Navigating the quagmire of the hedge fund universe is not easy or cheap. In their efforts to cut costs to improve returns, investors have taken on more control of hedge fund allocations, choosing to invest direct rather than through funds of funds.
“Some investors who began investing directly a few years ago are now reconsidering and engaging with funds of funds again for all or part of their hedge fund portfolio.”
Lisa Fridman
Yet, several years in, many have repeated the same mistakes just as funds of funds adopt a new, more sophisticated evolutionary role. In a world of increasing dispersion, where returns favour smaller managers, could the total cost of allocating direct be higher, in fact, than the premium paid for funds of funds managers’ skill?
“There are some signs of a trend reversal as investors have become aware of the true costs of direct investing,” says Lisa Fridman, head of European research at Pacific Alternative Asset Management Company. “Some investors who began investing directly a few years ago are now reconsidering and engaging with funds of funds again for all or part of their hedge fund portfolio.”
The same mistakes again
Institutions have tended to allocate directly to large, multi-strategy, blue-chip managers despite the considerable body of evidence showing large managers are less likely to provide better risk-adjusted returns than their smaller counterparts.
In recent years many of the mega funds, such as Brevan Howard, Bridgewater and Bluecrest, that have grown as investors piled more money with large, successful firms have found themselves pushed further into fixed income as size restricts their flexibility to trade without impacting markets. Fixed income has faced significant headwinds as central bank intervention increased and volatility declined. Some of those large funds have had a period more recently where rolling returns have gone down rather than up.
Mark Woolley, managing director of Blackrock Alternative Advisers, adds: “As managers get bigger, they become more correlated as there are only so many trades they can take part in. Investors can therefore be concentrating their exposures if they allocate to more than one large manager. Doing so also reduces the risk/return ratio. Smaller and emerging managers show minimal overlap, which is where the diversification benefits come from.”
Furthermore, some argue, allocating direct to large multi-strategy hedge funds can mean second, third or fourth tier managers as many multi-strategy funds developed from one core area before branching out.
“In some ways investors’ willingness to go direct is ironic,” believes Jeff Holland, managing director of Liongate Capital. “Most funds of funds allocated to the largest managers pre-2008. Since the crisis funds of funds have become far more sophisticated and are very much looking at what the underlying managers are investing in and aggregating that at the portfolio level. Many are looking at mid and small managers whose returns are higher, but they are also harder to identify, monitor and conduct due diligence on. In contrast, investors either going direct or using traditional consultants have been building portfolios that look a lot like the legacy portfolios of pre-2008 funds of funds.”
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