Infovest21 Investor Focus: The Value-Added of a Fund of Funds

The financial crisis of 2008, the Madoff Ponzi scheme and other similar frauds, relatively disappointing returns in 2008 and 2009, liquidity mismatch, the pressure on fees, lack of transparency, the growing knowledge and experience of pensions and consultants with hedge fund, as well as increasing institutional requirements for control and transparency have taken a toll on institutional usage of funds of funds.
Various surveys provide statistics showing pensions taking a more direct investing approach to hedge funds rather than the funds of funds route especially those that have in-house capability to select hedge fund managers.

A recent Preqin survey found that of the institutional investors they surveyed, most have been investing since 2001. When these institutions first made their hedge fund investment, 64% selected fund of funds, 24% used a combination of funds of funds and single managers while only 12% allocated to single managers. Today, the survey found 31% of respondents invest directly with single managers, 34% use a combination of single managers and funds of funds, and 35% are now solely invested in funds of funds.

Another example: Towers Watson said it did nine searches for funds of funds in 2009, down about 80% from 43 searches in 2008.

Asset flows
HFR said funds of funds lost $187 billion in assets from the first of 2008 through mid 2010. In the second quarter of 2010, funds of funds had a $2 billion outflow. Only 31% of funds of funds experienced inflows compared with 59% of all single manager funds in the first quarter of 2010. In this same time frame, hedge funds had inflows of $9.5 billion.

Lois Peltz, president of Infovest21, says, “Another way to look at the situation is to determine the percentage of the industry assets funds of funds represent compared with the total hedge fund industry. In 2010, funds of funds represent about 34% of the industry, down from 59.3% in 2005 and 54.5% in 2006. However, funds of funds had been as low as 18.3% of industry assets in 1999 and as high as 78.8% in 1992.”

Increasingly sophisticated investors are asking funds of funds about the value added they provide i.e. what are they doing to justify their fees. Access to top managers means less than it used to as a number of top managers opened up in the past few years to replenish their assets.
Avoiding manager mistakes, providing strong liquidity management, providing specialist or niche products are some of the ways funds of funds are adding value today. Some are moving more assets toward managed accounts so they can provide more transparency, liquidity and control to the investor. Other large funds of funds are going one step further and providing active management.

Excerpt from Infovest21's June issue of Investor Focus.