers. This is a relationship and trust business where a long-term approach of repeat visits to offices can lead to sales success.
With over 2000 fund of funds, this marketplace is one of the most competitive industries. Unless a fund of fund firm is one of the largest in the industry or has generated one of the top historical track records, it is imperative to identify a market niche within which they can excel. Although the industry is facing some headwinds, those that have been able to create a differential advantage should be able to effectively raise assets.
Don Steinbrugge is the founder and managing member of third-party hedge fund marketing firm Agecroft Partners.
The opinions expressed in this guest article do not necessarily reflect the opinions of eVestment|HFN or its affiliates. Nothing herein shall constitute investment advice or tax advice.