Failed by the fund of funds industry, investors are beginning to plant, nurture and clip their hedge funds themselves, finds Martin Steward

While few go as far as the fund of funds manager who describes his industry's reputation as "somewhere between that of a drug dealer and a paedophile", no one denies they have had a tougher time justifying their work since 2008.

"The last two years has fundamentally changed the work we do," says Lawrie Chandler, an associate partner with Frankfurt-based advisory firm eHedge, describing the "falling away" of funds of funds. Part of that work includes helping a UK local authority pension scheme to close down its fund of funds and ‘in-source' its absolute return portfolio.

This is not simply about funds of funds underperforming or failing to avoid the big blow-ups and frauds. It reflects growing recognition of fundamental flaws in the very concept of the all-weather, diversified fund of funds that have been the core of pension fund investment in hedge funds for the past 10-15 years.

In 2002, had you asked European pension fund managers why they were buying a fund of hedge funds, the answer would inevitably have been, "for diversification". But the funds they favoured were better categorised as ‘low volatility' than ‘negatively correlated'. During the ‘Goldilocks' era, few asked about how low-vol returns were achieved by selling volatility and building up lethal left-tail risk (which just magnified the left-tail risk embedded in traditional portfolios).

Then there were the gates, another result of a fundamental flaw: the idea that one could sustain an asset-liability mismatch by ‘barbelling' liquidity exposure (rotating subscriptions and redemptions through the most liquid strategies to maintain a constant allocation to the least liquid).

"There's a whole bunch of trust that turned out not be repaid," says Mike Faulkner, CEO at investment consultancy P-Solve. In return, a whole lot of investment capital is not being repaid to funds of funds. Figures from HFR suggest that the hedge fund industry as a whole lost a much smaller proportion of its assets during 2009 than the fund of funds industry in particular. And in Q1 2010, funds of funds experienced negative flows while single-manager funds have had positive flows for the first time in the history of the data.

"The first ‘go around' with hedge funds in Europe was focused on products and packaging, and treating hedge funds as an asset class," says Jim Vos, CEO of Aksia, a US hedge fund investment advisory firm that recently opened a London office.

There are two basic ways to avoid these pitfalls. Investors can stay with their fund of funds manager, but "get away from a ‘one size fits all, take it or leave it' product transaction and move towards having a relationship", as Morten Spenner, CEO of fund of funds manager IAM, puts it. Or, as the HFR numbers suggest is happening, you can start selecting hedge funds yourself. Either way represents a recognition that hedge funds are not an asset class but rather a series of business models that can be adapted to a variety of investment strategies which, in turn, deliver distinct risk exposures that it does not necessarily make sense to package together.

The liquid-versus-illiquid strategy distinction is perhaps the most obvious. Surely it makes more sense to go direct for illiquid strategies like distressed debt, knowing that all of your fellow investors have locked their money up alongside you with their eyes wide open? Moreover, going direct offers the opportunity to negotiate terms and perhaps set up side letters, for example. "We see clients who want hedge funds in the liquid space, and then cherry-pick managers outside of that, because they want to have much more of a relationship with managers of illiquid strategies," says Spenner.

The UK's Universities Superannuation Scheme (USS) was a latecomer to hedge funds precisely because of concerns about industry liquidity mismatches, according to Mike Powell of the absolute return strategies team. Now, its hedge fund programme is focused purely on the most liquid strategies, while illiquid ‘hedge fund' strategies get shunted into the private equity portfolio. "The ownership structure of private equity partnerships are much better suited to underlying investments in illiquid instruments," says Powell.

