Funds of funds are facing an existential crisis. Tested to destruction by the events of 2008, they are engaged in a fighting retreat, in which their ability to spot talented managers and assess the quality of operational infrastructure is gradually being overrun by the ability of consultants to steer large amounts of institutional money into established managers whose brand often exceeds the value of their performance. Give the free ride investment consultants have enjoyed, this does not necessarily represent progress, for managers or investors.
Industry surveys make miserable reading for funds of funds these days. It is hard not to see why. The Goldman Sachs survey of global hedge fund investors, now in its thirteenth year, has never received so few responses from funds of funds. This year they made up just one in three respondents, against two in three as recently as 2008. It gets worse. Last year, a study by the prime brokerage group at Deutsche Bank found more than half of investors now prefer direct investment over funds of funds. Assets under management (AuM) by funds of funds had fallen from $1.2 trillion in 2008 to just $810 billion by February this year. A study of funds of funds by S&P Capital IQ Fund Research reckoned that by 2011 nine out of ten funds of funds were “un-gradable,” once their performance was measured against absolute rather than relative return benchmarks. Even the modest improvements in performance at the beginning of this year cannot reverse the verdict of the last six years. Since the financial crisis of 2007-09 put the claims of funds of funds – access to best of breed managers plus diversification of risk -to the ultimate test, which they failed comprehensively, their popularity has wilted. The reputational stain of putting money into Madoff has also proved indelible. Yet the heirs to the funds of funds as the chief arbitrators of who gets allocations in the hedge fund industry do not necessarily represent an advance. They are the investment consultants.
The same Deutsche Bank study that charted the increased preference for direct investment also noted a doubling in the proportion of institutional investors that rely on the advice of consultants to 60 per cent of its survey respondents in the last two years. The proportion has almost tripled since 2002. Two out of three public and private pension funds now use investment consultants when making direct hedge fund investments, compared with just one in seven in 2010. “There is a strong trend among large pension funds and 401(k) plans to shift business away from funds of funds and replace them with investment consultants,” says Don Steinbrugge, managing partner at Agecroft Partners, a Virginia-based third party marketing firm. “It is a trend mainly associated with the large $5 billion plus pension plans. However, sub-$5 billion plans appear to be sticking with funds of funds.” According to predictions by the prime services group at Goldman Sachs, consultants were on course to control nearly one fifth of the $2 trillion-plus managed by hedge funds by the end of last year. As recently as 2007, consultants accounted for just 3 per cent of the monies flowing into hedge funds. This is an entirely predictable consequence of the institutionalization of hedge fund investing. Institutional investors are locked into a marsupial relationship with investment consultants, which have long advised them on their long-only allocations, and adding hedge funds to the list is scarcely a revolutionary move. Whether they will be any good at the job, given their far from stellar record on traditional investing, is not a question most institutional investors are yet ready to ask. The grip of the consultants on hedge fund allocations is bound to tighten, irrespective of the quality of their decision-taking.
"There is a strong trend among large pension funds and 401(k) plans to shift business away from funds of funds and replace them with investment consultants."
So it is worth asking how they go about the work. Stephen Oxley, managing director at Pacific Alternative Asset Management Company (PAAMCO), an $8 billion fund of funds, stresses the importance of distinguishing between the different types of consultant. Specialist firms such as Aksia and Albourne Partners he sees as “independent assessors or researchers of hedge funds and funds of funds.” Certainly Albourne – which astutely abjured the temptation to set up a fund of funds of its own in the boom times – has, in the estimation of many ion the industry, become the most powerful influence over hedge fund allocations today. Its clients have $270 billion invested across 2,000 hedge funds. Albourne carries out operational due diligence on managers and rates them accordingly, publishing its top-pick funds in monthly reports for clients. As David Harmstron of Albourne in North America points out, the secret of the success of the firm is its abstention from investing actively in hedge funds on its own account, unlike some other consultancies. “We are 100 per cent advisory and do not want to also take discretionary decisions, as this can create conflicts of interest,” he says. Research and operationally focused due diligence of the kind provided by Albourne was cited by 49 per cent of investors in the 2012 Goldman Sachs prime brokerage survey as the main reason for using a consultant. As Oxley points out, this puts the traditional investment consultants, which are readier to invest, in a less favourable position. “Investment consultants can operate in a more fiduciary manner where they have discretion,” says Oxley. “The business going to these consultants would have historically flowed to funds of funds. Some of these consultants even run their own funds of funds business.” Though a fund of funds can scarcely be expected to enthuse at consultants entering their market, running money as well as advising on it clearly raises issues.
