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For the past year pundits have been predicting the extinction of the fund-of-hedge-funds business. The reasoning: As pension fund managers and other institutional investors become increasingly savvy, they will turn to multistrategy single-manager firms to satisfy their diversification needs and to avoid the second layer of fees that come with funds of funds.
The September meltdown of Greenwich, Connecticutbased Amaranth Advisors a onetime $9.2 billion multistrategy manager that lost $6 billion in less than two weeks largely as the result of a bad energy bet may just make the experts change their tune. Amaranth investors that held direct positions in its multistrategy funds saw most of their capital evaporate within a matter of days. By contrast, those whose holdings were part of bigger multimanager portfolios escaped with far less devastating losses.
What happened has been an advertisement for funds of funds, says Ed Robertiello, head of hedge fund research and manager selection at Credit Suisse in New York. Most funds of funds that had invested in Amaranth had exposure in the 5 percent range; while it hurts, its not an absolute catastrophe. Robertiellos Zurich-based firm, which managed an estimated $20 billion in funds of hedge funds as of June, had sunk about $8 million of its relative-value and multistrategy portfolios in Amaranth.
Indeed, fund-of-funds firms have long been positioning themselves as the natural antidote to such disasters. They contend that the value of their diversified portfolios and extensive due diligence justifies the additional set of fees. Even firms that lost money on Amaranth can argue that a few blowups are inevitable and that the best way to minimize the damage is by investing in a diversified fund of hedge funds.
Many investors agree. Capital was flowing freely into funds of hedge funds well before Amaranth collapsed, as evidenced by the 2006 Fund of Funds 50, our fifth annual ranking of the worlds biggest multimanager hedge fund firms. The 50 managers on the list oversaw a combined $550 billion in assets as of June 30, 2006, up 21 percent from the $454 billion they had a year earlier. Many firms grew even faster, especially those like Blackstone Alternative Asset Management whose products are tailored to institutional investors.
Institutional interest in funds of funds has been very strong this year, says Gideon Berger, head of asset allocation at New Yorkbased BAAM (No. 15 on the list), whose assets grew by nearly 41 percent, to $13.1 billion.
London-based Man Investments, which ran $39.8 billion in multimanager hedge funds as of the end of June, takes the top spot in this years Fund of Funds 50. Man unseats last years No. 1 firm, UBS, in large part because the Swiss giant sold its $18 billion Global Asset Management fund-of-funds business, along with three private banking units, to Julius Baer Group in December 2005 for $4.6 billion. (Julius Baer, unranked last year, leaps to No. 8 on our list.) Even so, Zurich-based UBS had $37.8 billion in fund-of-funds assets under management and falls just one place in the ranking. Genevas Union Bancaire Privée ($30 billion in assets), New Yorks Permal Asset Management ($26 billion) and HSBC ($25.2 billion) round out the top five.
The big want to get even bigger, especially where massive but largely untapped U.S. pension portfolios are concerned. GAM in London has reopened its funds to new investment and, having integrated them into Zurich-based Julius Baers European product line, is aggressively moving into the U.S. market. In September 2005, at the time of the announcement of its sale to Julius Baer, GAM hired Joseph Gieger to head up its U.S. effort. Gieger, who had been running the New York office of Geneva-based Lombard Odier Darier Hentsch & Cie. (No. 40, with $4.7 billion in assets), says his clients are demanding portable alpha and other innovative types of products, which GAMs merger with Julius Baer makes possible.
The other major consolidation among funds of funds took place within a single firm, when in January Credit Suisse combined its previously separate Zurich and New York businesses into a single $20 billion alternative investments unit run out of Switzerland by Ramon Koss. The No. 7ranked firm, whose CSFB Alternative Capital was No. 21 last year, has a 23-person research team, giving it the scale to concentrate on creating tailored solutions for both its high-net-worth and its institutional clients. Like GAM, Credit Suisse is actively courting U.S. pension money.
Manager due diligence is a big focus at all of the firms in the Fund of Funds 50. The fund-of-funds group at Blackstone, for example, draws on that firms sprawling network of in-house managers, portfolio companies and Wall Street partners to get a clearer view of a potential holdings real risk profile. BAAM withdrew its investment in Amaranth this summer, after BAAM representatives visited Amaranths energy traders in Calgary, because of concerns about the size of its natural-gas positions.
Many funds of hedge funds avoided the $6 billion debacle entirely. We did not partake in the Amaranth situation, and were very proud of that fact, says Martin Kaplan, CEO of Chicago-based Mesirow Advanced Strategies (No. 18, with $10.7 billion). We did not expect the fund to blow up, but our work did suggest a pretty significant amount of risk was being undertaken.
Mesirow, like many firms on the list, is moving toward a solutions-based approach to designing funds of hedge funds. When I got started in the business, there was sort of a one-size-fits-all mind-set, says Kaplan, who worked as an attorney at Katten Muchin & Zavis in Chicago before joining Mesirow in 1995. Today we want to make sure were adding as much value as we can. Mesirow runs about one third of its money in custom portfolios tailored to a full spectrum of targeted objectives everything from big funds looking for full-fledged portable alpha to family offices that simply want to squeeze higher returns out of otherwise conservative portfolios.
New Yorkbased Arden Asset Management is also catering to an increased appetite among institutional investors for custom solutions. The firm, which slips one spot to No. 17 despite increasing its assets by 30.4 percent, to $12 billion, leverages the relationships it has built with top hedge fund managers during its 13 years in the business to create unique products. Weve been able to customize programs that run along whatever the lines are that are of interest to our clients managers that have a longer duration to their investment theses, different transparency considerations or a desire for a more focused approach to portfolio construction, says Arden CEO Averell Mortimer.
Whether an individual fund-of-funds manager calls this level of attention a custom portfolio or a separate account, the personalized approach has contributed to the gains enjoyed by many of the biggest multimanager operations. Assets under management for the Fund of Funds 50 have increased by nearly $100 billion in each of the past two years. Most of the firms on the list insist that there has been absolutely no push-back on what they can charge typically a management fee of 1 to 1.5 percent of assets and an incentive fee of 5 to 10 percent of profits.
The fees have held remarkably steady, says Mesirows Kaplan. If youre able to generate strong risk-adjusted returns and do it at a fee that is fair, the clients will be willing to pay for that. That said, as institutions are increasingly allocating to this area, there will be at least continual pressure to justify your fee. That process of justification is taking innumerable forms as firms such as Mesirow tinker with their platforms to create what they hope will be the typical pension funds ideal combination of transparency, trading environment, investment talent, high-touch service and due diligence.
Although institutional investors increasingly have the sophistication to bypass the fund-of-funds channel altogether, given the relatively low overall allocations to hedge funds that most institutions have, for many of them it may not make sense to go direct. The fund-of-funds strategy gives institutions a way to access talent and sort of sleep at night, says GAMs Gieger. Were seeing a lot of people talk about going direct, but with the level of due diligence and ongoing monitoring thats required, theyre not necessarily doing it that quickly.
The meltdown of Amaranth is a reminder of the risks that come with investing in hedge funds. As BAAMs Berger puts it, Certain institutions that were dabbling with going direct have gotten a bit of a wake-up call that its not that easy. i
The Fund of Funds 50 was compiled by Associate Editor Michele Bickford with Researcher Ben Hansen under the guidance of Director of Research Operations Group Sathya Rajavelu and Senior Editor Jane B. Kenney. Inevitably, we will have overlooked some institutions that belong on our list. If we missed yours, please send an e-mail to FoF50@iimagazine.com to request a questionnaire for the 2007 ranking.