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In their nearly four years managing absolute-­return investments for the $140.6 billion New York State Common Retirement Fund, Peter Carey and his team completely rebuilt the third-­largest U.S. public pension plan’s hedge fund portfolio, moving from a strategy that depended on funds of hedge funds to a much more elaborate one that focuses on direct investing, portfolio construction and manager selection.

By last summer, Carey thought that other investors could benefit from the insights and expertise his group had developed overseeing the $4 billion absolute-­return port­folio, which was invested in 28 hedge funds. But New York Common is prohibited from managing outside money, so in November, Carey and his deputy, Robert Mazurek, announced that they had joined SkyBridge Capital II and would launch a new institutional business, ­SkyBridge Direct.

SkyBridge, No. 27 on the Fund of Funds 50 — ­Institutional Investor’s annual ranking of the world’s biggest multi­manager hedge fund firms, determined by assets under management as of January 3, 2011 — didn’t have a traditional fund of hedge funds until last spring, when it bought Citi Alternative Investment’s hedge fund business. SkyBridge is one of many multi­manager hedge fund firms seeking to diversify their capital bases and attract more institutional money. In doing so these firms are responding to the transformative trends dominating the fund-of-hedge-funds industry today and are working against the increasing tendency among institutional investors — like New York ­Common — to invest directly in a basket of hedge funds they create ­themselves.

“At New York Common we realized that we had basically built a fund of hedge funds in-house,” says Carey.

The firms constituting this year’s Fund of Funds 50 run a combined $525 billion, up 4.4 percent from the $503 billion that the 50 biggest firms managed when 2010 began but 40.1 percent less than the $877 billion they had as of mid-2008. The vast majority of the money is invested with the very largest firms. The five biggest managers collectively control 27.5 percent of the assets, as top-­ranked HSBC Alternative Investments Ltd and No. 2 ­Blackstone Alternative Asset Management each saw its assets under management jump by more than $6 billion last year.

The economic collapse that began in late 2007 and accelerated when U.S. investment bank Lehman Brothers ­Holdings filed for bankruptcy in September 2008 hit hedge funds hard. Overall hedge fund assets under management fell from a second-­quarter 2008 high of more $1.93 trillion to $1.4 trillion at the end of 2009, according to Chicago-­based Hedge Fund Research. Fund-of-hedge-fund assets shrank from $825.9 billion in mid-2008 to $571 billion at the end of 2009. Although the hedge fund industry overall is nearly back to its asset total before the financial crisis, fund-of-funds assets had recovered to only $646 billion when this year began.

Much of the reason for the less robust growth of funds of funds is that the bulk of the new assets flowing into hedge funds is from institutions. A March Deutsche Bank survey of more than 500 hedge fund investors representing $1.3 trillion in hedge fund assets found that 80 percent of foundations and endowments, 83 percent of pension funds and sovereign wealth funds and an astonishing 96 percent of insurance companies increased their allocations to hedge funds last year. But 62 percent of these same investors said that none of their new allocations will be made to funds of hedge funds.

Institutional investors are increasingly balking at the extra set of fees that multimanager firms impose. The standard fund of funds adds a 1 percent management fee and 10 percent performance fee to the typical 2 percent and 20 percent that single-­manager hedge funds charge. To survive, fund-of-funds firms are having to adapt and prove their worth.

“Funds of funds are partnering with institutions, and as they do that they are helping educate these investors in alternatives,” says Scott Carter, New York–based head of global prime finance sales and capital introduction at Deutsche Bank. As Carter explains, increased direct investment and fund-of-funds growth can co­exist as long as new investors keep coming in, because they often start with funds of hedge funds.