The conflict of interest is obvious. Much less obvious is the likelihood that decisions will be skewed towards larger managers. As investing in the hedge fund industry has institutionalised, the size of allocations has increased. The high performing emerging managers which have long characterised the best of the hedge fund industry can struggle to absorb large allocations, and are in many cases ruled out because their operational infrastructure allegedly falls short of minimum institutional requirements. As a result, some see investment consultants as nothing more than glorified access vehicles to household names, whose business bears a more than passing resemblance to the tried, tested and failed funds of funds model of the pre-crisis period. Investment consultants have an understandable reluctance to take risks on investment advice, especially on behalf of clients whose natural conservatism they have done nothing to disturb. Inevitably, the biggest managers – the Man GLGs, Wintons and Brevan Howards - dominate the portfolios built by investment consultants. “Hedge fund consultants mainly recommend the large, well-known, established blue chip firms,” explains Stephen Oxley. “The consultants primarily invest in institutional managers with an institutional operational framework.” This is not the best way to achieve performance. Countless industry research papers and studies have shown that emerging managers easily outperform their larger brethren. Their strategies are novel, their managers hungrier, and their positions nimbler. Unlike established managers, which soon settle down to gathering assets and collecting fat management fees that can keep them going even if performance falters, smaller managers struggle to survive without performance fees.
Certainly, fund of funds are looking to capitalise on this history. The predictable preference of investment consultants for larger funds has given them an opportunity to reinvent themselves as allocators to alpha generators among emerging managers. “Most pension funds are still new to the hedge fund game and want exposure to brand name managers, which they view as safe,” says Steinbrugge. “Consultants provide this for them. Funds of funds, having taken such huge hits to their business since 2008, are becoming more innovative and are focusing on returns often by investing in mid-sized or smaller managers.” The 2013 Deutsche Bank prime brokerage survey confirms that a majority of allocators (58 per cent, to be exact) see the raison d’etre of a fund of funds as providing them with access to niche managers or smaller funds. Some funds of funds haver of course always sought to specialise in emerging managers, but others have had to alter their approach as investment consultants have come to dominate their previous occupation. A survey conducted last year by SEI found that 84 per cent of investors believed that funds of funds would still exist in 20 years’ time. 72 per cent of respondents to the same survey acknowledged that funds of funds continued to play a valuable role in institutional investment portfolios. Yet even SEI, which has much at stake in the field, warned that funds of funds have no divine right to survive. The firm warned that, if funds of funds are to retain investor confidence, they must customise portfolios, focus on emerging managers and niche strategies, enforce a more active approach to risk management, concentrate portfolios, increase specialisation, create managed accounts, and offer both consultancy services and lower fees.
Certainly some funds of funds are taking the SEI advice and becoming more like investment consultants. “Investors are becoming more comfortable allocating directly to hedge funds or via consultants, so funds of funds are having to reinvent themselves as investment advisers, albeit with fiduciary responsibilities,” explains Chris Jones, head of alternatives at bFinance, and a former CIO at fund of funds Key Asset Management. Their main point of vulnerability is fees. The 2013 Goldman Sachs survey of hedge fund investors found that investor pressure for lower fees to managers is making unspectacular progress: 83 per cent of the 2012 investments by respondents were made at full fees, and the average fee level across all the managers surveyed has fallen from 2 and 20 to 1.65 and 18.3, a fall of 17.5 per cent in management fees and less than half that in performance fees. But in this environment, fund of funds laying additional fees on top of a fee structure which remains generous to mangers is proving hard to sustain. According to data provider Preqin, one funds of funds in ten is now happy to skip a management fee altogether, and few charge the full 1 and 10 they collected in their glory days. Investors have long complained they are paying 3 and 30 for the privilege of being in funds of funds.
