For many institutional investors, investing directly in hedge funds is not practical for governance reasons. Historically, this has left only the traditional co-mingled fund of hedge funds (FoHFs) as an option, unfortunate given the significant flaws we perceive in this model.
We have had discussions with FoHFs around these flaws and continue to welcome engagement with them. While some of the best have recognised and addressed some of them, the vast majority – including mainstream, multi-strategy pooled FoHFs but also even the separate accounts offered by some organisations – remain sub-optimal. In addition, many pooled FoHFs that claim to be niche often have the majority of their portfolios invested in mainstream strategies.
In the 1990s, FoHFs were created to offer preferential access to alpha the best hedge funds could produce, and at the time that alpha was substantial because the industry was much smaller and dominated by truly skilled investment professionals with first-mover advantage. However, as the hedge fund industry has matured, the majority of the FoHFs have failed to adapt to reflect the new investment world where they produce less alpha and institutional investors have ready access.
Among the persistent weaknesses are:
• Poorly-aligned fees
Although FOHF fees have slowly been coming down, the absolute level remains too high, both on a pooled and separate account basis. The problem is an inflated cost structure that can only be supported on the old-fee model. The new fee model is considerably lower and in that scenario most cannot survive. Performance fees should be better aligned with investors’ interests. In particular, they should only be based on
true alpha creation, not total return. Almost no performance fees are designed this way and therefore actually encourage misalignments (more so than a basic ad valorem fee). FoHFs should consider ways to avoid asset-gathering incentives over time – for example, by setting strict capacity levels in advance. An institutional client investing in a typical FoHFs achieving a net return of cash-plus-5% per annum would likely be paying fees of close to 5%. This is unacceptable.
• Underlying manager fees too high
Through better negotiations with managers and, in particular, the use of well-designed hedge fund smart beta products in some areas it should be possible to get to an average fee far lower than the typical fees found within even the best FoHFs. Of course, one should never choose a manager on the basis of fees alone, it is the net alpha (net of both fees and beta) that is key. So FoHFs should make more use of fee modelling tools and their relationships with underlying managers to ensure the proportion of forward-looking true alpha being paid in fees is appropriate for each hedge fund as well as at the total FoHF level.
Correlation with equity and credit beta is higher in FoHFs than most institutional clients would like. Unless fee structures change radically, FoHFs should rarely include significantly net-long long/short equity and credit hedge funds, as most investors would be better placed getting this exposure via their long-only managers. Of course that is not something a FoHF can do, hence why this persists.
The number of managers in portfolios should be more limited to ensure that it remains a focused fund, while still running the appropriate risk levels. Most FoHFs are over-diversified and have stayed open too long, having not set limits on the number of funds and/or diversification at outset.
• Asset/liability mismatch
Many FoHFs have historically offered greater liquidity to clients than they actually have in the underlying funds, causing major issues if clients start redeeming at the same time. While many FoHFs have improved, they are still generally not very flexible on redemption. For example dilution levies are unusual and FoHFs do not typically make it possible to pay redeeming clients in units rather than cash where there are any remaining locks.
• Transparency and risk monitoring
Only the best FoHFs get holdings-based risk analysis done on all of their underlying funds. More direct managers should put their portfolios on proprietary or established third-party platforms to allow the production of a combined total portfolio risk analysis.
In the context of hedge funds, we have tried to change things for the better by highlighting these issues, working with hedge funds to improve their fee terms for the benefit of our clients, helping managers design innovative hedge fund smart beta solutions and offering a delegated service that aims to address the flaws we have identified. A number of traditional FoHF’s have transitioned into hedge fund solutions providers, offering a range of services across bespoke, opportunistic and advisory style mandates; this additional competition can only be good.
But, perhaps unsurprisingly, our approach has resulted in some criticism of the consultant-driven approach to hedge fund selection. Questions have arisen around conflicts of interest, competence and bias towards the largest and best-known firms. While not in a position to respond on behalf of all consultants, we would say that our clients should be given a little credit for having the ability to judge on these matters and for having a very keen eye on the net-of-fee result. Having set a high bar for managers, our clients should be the first to remind us if we do not practice what we preach, including delivering strong risk-adjusted performance.
Craig Baker is global head of investment research at Towers Watson