Jul 2017 by Joe Burns
The hedge fund industry continues to hit record levels in terms of aggregate assets under management. Current assets now exceed $3T, of which an estimated $600B is invested via Fund-of-HedgeFunds (FoHFs).
The hedge fund industry continues to hit record levels in terms of aggregate assets under management. Current assets now exceed $3T, of which an estimated $600B is invested via Fund-of-HedgeFunds (FoHFs). For context, the hedge fund industry managed approximately $2T pre-crisis, with FoHFs representing roughly $800B of that total. So, while the overall industry has grown by 50% in AUM over the past 10 years, the percentage of FoHF capital has decreased from 40% of that total to 20% since 2007.
Any company, industry or asset class that loses half its market share over a 10-year period is bound to encounter certain pressures. Driving the ongoing redemptions and general investor dissatisfaction in the traditional FoHF model has been the perception (or reality) of excessive costs and disappointing returns. And while certain firms have gained significant market share over the past decade via reliable performance and excellent client service, the challenges impacting the overall business model are structural in nature, and unlikely to abate anytime soon.
Does that mean that investors in hedge funds should "only" invest directly into single funds, eschewing the obvious benefits of multi-manager diversification? Not necessarily. The concept of a "MultiFund Solution" is a relatively new, but potentially crucial approach in providing investors the opportunity to protect capital, enhance returns and diversify their portfolios via a single allocation.
So, how does a Multi-Fund Solution differ from a traditional FoHF portfolio, and what are the benefits for the underlying investor? In our view, there are several critically important distinctions.
• Fixed number of managers: no new managers added to each fund post-launch
• Established allocation range: hard-coded range of position sizes per manager
• Transparent investment guidelines: investors see managers, sizing & risk limits (pre-investment)
• Established manager capacity: e.g. secure specific manager capacity over defined period
• Predetermined Exit Strategy: e.g. max. drawdown, key man departure, business risk oversight
• Limited Fund Capacity: not an asset gathering vehicle (fund size limited by capacity / sizing)
• More concentrated: 4-8 managers in each fund, as compared to 25-40 in most FoHF portfolios
• Less beta: fewer managers, with focus on multi-strategy and/ or lower net specialist funds
• More disciplined: cap the number of positions in each multi- fund solution (e.g. no dilution)
• Less conflicted: an independent firm focusing on enhancing the client experience (not AUM)
• More transparent: fewer managers = deeper understanding of return drivers and risk exposures
• Less expensive: 50bps fixed fee
Traditionally, there have been three approaches to investing in hedge funds: choose one, select a few, or outsource the selection process to a FoHF. Each approach has embedded advantages, with meaningful challenges. The “Fund-of-One” is great when it works, but carries significant concentration risk. Choosing a handful of funds can be harder to manage from a legal/tax/reporting standpoint. And the traditional Fund-of-Funds model typically has high fees, too many managers, and a potential misalignment of GP/LP interest as it relates to capacity management (as evidenced by the rarity of a FoHF closing to new capital). One can posit that this approach worked best prior to the “institutionalization” of the hedge fund industry, when managers ran with much higher levels of volatility, with lower correlations and 20/30/40-fund portfolios provided a level of diversification accretive to the risk-return profile of the overall fund.
The Multi-Fund Solution approach is designed to capitalize on those distinct advantages, while removing the challenges. Investing via a limited number of managers significantly lessens the single-manager concentration risk (especially when focusing on diversified multi-strategy funds); the vehicle itself has a single K-1 with integrated performance attribution, risk management and reporting efficiency; and the concentration, transparency and capacity management benefits as compared to the traditional multi-manager model flow directly through to the underlying investor.
Efficient access to a limited number of high-quality funds in a simplified structure with lower fees, potentially higher returns, lower volatility and less market/industry beta vs. competing single and multi-manager products? For certain investors, the Multi-Fund Solution may be the preferred approach to achieving their risk/ return objectives.
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