Hedge funds are booming - but funds of funds are not. Joseph Mariathasan outlines the ways in which the intermediaries are re-thinking their role

The hedge fund industry has been steadily but surely institutionalising, moving away from its roots as a sophisticated wealth-management solution for high net-worth investors. This is having a profound effect on funds of hedge funds (FOHFs). Not only are they having to adapt to a client base with - post-Madoff - much greater demands for proof of added value and an emphasis on transparency; while the hedge fund industry as a whole has been growing, the FOHFs part of it has actually been shrinking due to the increasing trend for more sophisticated, institutional investors to allocate directly, without the old intermediaries.

“Prior to the crash, the market was 60% high net worth and 40% institutional,” says Omar Kodmani, president of the Permal Group, a FOHF firm. “Post crash, it has flipped, and the 60% institutional investment has become more important for funds of hedge funds. Ten years ago institutions accounted for just 3% of our investor base, and now they account for 46%.”

Like Permal, Stenham Advisors has been in the business for some time. It started as a multi-family office over 20 years ago, but institutions now account for two-thirds of its assets, according to investment director Javier Uribarren.

Mustafa Jama, CIO of Morgan Stanley Alternative Investment Partners’ FOHF agrees: “Now at least 50% [of hedge fund investment] is from institutions, which have more resources, so it is logical for them to invest directly.”

In this post-Madoff environment the value added by FOHFs has also been questioned. Arguably, any FOHF that had exposure to Madoff was not undertaking the due diligence that their clients thought they were paying for. Not surprisingly, assets of many plummeted and some companies went out of business.

“It changed the view of many investors about what might be under the bonnet of hedge funds,” says Phil Irvine, director of PiRho Investment Consulting. “Institutional investors with significant bargaining power always push for more effective governance and transparency. As a result of this pressure, many hedge funds are now looking to launch UCITS-compliant funds addressing a much broader investor base.”

In October 2011, a Preqin study showed that 44% of hedge fund investors said that fund-level transparency had improved the most during the previous 12 months. However, 50% still felt that further improvement was necessary.

Operational due diligence (ODD) has come to the fore. “Before 2008, when investors undertook ODD, looking at our own ODD was an afterthought,” says Kodmani. “After Madoff, it became the first team investors wanted to see.”

Institutionalisation has meant a shift in the type of services and the products that intermediaries offer. “Generally larger clients are interested in having more of a partnering approach with FOHF managers - either bespoke portfolios or assistance with picking individual hedge fund names,” explains Irvine.

Large institutions, in particular, can afford to have well-resourced teams that can identify the major funds with successful track records. For FOHFs, this has meant improving tailored solutions that can complement an institution’s in-house capabilities.

BNP Paribas Investment Partners, for example, has recently strengthened a nine-person team in its subsidiary THEAM, dedicated to hedge fund solutions. “Investors are not so willing to invest in FOHFs as they do not want to mingle their assets, or have specific constraints,” says team head Eric Debonnet. “We offer single investor portfolios of hedge funds as bespoke offerings.”

To support this effort, BNP Paribas has also taken a 50% stake in Innocap, a North American provider of managed account solutions. “Some investors don’t want commodities, others no short selling,” Debonnet explains. “There is also a requirement to satisfy specific objectives - such as a portfolio of strategies that are negatively correlated to bond markets - [which is] understandable given the high exposures of pension funds and insurance companies to bonds and the volatility seen in the sovereign debt markets.”

Lisa Fridman, head of European research at PAAMCO, says more investors are working with her firm on customised accounts - for example, portfolios focused on emerging managers. “Investors are using FOHFs for complementary strategies and exposures that do not overlap with in-house capabilities,” she confirms.

The desire for more customised portfolios and greater transparency inevitably leads investors further down the managed-account route.

Kodmani reveals that 45% of Permal’s assets are now allocated via managed accounts, and he thinks this is likely to grow.

Debonnet notes that insurance companies facing Solvency II regulations will have capital requirements of as much as 49% for hedge funds. But if the opacity of a straightforward NAV can be broken down into its component parts - equities, bonds, commodities, and so on - these can be added to the traditional assets in their portfolios to reduce the net additional capital required.

Better transparency and liquidity also offer more flexibility to take advantage of tactical market opportunities, which may prove difficult for a commingled fund constrained by strict investment guidelines.

Kodmani notes that managed accounts enable investors to ask managers to adopt more concentrated, higher-conviction versions of their strategies that may be unattractive in terms of the volatility they would introduce into a pooled product.

“We have the ability to ask our managers to produce portfolios that just reflect their best ideas,” says Kodmani. PAAMCO’s Fridman agrees: “Having these structures in place allows us to be more dynamic in working with the managers on shorter term ideas.”

The arguments for managed accounts are not all one way: HSBC Alternative Investments does not use them at all, according to global head of portfolio management Tim Gascoigne. “The appetite for managed accounts has dissipated over the past 18 months,” he insists. “They have the same liquidity as the underlying investments, but they can have higher fees and there can be conflicts of interest when a FOHF is looking to reallocate investment. Moreover, the best hedge fund managers do not offer them.”

So the role of FOHFs as a complement to direct allocations is rapidly evolving as this part of the industry fights to survive and grow.

For institutional investors, the sheer workload involved in managing a portfolio of direct hedge fund investments may also prove to be uneconomic once the numbers start going up.

Jama argues that FOHFs can add value through developing strategic relationships with their clients in areas such as sharing information and knowledge transfer.