“Many investors complain funds of funds are another layer of fees, and investment consultants obviously make that argument too and market themselves as a cheaper alternative,” accepts Stephen Oxley. But he argues that PAAMCO spends the majority of the additional fees on the staff – all 130 of them – that talent-spot the high performing managers, whereas consultants have a much larger infrastructure and overhead to support. But almost anything a funds of funds charges will make its model look substantially more expensive than the investment consultant alternative, and it is not hard to find a funds of funds manager who complains that consultants are undercutting their businesses. “1 and 10 is no longer than norm at funds of funds,” agrees Craig Stevenson, a senior investment consultant in the manager research unit at Towers Watson. “I suspect it is closer to 0.75 per cent and just south of 10 per cent. Nevertheless, we are still very far south of that.” Investment consultants’ access to large allocations also gives them greater bargaining power with managers. “We are pro-active on fee negotiations with the underlying manager, which means our clients get charged less as well by the hedge fund,” says Stevenson.
That said, the larger allocations and the accompanying increase in leverage on fees is another aspect of the concentration of risk at larger and better established managers. Naturally, consultants dispute the claim that they are biased in that way. “We try to be open minded,” says Craig Stevenson. “Obviously we want managers who can accommodate institutional requirements, not just in the middle and back office, but also in the investment team, although it would be misleading to say we work exclusively with the biggest managers. For example, we hold a positive view on a manager that has firm AuM currently well below $250 million.” Speaking at GAIM Ops Cayman in April 2013, Charlie Cassidy, managing director at consultancy Cambridge Associates, said his firm was excited by opportunities in emerging markets. “We are looking at managers in North Africa, Asia and Latin America,” he said. “We have had an increasing amount of client interest in emerging economies and emerging hedge fund talent in those jurisdictions and we do not see that changing at all.” But lack of interest in the small and the exotic are not the only complaints levelled at investment consultants. There is also concentration risk. If they ensure that money congregates at a smaller group of large managers, investment consultants are almost certainly guaranteeing correlated risks and returns as well.
Craig Stevenson of Towers Watson confirms that his firm has a focused list of around 50 approved funds. A typical client will allocate to between 12 and 15 of these, making it hard to sustain the view that client portfolios are well-diversified. “The range of returns between the best performing and worst performing long/short equity funds on the Hedge Fund Research Index in 2011 was 265 percentage points,” explains Stephen Oxley. “That is an extreme figure but it illustrates how broad the range of returns can be in hedge funds. It is one of the reasons why funds of funds build diversified portfolios of hedge funds for clients.” However, there is always a risk funds of funds become overly diversified, with the returns of the worst-performing managers devouring the returns of the top decile, as a 2011 Citi Prime Services research paper warned. Stevenson is not slow to point to the risk. “The question to ask is whether having 15 managers as opposed to 45 managers in a portfolio is more efficient particularly in the context of a client’s wider scheme allocation,” he asks. “Clearly portfolio construction is key. We construct portfolios with the appropriate level of diversification and our clients are not exposed to undue concentration risks. About 5 to 10 per cent of clients’ portfolios are actually in our hedge funds across the board so the allocation, when considered on a look-through basis to an individual hedge fund, is quite modest.”
"There will always be change in this industry and even the largest hedge funds can run into difficulties."
But investment under-performance is not the only risk to stem from concentration on a small group of large managers. Large fund managers may have institutional quality operational infrastructure, but that alone cannot insulate them from failure, even in the worst possible way. After all, Madoff and Galleon were both household names. “Consultants’ clients feel comfortable with established organisations and they feel they will always be there much like they believe long-only managers will always be there,” warns Stephen Oxley. “However, if we look at who were the best and largest hedge funds five, ten or 15 years ago, the landscape is incredibly different to what it is today. There will always be change in this industry and even the largest hedge funds can run into difficulties.” This unquestioning faith in the trued and trusted is a potentially lethal threat to the entire hedge fund industry. If a large and well-regarded manager failed through inept investments or downright fraud, and pension funds lost money, a regulatory prohibition on pension funds investing in alternative asset classes would follow as night follows day.
Indeed, there is a view that the investment consultant preference for the large and established managers reflects a willingness to skimp on operational due diligence. This is, say some, the mirror-image of the intense focus of funds of funds on operational due diligence, since smaller managers are at greater risk of operational shortcomings. Rajiv Jaitly, a former COO at Axa Investment Managers who is now an independent consultant, says operational due diligence is not a priority for investment consultants. “In areas of operational due diligence, consultants are nowhere near as intensive as some funds of funds and I suspect many view it as an add-on service that eats into their bottom line,” he says. “I have heard about consultants travelling long distances to meet a fund as part of their operational due diligence exercise who did not once step out of the boardroom during the meeting. I was staggered. Due diligence is about getting an in-depth feel for the operational processes at an investment. On top of that, I rarely see consultants carrying out operational due diligence on outsourced service providers – this again is a serious shortcoming.”
