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How fund of funds are embracing change

Recently Norman Cook's (aka ‘Fatboy Slim') greatest hits compilation was released. What is notable about this fact, beyond the curious time compression between the achievement of hit records and the release of a greatest hits album, is the cover. A chubby, smug young man wears sunglasses, angel's wings and a T-shirt saying "I'M #1 SO WHY TRY HARDER?".

The link between music and funds of hedge funds may not seem obvious. The unlikely connection comes from the fact that some fund of funds will face increasing pressure in the near future, resulting from an ‘I'M #1 SO WHY TRY HARDER?' attitude, developed after years of undeniable success.

Success came to the first generation fund of hedge funds in the 1980s and 1990s, as they provided a valuable service in packaging hedge fund talent mainly to high net worth individuals. With few hedge funds, and most clustered around Manhattan, screening the universe and performing due diligence was a lighter burden.

Any necessary introspection was delayed by the favourable circumstances fund of hedge funds encountered during the early 2000s. Pension funds had suffered a near knockout punch of rising lifespans, poor equity performance and falling interest rates. At the same time, stellar performance of the ‘Harvard/Yale' investment model, characterised by large allocations to alternatives, became more widely known. As a result, fund of hedge funds that had already started to ‘institutionalise' in the late 1990s were able to grow their AUM dramatically.

It is never easy to pinpoint the end of a good party. In the case of the slowdown in AUM growth, some say 2004, others 2005. Furthermore, the phrase "fund of hedge fund shakeout" has gained considerable traction lately.

But the shakeout thesis misses a key point. While it is true that the fund of hedge fund industry is crowded numerically, the true diversity of approaches is limited. Even with fewer providers, without evolution and innovation, the industry will struggle. Specialised products hold promise, but only if they represent a real change in thinking and are not the equivalent of adding a fancy stereo to a 15 year-old car.

More importantly, the blindly negative coverage might turn potential investors away from a sector that offers a material contribution to return enhancement or risk reduction. The risk/return profiles available when a fund of hedge fund does its job properly are among the best of any asset class or market worldwide. If fund of funds can configure themselves correctly - in terms of philosophy, process and people - success will continue unabated.

The next generation fund of hedge fund will keep the winning elements of the process-driven class of the late 1990's/early 2000s: solid infrastructure, thorough due diligence and dependable client servicing. However, reliability will be overlaid with investment management experience and talent; process will be injected with entrepreneurial vision and drive.

The outcome of the new machine will be better performance, without sacrificing the risk mitigation techniques that the first ‘institutional' firms brought to the industry.

Better performance will also come from covering the new global universe, which has become significantly larger and more complex. This means extensive travel by analysts with experience of trading and investing. An asymmetric exchange between young/inexperienced hedge fund researcher and older/wiser hedge fund manager will be replaced by an informed, professional but always rigorous due diligence process.

Fund of funds' sometimes emotional fear of disclosure will be supplanted by intelligent transparency, where confidence in the ability to create sustainable performance will allow provision of the detailed information that institutional investors demand.

Experienced investment professionals focused on investment fundamentals will lead the research engine of the next generation fund of funds. Top-down selection of rich opportunity sets will increase the probability of success for hedge funds selected by the bottom-up process.

The depth of qualitative research will be matched by quantitative and operational research, for a complete view on a manager. In-depth qualitative research will be enabled by having well-resourced and specialist quantitative and operational teams.

‘One size fits all' product development will be superseded by clearly differentiated offerings presenting investors with a choice and fulfilling specific investment needs.

Investment skills and entrepreneurial drive must be allied to process as the fund of hedge fund model continues to evolve. It is by this evolution among others that the industry will continue its past success.

Chris Bouckley is managing partner of Caliburn Capital Partners in London

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