 London-based HSBC Alternative Investments Ltd, No. 1 in this year’s ranking, with $36.8 billion in assets, illustrates how the fund-of-hedge-funds industry is changing. Started 16 years ago and housed within its parent’s private bank, HAIL’s fund-of-funds business has principally catered to high-net-worth individuals and family offices, often based in Europe. But in 2005, HAIL began making a concerted effort to build up its institutional business, says ­Timothy Gascoigne, HAIL’s global head of portfolio management. He estimates that today these investors make up 40 percent of its fund-of-funds clients and the bulk of the new money flowing into its funds.

Because HAIL has been in the fund-of-funds business for so long, it is invested in some of the top-­performing, hard-to-access hedge fund companies, like Tudor Investment Corp. and Moore Capital Management. Gascoigne estimates that one third of the managers with which its main fund has invested are closed to additional capital or new investors. During the crisis, when some closed funds opened, in some cases for the first time in decades, HAIL was able to increase its allocations to those managers because it had cash on hand.

It is hard to beat New York–based Blackstone Group for name recognition among U.S. asset owners. Founded in 1985 as a private equity firm, running money for traditional institutional investors such as U.S. public pension funds, Blackstone entered the fund-of-hedge-funds business in 1990 when it launched Blackstone Alternative Asset Management. Led by former investment banker and Lehman Brothers co-CEO J. Tomilson Hill, No. 2–ranked BAAM commands a massive $34 billion in fund-of-hedge-funds assets, up 22.2 percent in the past year and nearly threefold since 2006.

“For about eight years now, our clients have looked to us to provide investment solutions using hedge funds,” says Hill. “The term ‘fund of funds’ implies a static approach to investing in hedge funds utilizing a finite menu of existing products, whereas our business is focused on customized products using a dynamic process.”

BAAM might be among the best at the customized and advisory business, but the firm is far from alone. Most of the largest fund-of-funds managers offer a bespoke approach. The reason is simple: To justify their fees, fund-of-funds firms need to offer institutions something more than what those investors can do on their own.

An institutional quality fund-of-funds manager can make a real difference, says Kent Clark, New York–based CIO of ­Goldman Sachs Asset ­Management’s hedge fund strategies group, No. 6, with $20.8 billion in assets. “Having a research process that you can track over time, which means that performance is documented and standards are kept, is a huge advantage,” he explains. “It is about accountability.”

Smaller fund-of-funds managers, especially those below the $3.7 billion cutoff to make this year’s Fund of Funds 50, often are not in a position to customize. But they too want institutional dollars. They argue that size matters — reasoning that the sheer amount of money the very largest firms have to put to work hurts their ability to produce alpha. Managers with fewer assets can adapt more quickly and can invest with small hedge funds, whose performance can be better than those of well-known large hedge funds accessible to everyone.

“One of the things I prefer about our portfolios is that we run the gamut of managers,” says Jill Schurtz, CEO of New York–based Robeco-Sage, a $1.3 billion fund-of-funds firm started by three former Goldman Sachs partners in 1993 and now owned by Dutch firm Robeco Investment Management. Robeco-Sage, which offers customized accounts, invests in larger hedge fund firms, but it also finds opportunities with funds managing $500 million or less. Big funds of funds have difficulty giving money to such small managers, because the investments are unlikely to have a meaningful impact on their results. Some large multi­manager firms can get around this in part by operating seeding businesses.

The bifurcation in the market really challenges the fund-of-funds managers in the middle — those that are too big to invest easily in managers with only a couple hundred million dollars in assets but lack the resources of the very largest firms.

At No. 25 on our list, with $7.9 billion in assets, London-­based Fauchier Partners is just starting an aggressive marketing push into the U.S. Unlike many of its European brethren, ­Fauchier’s business is almost entirely institutional. “There isn’t any secret to being a successful fund of hedge funds,” says Fauchier Partners CEO Clark Fenton. “Conceptually, it is very simple, but it is very hard to execute. It is about picking the right managers, doing the operational due diligence to make sure there is no fraud and the investment terms are just and true, then putting the managers in the right combination and sizing up the ones that will do well. The final building block is risk ­management.”

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