A New Era for Funds of Hedge Funds: Sunrise or Sunset?

by: AllAboutAlpha

Hot off the presses, London-based information provider Preqin this week released its May 2010 Hedge Fund Investor Spotlight, with the lead article being that a “new era” for funds of hedge funds (FoHFs) has finally, after two-plus turbulent years, begun.

The proof: A leveling off of assets leaving the coffers of FoHF firms, a cooling of consolidation activity among FoHFs, an increase in the number of hedge fund investments per FoHF firm and, most importantly, evidence of an increase in expected new FoHF launches in the second half of the year (click here to view some of AllAboutAlpha.com’s previous coverage of Preqin surveys and research).

According to the firm…

…recovery is occurring, and capital flows are now positive, with many institutional investors resuming their searches for funds of funds to manage their hedge fund assets in 2010.

Preqin’s assessment stands in stark contrast to other sentiment out there, in particular from Yale Investment Management CIO David Swensen, who according to this Economist article called FoHFs “a cancer on the institutional-investor world” that “facilitate the flow of ignorant capital”.

It also stands in contrast to some of Preqin’s own numbers, which show the number of FoHFs out there in the world didn’t decline last year, but that the assets they manage, on average, was sliced in half – to $2.75 billion from $4.78 billion.

It goes almost without saying that the FoHF business took a giant slap across the face during the global economic downturn, not only because of trading losses within their underlying roster of hedge funds but also because of the double whammy of being hit by redemption requests at the same time as being locked out of getting capital from their investments.

And of course there was – and is – the Madoff factor (click here for AllAboutAlpha.com’s recent review of Madoff whistleblower Harry Markopolos’s book, “No one would listen.”)

And while hedge funds did perform better in last year’s market rebound, FoHFs were collectively less quick to recuperate from poor returns and redemption requests and continued to suffer at the hands of low investor sentiment – i.e. a do-it-yourself-at-a-lower-price-point syndrome.

And the Madoff factor.

What’s more, size varies significantly, with the smallest FoHF manager in Preqin’s database managing $4 million and the largest with $30.6 billion – confirmation there are fewer middle-of-the-road FoHFs out there. The biggest segment within the spectrum is those with between $2 billion and $5 billion in AUM.

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Of those, the top five largest as of March 2010 were HSBC Alternative Investments, Blackstone Alternative Asset Management, USB Alt. & Quantitative, Grosvenor Capital Management and Man Investments.

Among the report’s other findings: that some 82% of all FoHF consider hedge fund managers on a global basis in order to access the best opportunities. Emerging market investments are becoming increasingly important, with a number of FoHFs setting up offices on the ground in places like Brazil to better access investment opportunities.

As for strategy, a little more than half of all FoHFs consider multi-strategy as the way to go, though macro, long/short equity CTA, distressed and market neutral also ranked high on the list. UCITS-compliant funds and managed account structures were also deemed popular, with several firms launching one or the other in late 2009-early 2010.

Man Investments in particular was awarded a managed account mandate by the GBP 23 billion University Superannuation Scheme (USS). As part of this arrangement, USS will have full transparency over manager selection.

Clearly, investors still think funds of funds continue to offer diversification and (hopefully) an ability to pick the best managers. But even so, there is growing anecdotal evidence that some investors are leaning more toward either figuring out hedge fund allocations themselves or relying on consultants to help them select managers rather than go the FoHF route.

We’ll be keen to see what Preqin’s take on the FoHF world is a year from now.