Infovest21 Investor Focus - Survival of the adaptable

Large US pensions are increasing direct allocations to hedge funds.

Of the ten US public funds with the largest allocations to hedge funds, Massachusetts Pension Reserves Investment Management and Pennsylvania State Employees’ Retirement System are the only two pensions solely invested in funds of funds. Meanwhile, Pennsylvania Public School Employees’ Retirement System, Virginia Retirement System, The Teachers Retirement System of Texas, New York State Common Retirement Fund and the Texas County & District Retirement System are 100% invested directly in hedge funds.

MassPRIM recently decided that about $500 million of the $3.5 billion allocated to funds of funds will now be diverted to direct allocations in hedge funds. A reassessment will take place by year-end 2011 and the pension will decide whether more should be allocated to hedge funds directly.

MassPRIM says the move will prevent manager overlap, provide transparency and save about $4.2 million in fees. It paid about $30 million in fees to funds of funds. Transparency was also an issue for MassPRIM as it didn’t immediately know the extent of its exposure to Level Global when the hedge fund was raided by the FBI in November 2010. MassPRIM’s funds of funds - K2 Advisors, Rock Creek and Grosvenor Capital - had each allocated to Level Global with $24.7 million, $13.3 million and $10.7 million respectively. Arden Asset Management had invested $11.6 million with Diamondback Capital Management, which was another firm raided by the FBI in November.

Lois Peltz, president of Infovest21, points out that performance is another reason the large US public pension funds are increasingly allocating directly to hedge funds. "The average hedge fund outperformed funds of funds in six of the seven past years. The largest differentials occurred in 2009 and 2010," she said.

At Infovest21 ’s Investor Seminar on Pension Underfunding and Its Implications for Hedge Funds/Funds of Funds,” Don Steinbrugge, chairman of Agecroft Partners, pointed out that over a certain mandate size – perhaps $100 million – pensions will eventually directly allocate to a manager rather than use a fund of funds. “Most of the pensions that have gone direct had done so recently. Approximately 80% have done so in the past three years,” he adds.

A number of surveys support this trend toward direct investing.

• A Pensions & Investments survey found the largest institutional allocations’ direct investment in hedge funds increased 75.6% to $77.8 billion through September 2010. In comparison, investing via funds of funds increased 20.8% to $31.9 billion.
• Cliffwater’s survey found 49% of the US systems invest directly in hedge funds while 33% only invest through funds of funds. Another 18% of the systems do both - invest directly in hedge funds and through funds of funds.

On an asset weighted basis, 64% of hedge fund investments are invested directly and 36% through funds of funds.

Funds of funds take a more solutions-based approach
Yet, most industry observers say funds of funds serve a function and are here to stay. Their role, however, is changing.

“Many funds of funds aren’t adapting; many are in denial. Some won’t negotiate fees or do separate accounts. The Darwinian approach may take form - and in some ways already has - where it's not the strong that survive but the adaptable. The entrepreneurs who, while sticking to their knitting, are constantly evaluating the most effective and efficient methods for delivering the information, for aggregating the data and providing insight on how alpha was generated, how beta was mitigated and the investment instruments appropriate to those decisions,” said Rachel Minard, executive managing director at Optima Fund Management at the Infovest21 Pension Underfunding Seminar.

Most effective are those funds of funds which are changing their business model to accommodate the new institutional obligation of the partnership.

Some funds of funds are taking a more solutions-based approach i.e. developing advisory businesses. Those funds of funds say they find themselves competing against consultants, specialist consultants, wealth managers and multi-strategy funds.

“Some of the better consultants are looking holistically at their investors' portfolios to determine which hedge funds are appropriate versus just hiring a product. People aren’t selling products anymore – they’re selling solutions-oriented programs. That is why many hedge fund specialist consultants are getting so much business now: they empower the institution by their selecting which funds meet the investors' risk and return targets, keeping the discretion squarely with the fiduciary but having this large trough by which to evaluate and cross-reference hedge fund options against their existing holdings,” adds Minard.

“Everything is holistic. You’re not looking just at their [investors’] alternatives but also their by-laws, cash balances, obligatory monies due to shareholders or endowments. Look at every facet and focus on liquidity, capacity, transparency,” says Minard

Various institutional investors are hiring funds of funds for various functions. Some want them to do asset allocation studies while others are looking for risk management. Some want them to identify the most appropriate managers, vet them, set up investment guidelines, do reporting and monitoring.

Some funds of funds are finding themselves moving into the subadvisory business as some pensions are looking for a fund of funds that can facilitate knowledge transfer so the pension may eventually take on the internal management of the hedge fund program.