This vulnerability is recognised by some investment consultants. Towers Watson, for example, has recruited a number of people into its operational due diligence team, including several from funds of funds. “This was a common criticism up until recently about investment consultants,” says Craig Stevenson. “We have expanded our team substantially and we intend to continue to increase headcount through experienced hires. I cannot speak for my competitors but our operational due diligence team size is now comparable to most funds of funds.” Stephen Oxley agrees that consultants are now aping the revamped funds of funds model and bolstering operational due diligence teams. “Admittedly, consultants focus on big funds whereas some funds of funds work with niche, smaller managers where the operational work required is of a higher order,” he says. “However, we are aware of consultants hiring more operations professionals and developing their operational due diligence, which shows they recognise the importance of this work.”
If lack of operational due diligence expertise is a less valid criticism of investment consultants than it once was, one stricture is still telling: investment consultants, unlike funds of funds, do not eat their own cooking. They have no direct capital exposure to their hedge funds. “Investment consultants just provide investment advice,” says Jaitly. “Unlike funds of funds, which have capital invested and at risk in hedge funds, consultants just have to manage reputational risk. I suspect this is why their operational due diligence has been so lacklustre.” Craig Stevenson acknowledges the criticism, but denies lack of co-investment reduces the sense of responsibility. “Towers Watson is a fiduciary to its clients and has been at the forefront of taking its fiduciary responsibilities very seriously,” he says. “We have to comply with internal accounting and auditing standards, and if we give advice that is bad, we face serious liability.” Stephen Oxley reckons the question requires a more nuanced answer than that. “A fiduciary manager has a responsibility to be as impartial as possible,” he says. “I find it difficult to understand how a consultant can say they are impartial and independent when they have an internal hedge fund team implementing clients’ portfolios without necessarily considering outside alternatives. The selection process in this case is partial.”
Indeed, an old saw about the role of the investment consultants in investment decisions from the long-only world has returned to haunt them in the alternatives industry as well: that they accept “pay to play” commissions, or fees from hedge funds for which they secure allocations. A consultant which offered business management advice, or rated a manager, would certainly be at risk of being accused of a conflict of interest. Craig Stevenson dismisses the idea. “We do not receive any fees whatsoever from managers and we have complete discretion over our manager ratings,” he says. “We are not in any way compelled to rate a manager and there is no financial incentive for us to do so. It would be a huge conflict.” Harmstron of Albourne agrees that accepting payments for allocations represents an conscionable conflict. He adds that “some consultants may receive rebates from managers, which we see also as a conflict.” Reputation alone certainly argues in favour of the claim that, if any investment consultant is receiving fees from managers for allocations, the culprit is more likely to be a smaller and less regulated firm. “I would be very surprised if large consultants got paid by managers for placing assets as these organisations are very tightly regulated,” explains Steinbrugge. “However, I suspect smaller consultancy shops might get a fee, but those organisations would be required to disclose publicly to their clients about that conflict and it would be up to the client to determine whether they are okay with it.”
Talk of disclosure of conflicts of interest, and of reputation, are a reminder that both investment consultants and funds of funds bring historical baggage to the current contest between them. But on party - funds of funds – is evolving faster than the other, because it has to. Weaker funds of funds have either shut down or been acquired. The survivors have made operational due diligence and manager research central to their proposition. Investment consultants, which have suffered remarkably little questioning of their own performance in the great financial crisis, must at some point be asked some searching questions about the quality of the advice they give and have given. A small band of pension funds, including the Universities Superannuation Scheme (USS) in the United Kingdom, are already severing the marsupial ties. They are building their own alternatives investment teams, enabling them to jettison investment consultants as well as funds of funds. It is only a matter of time before other end-investors succumb to the same logic. It is a threat Craig Stevenson understands. “The industry is constantly evolving and the trick is to evolve with it,” he says, but will not be drawn yet on what investment consultants will look in five or ten years’ time. Steinbrugge is confident they will adapt and survive, whatever their enemies wish for them. “Consultants will not be finished when their client base evolves,” he predicts. “They have been around for 27 years and they are constantly reinventing themselves.”