while a number of large family offices were among the very first investors in hedge funds, smaller ones mostly entered this arena only a few years ago, lured by the promise of steady positive returns in any market environment.
Typically, they invested in broadly diversified multi strategy funds of hedge funds and then endured losses of more than 20% throughout the credit crisis while also seeing a portion of their investment turning illiquid. As a result of their disappointing investment experience, many of them have terminated or reduced their exposure to such vehicles and remain reluctant to reinvest.
Although market conditions throughout the credit crisis were certainly challenging, it must be said that too many funds of hedge funds turned out to be rather poorly managed and failed to add value. Much has been written on their failures to properly match assets with liabilities and avoid detectable frauds, notably Madoff. Less attention was paid to the problem that many large multi strategy funds underperformed because they faced capacity constraints and ended up with investments in a similar set of underlying managers.
Even less discussed was that many advisers had a rather limited understanding of the industry and failed to adequately inform clients about the inherent risks of proposed investments. Often, they lacked the required resources or were not willing to invest the time and money to perform comprehensive due diligence on prospective managers and conduct ongoing monitoring. As a result, they selected poorly performing managers or failed to react to warning signals. Even worse, some of them simply recommended clients invest with those funds that paid them the highest rebates.
Having been so critical, the question arises whether funds of hedge funds investments have paid off and, more importantly, if they will do so going forward. Over the long-term, even the average fund comfortably outperformed most other risk assets with lower volatility and smaller drawdowns. Top quartile funds of hedge funds have also delivered better capital preservation and liquidity management throughout the downturn than the average manager.
Well-selected fund of hedge funds have proven to be a rewarding investment and we believe they will continue to do so. That is because their main advantages all remain valid, namely performing investment and operational due diligence in order to select the best managers while providing diversification and access to funds closed to new investments,.
Recent industry developments have also been positive as liquidity mismatches have been largely rectified and fees have come under pressure. Additionally, the industry has responded to the criticisms of opacity, insufficient regulation and poor liquidity. This is evidenced by the recent proliferation of Managed Accounts, UCITS III funds and liquid replication strategies. We think funds of hedge funds constitute a more compelling investment than two years ago simply because many poorly managed or financially unviable funds have been forced out of business, thereby raising the average quality.
Leaving the past and present behind, we would like to provide a number of forecasts:
• Funds of hedge funds will see their assets under management increase, albeit at a slower rate than in the past.
• Family offices and private investors will be responsible for the bulk of this growth.
• Institutional investors will increasingly prefer to invest directly in single manager hedge funds.
• Industry consolidation will continue, with more managers being taken
over or going out of business.
• Larger multi strategy funds will increasingly focus on investments
with smaller managers to
differentiate themselves.
• The funds of hedge funds universe will become more specialised and diverse, offering more style specific, regional and inefficient niche market strategies.
• With the higher specialisation across funds, return dispersion will also increase.
• Loosely regulated offshore structures will survive but fund flows will lean towards more recognised domiciles.
• Passive fund of hedge funds strategies will lose appeal as they constitute a contradiction to the guiding principles of active investing and identifying individual investment talent.
Many recently touted solutions, such as Managed Accounts and UCITS III funds, may have their individual merits but they also come with their own specific risks and limitations. We fear the foundation for fresh disappointments is being laid, as many advisers seem to again be failing in the management of client expectations and inadequately informing them of risks involved in such investments. Similarly, some recent legislation seems to have been driven more by political motivation than by genuine desire to protect investor and features
the potential to be counterproductive by curtailing managers’ flexibility.
Funds of hedge funds have gone through turbulent times and individual investor experiences may even have been dismal for a host of reasons. We remain positive on their return outlook, but stress the importance of rigorous due diligence and an unbiased fund selection process. In the absence of in-house expertise and taking into consideration the complexity of underlying strategies as well as the sheer size and continuing evolvement of the funds of hedge funds universe, we would argue a truly impartial financial adviser who features the necessary experience and expertise constitutes the best solution for overcoming the obstacles outlined above.
