Funds of funds set for shake-up as asset growth explodes

Financial News

January 4, 2004

The boom in the funds of hedge funds business last year could bring problems for managers and investors. Funds of hedge funds have been hugely successful in terms of growing assets under management but performance has been mixed and participants predict a shake-up of the industry is not far off.Ken Kinsey-Quick, head of multi-manager funds at Thames River Capital, has witnessed the evolution of the business, but warned that it brings attendant problems.

"There have certainly been huge flows into funds of funds over the past year. But a lot of managers are closing, so one of the big questions has been where to put your money," he said.

Rossen Djounov, investment director at Forsyth Partners, which runs 10 bond and equity funds of funds, and four funds of hedge funds, said: "It has been a good year from where we stand, with a substantial return to popularity for hedge funds. Two to three years ago demand was led by high net worth individuals or more esoteric investors. Now we are seeing demand from private banks, life insurance companies and even some pension funds."

For investors who do not feel confident enough to pick funds and managers themselves, funds of funds are a first entry point, offering multi-strategy and multi-manager exposure. "Funds of funds are popular with investors who want to allocate for themselves, and also with those who are not sure whether the current rally in equity markets is for real," said Djounov.

Early in 2003 many investors were still in shock after three years of turbulent markets and, although many had looked at alternative investments, few had committed funds. The regulatory environment in the US and in Europe was tightening, with authorities starting to consider registration of hedge funds and managers and closer monitoring of offshore holdings.

But the global industry has kept growing, especially in Europe and Asia. It was reportedly worth $563bn ([euro]461bn), with some 6,000 funds, at the end of 2001 and some $650bn at the end of 2002. It is projected to top $1.5 trillion by 2010, according to a Cap Gemini Ernst & Young report. The 20 largest hedge funds firms now control almost one fifth of global assets in the sector.

Hedge funds offering a variety of strategies continued to be launched at a hectic rate through 2003. Credit Suisse First Boston's Brevan Howard fund was the largest European private equity vehicle, attracting $1.2bn in its first month of business. When the acclaimed manager William von Mueffling left Lazard Asset Management to start his Cantillon Capital fund, he had no trouble raising $2bn. Thames River Capital has increased funds under management threefold during the year. But investment consultants caution against an unhealthy focus on asset gathering, rather than performance, and many still warn of the lack of transparency, principal protection and liquidity in the sector. Hedge fund indices underperformed the S&P 500 by almost 10% to end-November while some strategies, especially those reliant on shorting, were down by almost 30%. Most funds of funds turned to leverage to help boost returns - levels of 400% were not unusual.

Inflows to convertible arbitrage funds, the star strategy of 2002, fell away through 2003. Kinsey-Quick said: "However, distressed strategies had a fantastic year. And also credit - the new kid on the block. Essentially the high beta strategies which focus on growth did well but it was a difficult year for value-orientated funds."

For funds of funds, the double layer of fees continues to be an issue. In difficult markets, a 5% fee handicap is too great for all but the best to beat. On the other hand, there is a growing performance gap between the top and bottom two quartiles. The best funds close quickly, and the proposition of paying an expert to select and access top talent is more widely accepted.

Djounov said: "Fund of funds fee structures are certainly better understood now. Some managers have even been able to raise fees. Good managers are in a very solid position. But with increased popularity has come transparency, and with better transparency investors have become more discerning. Investors appreciate the value of brands, but the returns also have to be good, and not too volatile."

Kinsey-Quick believes fees for funds of funds will remain under pressure, and soon divide product providers into two main categories. "Either hedge fund managers have to become like the big investment houses, highly process-driven, handling big mandates on low margins, or they can choose to be niche players, where they will have to offer innovative products and ideas and superior performance," he said. Thames River Capital has opted firmly for the latter.

A surprise development in 2003 for the industry in Europe was the relatively benign regulatory environment. Ireland completed its first year of allowing marketing of hedge funds without incident.

Germany approved a law effective from January 1, which permits hedge funds to be offered there for the first time. The UK has not moved as far but is considering a more relaxed regime. The US Securities and Exchange Commission published a report at the end of September recommending further regulation of hedge funds, but its focus has been displaced by the widening investigation into late trading and market timing among mutual funds. Industry commentators believe it may be March before the spotlight returns to hedge funds.

Demand for new managers to fill fund of funds portfolios continued to grow win 2003. Where small teams from investment banks formed the last wave of hedge fund managers, new talent is coming from hedge funds themselves, according to Kinsey-Quick. "You see quite a few strong second-line managers from hedge funds breaking out on their own."

He believes funds of funds have to focus their portfolios more in coming years if they are to deliver on promises of consistent outperformance.

While most funds of funds still have 15 to 20 managers, Thames River Capital is developing a radical concept of "fivers" - funds of funds with only five strong, established managers each holding 20% of the mandate.

Such consolidation carries some risk for the industry and for investors. As hedge funds become more mainstream, they lose the appeal that fuelled their popularity, warned Djounov.

He said: "Many investors are not convinced that equity markets are out of the woods yet. They want diversification, and there is a danger that hedge fund portfolios are becoming more concentrated."

A survey of European funds of funds managers, conducted by Edhec, the French business school, and sponsored by Finmat Global Fund Services, found that many were already struggling to provide diversified, risk-managed portfolios.

Only 42% of the managers offered funds with specific diversification attributes, due mainly to "confusion about the fund selection tasks and what actions provide the real value in a fund of funds".

Portfolio allocation remains confused with the idea of choosing the best managers, the report said.

Through 2003, hedge funds and funds of funds had problems other financial sectors might envy - huge inflows, burgeoning opportunities and sympathetic regulators. But the expansion of the past few years will inevitably be followed by some consolidation.

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