The structure of the fiduciary model for hedge funds is not so dissimilar to a customised fund-of-funds mandate, argues Stephen Oxley.

Are fiduciary consultants neglecting their duty of independence with regard to alternative investments, specifically hedge funds? Traditionally, when pension funds and other institutions invest in hedge funds, they select a range of funds either in the form of hiring an external fund of funds or by creating their own portfolio built by an internal team. The portfolio approach has been deemed appropriate for hedge fund investments because of the risks associated with investing in one or a small number of hedge funds.

It is well known that diversification reduces the volatility of returns of a stock portfolio, but this is also true of hedge funds because, like stocks, the returns vary considerably from one to the next. In 2011, for example, according to HFR, the range of returns between the best performing long-short equity hedge fund and the worst was a staggering 265% (up 198% versus down 67%). Even the more-diversified multi-strategy fund universe exhibited a 112-percentage-point return difference between the best and worst performers.  

Traditional asset managers tend to hug benchmarks, so there is nothing like the level of manager selection risk as there is with hedge funds. On top of that, there is also a not insignificant risk that a hedge fund can end up with a net asset value of zero through bad management, poor operations, excessive risk taking or fraud. 

Recently, some investment consultants have suggested to their clients that the broad portfolio approach to hedge fund investing is no longer as important as it was. They argue that hedge funds have come of age - many firms are of a size similar to traditional asset managers - and their investment approaches are diversified, through the use of multi-strategy funds, for example. Investment in a handful of hedge funds may arguably be sufficient, particularly if the consultant has a fiduciary or discretionary mandate and can select (and de-select) funds for the client. A further key advantage is also claimed - that of fees. Consultants typically charge less than funds of funds.  

While the stated fee may be lower (consultants tend to do less work for the client), it is nonetheless often based on a percentage of assets managed, or on a performance fee, or both. And that’s where the question of independence arises.

One of the primary duties of a fiduciary is to be impartial. Arguing, as some consultants do, that the old fund-of-hedge-funds model is redundant - yet at the same time suggesting a multi-manager approach, which happens to be run by the same consultant - can appear to be conflicted. 

Consultants argue they are simply doing what they have always done - finding best-in-class investment managers (in this case, hedge fund managers) for clients. But the focus should always be on what is best for the client. The structure of the fiduciary or delegated consulting model for hedge funds is, in fact, not so dissimilar to a customised fund-of-funds mandate. The content of the consultant portfolio is likely to be more concentrated and more likely to contain ‘big name’ hedge funds, but, in concept, it is similar. However, such consultants do not always suggest the external alternatives to their clients. 

Overall fees are, of course, important, but what matters more to the investor is the net return and the level of risk being taken (including manager blow-up risk). It may well be that investing in a few well-known, multi-strategy commingled hedge funds is the optimal approach for some investors. But for others, their size, sophistication and level of governance may indicate that other approaches should be presented in an impartial way as options to be considered. 

Stephen Oxley is managing director at Pacific Alternative Asset Management Company