Funds which charge investors to pick out successful hedge fund bets are struggling to reinvent themselves and convince their clients they are worth the fees.
The $895 billion hedge fund of funds industry has seen assets contract sharply in the years since the financial crisis, with the number of firms down 30 percent in part because of weak returns that have generally lagged straight hedge funds.
The downturn in the fund of hedge funds industry started in the 2008, at the height of the crisis, with outflows of $40.9 billion, increasing to $118.4 billion the year after, Hedge Fund Research data showed. They slowed to $4.1 billion in 2014, only to rise again in the first half of this year to $5.2 billion.
Since then, the high-profile collapse of London-based Liongate Capital, which shut this quarter citing an exodus of clients, has put the sector in the spotlight.
A desire on the part of pension funds and others to invest directly in a manager, thereby avoiding the extra layer of fees, has forced fund of funds to expand the services they offer or merge to boost assets and get economies of scale.
"Hedge funds have changed, our clients have evolved and they have become more demanding," Ronan Cosgrave, managing director at U.S. firm PAAMCO, which manages $9 billion.
"Any fund of funds which is successful in 10 years will be those which have anticipated and changed with the market. You've got to be doing something the client thinks is valuable to get paid for it."
Funds of hedge funds traditionally charged an annual management fee of up to 1 percent of an investor's assets and a performance fee of up to 10 percent to pick individual hedge funds. Those charges were layered on top of the individual hedge funds' 2 percent management fee and 20 percent performance fee.
Many cost-conscious investors have walked away rather than stump up the cash, more confident in their abilities to pick a winning manager as new rules encouraged the hedge fund industry to become more transparent.
A number of pension funds, in particular, have also developed expertise to select funds in-house and so no longer require the expensive middleman.
"Fees on fees hurt a lot more than they did when people were talking 10 or 15 percent annual returns," said Jim McCaughan, chief executive of PGI.
"When you're down in the 4, 5 or 6 percent annual returns, the extra fee makes a difference."
Survival Of The Fittest
Funds of funds are adapting to succeed in this new environment, with many offering bespoke accounts giving clients full transparency about what assets they are invested in.
Others, like Arden Asset Management and Franklin Templeton's K2 Advisors are tapping into the growing demand for new 'liquid alternatives' mutual funds, where an asset manager offers cheaper, more transparent access to top hedge fund trading strategies using liquid assets such as stocks and currencies.
And while many pension funds were still focused on making their own bets, others had tried and failed so were now prepared to use a fund of hedge funds, albeit at a lower price.
"While many investors had sought to go direct to underlying funds immediately after the financial crisis, a lot were now realizing it took enormous resource to monitor and construct portfolios that worked," said Aberdeen’s Global Head of Alternatives Andrew McCaffery.
For larger investors with $100-$200 million looking to use a separate managed account platform – a bespoke fund of funds – the management fee could be as little as 30 to 50 basis points, he said.
But while many fund of funds are aggressively pursuing a new business model, more are likely to go the way of Liongate.
"It's a very rough estimate, but I think anything under $1 billion for a fund of funds is going to struggle," said Marianne Scordel, founder of hedge fund consultancy Bougeville Consulting.
Data from Preqin shows the bulk – 72 percent – of the 2,306 funds which make up the industry have less than $1 billion in assets.
Along with the asset outflows, the number of new funds launching has also slowed: from 178 fund launches in 2010, just 83 launched in 2014, while year-to-date in 2015, that figure is 24, Preqin data showed.
"At the moment, you've got a strong tendency for M&A among fund of funds, because on their own, a lot of them are finding it hard to survive," Scordel said.
