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.”