This is just one aspect of the broader trend to break up the packaged offering, in recognition that different risks can play specific roles in a diversified portfolio - and that some hedge fund strategy risks may not be desirable at all. Even providers of hedge fund beta products, which one might expect to be offering the broad range of risks available, are being asked for specific betas. "More and more clients are interested in carving out the divergent aspects of our [hedge fund beta] strategy which are non-correlated with what they have in both their traditional and much of the rest of their hedge fund portfolio," says Mike Arone, managing director and head of product engineering for EMEA at SSGA. And while AQR Capital Management has not been asked to do the same with its DELTA Fund strategy, head of portfolio solutions Adam Berger says that it has been structured to leave out simulation of some "classic strategies", particularly from the fixed income arbitrage family, "that present excessive leverage and liquidity risk".

Not all funds of funds are created equal, of course, and senior hedge fund researcher at Hewitt, Guy Saintfiet, says that a key selection criteria at his firm is that they should have "most if not all of their assets from institutional investors", to improve the chances that underlying strategies will reflect the different requirements that liability-driven investors have compared with high net worth individuals. Still, not all pension funds will use hedge funds in the same way. "The ability to customise exposure is important," says Powell at USS. "Diversified funds of funds get you very generic exposure, whereas our hedge fund programme is designed for USS and doesn't look like an off-the-shelf product."

What are investors doing?
So what are investors doing? There are perhaps three basic ways of positioning hedge funds in a diversified portfolio: beta replacement and enhancement; negative correlation or absolute return; and opportunistic or cyclical plays.

In the first category by far the most activity has been in using long/short equity, particularly long-biased stockpickers, to improve the risk profile of a core equity exposure. This seems to be both a cause and effect of the long-running ‘convergence' trend, too: "A lot of clients are coming to us saying, ‘Our long-only manager has shown us this long/short product, should we put 20% in?'" observes Aoifinn Devitt, principal and founder of alternatives advisory specialist Clontarf Capital.

The recognition that some strategies carry a lot more systematic beta than others has helped investors be more specific in their identification of ‘absolute return' or negative correlation, leading them to focus on long/short equity managers with very flexible net exposures, and to favour previously shunned strategies like managed futures.

Finally, the extent of market dislocation has opened investors' eyes to opportunistic strategy overweights. Some have been obviously cyclical - distressed debt or convertible bonds, for example - and may represent a temporary medium-term tilt. Others are simply difficult to categorise in any other way - managers specialising in niche markets like insurance-linked securities, intellectual property, shipping finance, weather derivatives and the like. The rationale for doing this direct is obvious - as Mercer's senior hedge fund researcher Simon Fox puts it: "Often, long-term investors want to take a more significant tilt than is reasonable for a fund of funds."

USS runs its programme with a variation on this theme (three portfolios labelled core, tactical and niche) that cuts out the beta enhancement tranche. "The core portfolio is about long-optionality to reduce the left tail of the scheme," says Powel. That means highly liquid directional strategies like long/short with low average net exposure, managed futures, global macro and some trading-orientated credit funds. Tactical exposures include cyclical strategies like convertibles, distressed and merger arbitrage, while ‘niche' covers "anything non-correlated and interesting but not scaleable".

At the Barclays UK Retirement Fund the set up follows the outline above almost exactly. High-alpha, low-beta strategies like global macro go into an ‘alternatives' bucket, but most are positioned according to their dominant systematic risks: "We try not to silo too much in ‘alternatives' because it's better to think about where you can add value to the other parts of your portfolio," says head of manager selection Andre Konstantinow. In addition, there is the "niche" part that is less focused on integration into the broader risk profile of the scheme: "Almost all of our exposure is through single-strategy hedge funds, but we do have one small, bespoke fund of funds allocation, which is more concentrated and focused on high-conviction ideas."

It is notable that the scheme still uses a fund of funds for its more opportunistic allocation, as this gives an insight into how even the most sophisticated investors face resource constraints when it comes to breaking up the fund of funds structure. Even the 15-man alternatives team at USS can only spare Powell plus two portfolio managers and two due diligencers for hedge funds. In some ways, focusing on specific desirable risks and strategies eases the burden - "we try to match the funds of funds in terms of the depth of our due diligence, rather than breadth", Powell reasons - but one cannot help wondering how such a small team can stay on top of developments among niche strategists or early-stage managers (another area where dedicated funds of funds have been launched). Where Konstantinow delegates to a fund of funds manager, Powell does not (see ‘Competing advice' in this section).

