A dual model for hedge fund investing offers added benefits.

Many institutional investors have found the hedge fund of funds model to be a very useful entry point into a diversified and measured allocation to hedge funds. Such investors have enjoyed the dual benefits of multi-strategy exposure accompanied by the reduced draw on in-house resources for manager sourcing, due diligence and monitoring. Perhaps the best part of the hedge fund of funds approach is that it reduces the number of allocation decisions to one—in allocating 10% to hedge funds, there is no need to wrestle with five or six strategy decisions and a further 20 to 30 individual manager decisions. According to the February 2007 PerTrac HF Database Survey, there are 6,100 hedge fund of funds, with a total of US$700 billion in assets under management.

Approximately 86% of these funds reported performance in 2006, and only about 25% had assets of less than $25 million. According to the survey data and the authors’ own experiences, hedge fund of funds have increasingly become institutionalized—meaning that they are typically larger, have longer track records and are exhibiting a maturing trend of fewer launches compared to single-manager funds.

Hedge Fund of Funds versus Single Hedge Fund Managers

The appeal of the hedge fund of funds has generally been its potential to deliver strategy and manager diversification, comprehensive risk management, attractive risk-adjusted returns, improved capacity and liquidity, ease of administration and access to a broader range of managers with modest investment levels. Hedge fund of funds are also more easily understandable and readily adopted by busy trustees with diverse responsibilities. By comparison, in the same February 2007 PerTrac HF Database Survey, the number of single-manager hedge funds was significantly larger—13,675 hedge funds, with a total of $1.4 trillion in assets under management. More than 25% of these single-manager funds did not report performance in 2006. There were only 250 single-manager funds with assets of more than $1 billion and another 3,366 (33%) with assets of less than $25 million.

The appeal of single-manager funds has been their potential to offer compelling net returns due, in part, to the outsized bets being placed on a particular manager’s skill. Candidness and more granular reporting may or may not suit the palate of the institutional investor, consultant or trustee, but direct investment offers the benefit of improved transparency. Single-manager funds continue to draw attention because they tend to offer performance- based compensation that is well structured and aligns investor interests.

Historically, Canadian interest in single managers has lagged compared to that in the U.S. However, single managers are increasingly becoming part of the total strategy for hedge fund exposure, and for alternative investments overall. While they are currently embracing 130/30 and portable alpha strategies, Canadian institutional investors are expected to move more into hedge funds in the near future. Projected cumulative hedge fund net flows from Canadian institutions to hedge fund of funds over single managers in the 2006 to 2010 period have been estimated at 51% hedge fund of funds and 49% direct on flows of $510 billion, suggesting a growing interest and a closer second look at direct investment in single managers. Sensitivities to fees, net performance and diversification are also driving this trend.

Best of All Worlds

The perception that recent returns in hedge fund of funds have been eroded by additional fees and a higher correlation with other asset classes has led to the creation of the “coresatellite” approach, which divides the portfolio into a passively managed core component and an actively managed satellite portion. “Core” refers to a hedge fund of funds as the cornerstone alternative exposure, and “satellite” refers to supplementation with either a single-strategy hedge fund of funds or a single-manager hedge fund.

In Canada, there has been more interest in core-satellite approaches than in the straight substitution of single managers for hedge fund of funds in plans with assets under management of $10 billion and, generally, for U.S. plans with assets under management of less than $5 billion. In the U.S., single-strategy hedge fund of funds also seem very popular as a second-generation hedge fund investment for institutions. Typical features of a single-strategy hedge fund of funds, as opposed to the traditional multi-strategy model, include a tighter set of managers, managers who reflect analysts’ best ideas, allocations that reflect conviction, diversified exposure to potentially more volatile sectors, and relative simplicity and transparency.

Fiduciaries will always want, and need, their professional money managers to report back to them, whether they are single managers, single-strategy hedge fund of funds or multi-strategy hedge fund of funds. These same institutions will benefit from the unspoken covenants with their advisors, who agree to work alongside consultants in providing additional protection through useful education and status reports to arm them against headline risk (the concern that the fund will make headlines due to poor performance or controls) and job risk.

In order to get better results from their current hedge fund allocations, plan sponsors should work with their consultants to evaluate their risk tolerances, committee comfort and internal resources, as well as the options available in the marketplace. In doing so, they should keep the following guidelines in mind.

• Single-manager allocations should be selected to augment, offset or secure capacity and exposure to specific securities, geographies or strategies.

• A single-strategy hedge fund of funds with fewer managers should be focused on a particular investment strategy. This option offers boutique exposure to certain markets in a more concentrated fashion.

• A core-satellite approach should be built under one investment platform or through the opportunistic selection of select single managers.

There is some merit to middle-ground approaches, such as a diversified hedge fund of funds focused on one strategy (e.g., emerging markets or managed futures) or a core-satellite approach targeted to a plan’s particular objectives. An impressive 42% of North American institutional investors use a combination of hedge fund of funds and single managers—the dual approach. For the institutional investor, allocating to a hedge fund manager with experience in both hedge fund of funds and single-manager approaches can offer the best of all worlds—especially if the single-manager offerings are subject to the same rigorous screening, due diligence and monitoring requirements as the managers of the larger and more prominent hedge fund of funds clients.

Regardless of which approach the plan sponsor chooses, the basics of manager selection continue to apply. Plan sponsors should look for manager pedigree and sound operational infrastructure, a competitive trading edge, measured exposure to market factors, a proven track record over different market cycles, the ability to articulate the investment process, and the undertaking of reasonable risks relative to potential returns when evaluating their options.

Mark Sack is a business development consultant, and Darren Johnston is director of Rye Investment Management, a division of Tremont Group Holdings, Inc. msack@sympatico.ca; djohnston@ryeinvestmentmanagement.com

For a PDF of this article, click here.

© Copyright 2008 Rogers Publishing Ltd. This article first appeared in the Spring 2008 edition of INNOVATE magazine, published by BENEFITS CANADA.


Copyright © 2020 Transcontinental Media G.P. Originally published on benefitscanada.com

Join us on Twitter