What has been happening with hedge fund flows lately? The data is mixed. The industry itself – at least, as it is represented by the respondents to the State Street Alternative Fund Manager Survey – seems to feel that institutional investors are only interested in the biggest, best-known names. But that view might be out-of-date.

Data from eVestment shows consistent growth in assets by hedge fund firms managing up to $500m (€370m), and slowing growth for the big boys – especially in the $2bn-to-$5bn AuM range.

The picture from HFR is even clearer: it is of a marked change in net flows to hedge funds according to size over the past year or so. Q2 of 2012 saw inflows of over $11bn into hedge funds larger than $5bn, but outflows in most smaller funds; by Q2 of 2013, firms in the $1bn-$5bn saw net inflows almost as high as the largest funds, at $5.8bn. Moreover, there was no category seeing net outflows.

It appears that hedge fund investors have gone from favouring the largest firms to spreading their allocation evenly among different sizes of firms for the first time since 2008.

The explanation for the first half of this story is not a puzzle. Poor performance, poor diversification – and the poor due diligence uncovered by the Madoff fraud left a sour taste for institutional investors that contributed to a move away from funds of hedge funds.

“I don’t know of a single Dutch institutional investor who has made an allocation to a hedge fund of funds in the last few years,” declares Jan Soerensen, head of hedge funds for the Dutch pensions manager, PGGM.

Instead, there has been a move, at least by the larger institutional funds, towards in-house management of hedge fund portfolios.

 “After 2008, people felt that funds of funds had messed up and that they’d be better off going direct,” concedes Morten Spenner, CEO of the fund of funds firm, International Asset Management. “But when they went direct, they didn’t know that many hedge fund managers and they were less than enthusiastic about standing up in front of their boards and saying, ‘This guy running $100m is fantastic, he’s the next big thing in hedge funds’. It’s much easier to go with the guy running $30bn that they’ve read about.”

There is academic evidence that smaller and newer funds tend to outperform older and larger funds, but these present greater operational risks.

Soerensen argues that PGGM’s self-built managed account platform, which makes it the legal owner of its strategies and gives it control over its service providers, has proved to be critical to their ability to invest in smaller hedge funds.

“With a managed account platform, we do not face any operational risks that we cannot control when we invest in smaller hedge funds, which means that we do not have to stipulate any minimum requirements for assets under management before we consider investing,” he says.  

Still, funds of funds are better equipped to undertake due diligence and monitoring of such funds than most in-house teams. Ultimately, it is a question of resources.

PGGM, with its internal hedge fund team of 12 personnel, has invested with around 25-30 managers in total. To take another example, Finland’s Varma Mutual Pension Insurance Company started investing in hedge funds in 2002 through a fund of funds managed by Blackstone but immediately invested directly.

“We had experience of alternatives with our private equity investments which had also moved from a fund-of-fund approach to direct investing,” explains director of hedge funds, Jarkko Matilainen. “We wanted to save costs but used Blackstone to give us advice and we continue to use them for quant strategies and niche opportunities. They are a important partner.”

With that set-up, Varma’s three-strong hedge funds team has invested with 37 hedge funds.

By contrast, a dedicated, long-established hedge fund of fund manager like Permal has a multiple of that number of staff, invests with 200 managers at any one time, and analysing 400 or more managers per year out of around 10,000, according to senior investment officer, Christopher Fawcett.

So institutions that have gone direct over recent years might now have the networks and the confidence to invest with smaller managers – but it seems unlikely that this would represent the volume of assets that would move the needle that we see in the HFR data. While Soerensen makes the point that a small AuM is no barrier to investing with a smaller manager if you are going through a managed account, in terms of operational robustness, it remains a barrier in terms of the ticket size that that manager is willing to accept, or that that investor is willing to write. Varma’s minimum ticket is $50m, according to Matilainen, and they require a minimum of $300m AuM for a hedge fund to be considered. Even large institutions with plenty of fund-selection resources are unlikely to invest in smaller funds purely because even their minimum size of investment would dominate the assets of small hedge fund managers.

This is a problem for funds of funds, too. Some, like Permal, have a strategy of investing in newer managers to take advantage of the likely higher returns, and others have separate vehicles dedicated to investing in start-ups. Some pension funds, like CalPERS and APG, have similar programmes. But, this is not the mainstream: it doesn’t seem that these efforts would account for the change in flows that the data show.

So who are the new investors in smaller funds? Kevin LoPrimo, managing director of Global Prime Partners, which provides prime brokerage services for hedge funds that are smaller than $100m, argues that it is likely to be the family offices that, like the pension funds, used to invest in fund of funds who are now investing direct.

“With banks closing their prop desks, there are all those people looking or something to do, either creating their own funds or being hired by family offices,” he says.

Perhaps this should not be surprising. Moving into smaller funds for an investment professional means taking on more personal career risk than investing in a big brand. It is those entities, where the managers of money are arguably more closely aligned with the owners – such as family offices and endowments – that are best able to take on career risks by moving away from the herd.