Infovest21, a New-York based provider of information and research to the hedge fund industry, has just released its 2010 fund of hedge funds survey. The main finding, brought forward in the firm’s related announcement, is that “Funds of funds add more nimble managers, prefer small to medium-sized managers”. The contrary would have surprised me.
The last financial crisis has allowed investors to distinguish between the good and the bad (less the lucky ones) in the fund of funds industry. During the glorious years for hedge funds, between 2003 and 2007, managing a fund of funds was a reasonably easy task. According to the Dow Jones Credit Suisse Hedge Fund index, the hedge funds delivered a total net return of almost 75%, corresponding to a compound annualized ROR of 11.79%, during those 5 years. The low barrier to entry drove to the industry a lot of managers who realized the strong potential to earn over 2% (based on the standard 1% management fee and 10% performance fee) on managed assets with little research costs (who ever heard about due diligence at that time anyway). According to the Infovest21 survey, today the average fee structure is a 1.1% management fee with a 6.1% performance fee. All those new entries brought strong competition for assets amongst fund of funds managers and therefore a need to develop a real edge. The development of a real competitive advantage was not about adding leverage or investing in exotic/ not well known “alphabet soup” strategies but it was about building a strong research and adheres to high due diligence standards. The ones who picked the first two options are probably no longer in existence today or are still struggling to liquidate their portfolios.
According to the survey’s respondents, who were themselves above this threshold, on average, at least $1.4 billion is needed to "survive and thrive". With this level of assets, the managers earn on average (assuming an 8% annualized return) an annual fee of approximately $25 million. When considering making an investment with a fund of funds manager, investors should be mindful of how much budget is allocated to the company’s resources and not entrust their money with a manager who is looking to increase his margin at the expense of his investors (inadequate resources are the recipe for future disaster).
The move toward smaller hedge fund managers is not really a surprise. Post 2008, in the urgency, fund of funds managers had to rebuild quickly the confidence of their investors and achieved that by moving assets toward the well known, large and liquid hedge fund managers. Most of those managers are today well above their end of 2007 AUM due to this flight to “size” and are therefore likely to close to new assets soon. Furthermore, those managers founded in the late 80’s, early 90’s have to think proactively about their succession planning. Investors need to assess what will be the impact of the historical founders stepping down on the business and on the returns. Chris Shumway, Stanley Druckenmiller, John Horseman and Leon M. Wagner are a few examples of star fund managers who stepped down and retuned assets to investors in the last twelve months. Also big is not always beautiful, several academic studies have demonstrated that smaller and nimbler funds tend to outperform their larger peers. An additional incentive for fund of funds to diversify away from the blue chips is to differentiate themselves from the competition. An investment analyst in one of the big Swiss private bank recently told me that the biggest problem today was the high level of overlap between funds of funds’ underlying positions. In order to stand apart, the managers need to go off-road and find the gems wherever they are. Furthermore, institutional investors are more and more contemplating investing directly into hedge funds and if they realize that the end game is just to pick funds among the larger ones, they will certainly conclude that they can do it on their own.
Another interesting trend highlighted by the survey is the move toward industry consolidation. Almost two-thirds of the respondents have considered a strategic partnership while almost one-half considered acquiring another entity. Another 30% have considered merging or have merged with another firm. Adding to assets and/or distribution channels was the main motivation in these efforts.
The fund of hedge funds industry is changing fast to rebuild investors’ confidence and to prove that they can add value. I hope that they really learned the lessons from the last crisis and that bad habits are gone for good. Unfortunately complacency and greediness are very sticky within the finance industry and investors need to keep vigilant for not falling in the next trap.
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