"There are areas where investors feel comfortable selecting for themselves - macro or long/short equity, for example - but there are whole other areas that they need to be in where they don't necessarily have the expertise and will go to a fund of funds," says Matteo Perrucio, CEO of Hermes BPK Partners, which manages funds of hedge funds for the UK's BT Pension Scheme and other institutions.

Sure enough, diversified fund of funds providers are responding with more and more strategy-specific products. Hermes BPK is one, having launched a fund of debt restructuring strategies and a fund of trading strategies. IAM has had a long/short equity fund of funds running since 2005 and launched a fund of trading strategies in early 2009, which Spenner says are "generally used by investors who want to tilt their portfolio towards particular areas, but lack the governance budget to go direct". The fact that some have been around for years suggests that the trend is not all about managers worrying about the future of the diversified product and "scavenging for ways to attract assets back again", in the words of Devitt from Clontarf Capital (itself planning a fund of Asia long/short funds) - but there is definitely an element of this at play.

"Strategy-specific funds of funds give you much broader exposure to specialist mandates than you might want to risk on an individual basis, and a reasonable proportion of our clients have accessed distressed debt in that way," says Mercer's Fox. "But we've always said there will be an increasingly direct relationship between pension funds and hedge funds, not least as the hedge funds themselves institutionalise and facilitate the direct relationship." Saintfiet at Hewitt, an ex Hermes/BT Pension Scheme selector himself, agrees: "We do have a number of single-strategy funds of funds on our lists, but we have also seen that most of our clients are comfortable with single-manager allocations, possibly because these are smaller allocations."

Nonetheless, there is plenty of life left in the traditional diversified fund of funds, and not just because there is a constant stream of hedge fund first-timers using them. "Much as people would like to dance on the grave of the fund of funds industry, it remains a decent industry performing a valuable service for investors," as Aksia's Vos puts it. He agrees that it makes sense to put long/short equity in an equity bucket and distressed in an opportunistic bucket, but he also warns of the administrative difficulties associated with having your hedge fund selection expertise scattered across the portfolio pursuing different objectives, not to mention the benchmarking challenges it presents. That is why a lot of Aksia's work with institutional investors has been around transitioning from 100% funds of funds to core satellite or 50/50 portfolios mixing funds of funds with direct allocations. "You can have a core direct portfolio supplemented by strategy or regional specific funds of funds or a core of multi-strategy funds of funds supplemented with opportunistic direct allocations," he suggests.

"The client will start with a diversified fund of funds and then, to tilt towards strategies that give tail-risk protection, they allocate separately to macro and managed futures that are typically under-represented in traditional funds of funds," Saintfiet agrees. "In addition, they might see a certain strategy as attractive at a certain point in the cycle - like distressed. We think that most of our clients will end up in this core-satellite environment eventually."

There is potentially a nasty banana skin out there, of course. If the experts could foul it up so badly, why assume that newcomers will do any better? The Lehman Brothers catastrophe was "the Emperor's New Clothes moment for many in the alternatives world", notes Perrucio, so it is not surprising that many investors want to go it alone. "But my observation is that this industry has become more complicated, not less."

The process of breaking up the fund of funds is, to some extent, about freeing oneself from the dangerous biases of the structure. "For European institutional investors there is a real opportunity to make use of the hedge fund world - rather than be used by it," says Spenner. But it must be acknowledged that the failure of fund of funds owed at least something to the perverse incentives pension funds brought to the market. It is to be hoped that those pension funds do not bring the same errors - like mistaking ‘low-vol' for ‘diversifying', for example - in-house.