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The fund of hedge funds 50

As institutions flock to funds of funds, II presents its first ranking of the largest multimanager hedge fund firms in the world.

As institutions flock to funds of funds, II presents its first ranking of the largest multimanager hedge fund firms in the world.

By Justin Dini
December 2002
Institutional Investor Magazine

What do the Pennsylvania State Employees' Retirement System, the California Public Employees' Retirement System, General Motors Asset Management and the Swedish Seventh National Pension Fund all have in common?

Hedge funds -- and how they invest in them.

As have a growing number of fiduciaries, these big institutional investors have all embraced this alternative asset class, hoping to obtain absolute returns that are uncorrelated with broader stock market movements, while further diversifying their portfolios. But, typically cautious, they have been loath to leap into an area outside their core expertise and are hesitant to try to identify the best hedge fund managers on their own. Instead, they have turned to a group of intermediaries known as fund-of-hedge-funds managers, an eclectic group of firms that track hedge fund managers and, exercising varying degrees of discretion for investors, select hedge funds to build either standardized funds or custom portfolios.

In a bleak period for the financial industry, hedge funds stand out as one of the few growth businesses. Their ranks have burgeoned in the past few years. At the end of the first quarter of 2000, there were 3,293 single-manager hedge funds; by the end of the third quarter of 2002, that number had soared 35 percent, to 4,460, according to Chicago-based HFR, which assembles hedge fund data.

Funds of hedge funds have grown at an even faster clip. While HFR estimates that the number of funds of funds grew 32 percent, from 510 at the beginning of 2000 to 675 at the end of this year's third quarter, fund-of-funds assets swelled 84 percent during that period, against a 24 percent increase for single-manager funds. "From what we have seen, it has definitely been the fastest-growing segment in the hedge fund industry," says Joshua Rosenberg, managing director of HFR.

One reason for this explosive growth is the increasing interest of pension plan sponsors, a conservative bunch for whom multimanager hedge fund portfolios offer the best way to get comfortable with the asset class. Earlier this year, the $26 billion Pennsylvania State Employees' Retirement System committed more than $1.7 billion, or $575 million each to funds of funds run by Blackstone Alternative Asset Management, Morgan Stanley Alternative Investment Partners and Pacific Alternative Asset Management Co. GMAM, which manages the carmaker's $76 billion pension fund, last year hired fund-of-funds manager Glenwood Capital Investment (a unit of Man Group) as a strategic consultant for GM's hedge fund investment program. And this summer the Swedish Seventh fund, with $2 billion in assets, allocated roughly $48 million each (now down to about $40 million each) to EIM Group of Nyon, Switzerland, and Stamford, Connecticut­based K2 Advisors.

This surge in institutional interest has been a boon for fund-of-fund operators, who, like the funds they invest in, prefer to ply their trade in silence and obscurity.

In this month's issue Institutional Investor has set out to take a look at this increasingly powerful segment of the money management industry. In the tables that follow, we identify the world's biggest managers of funds of hedge funds, providing crucial information that includes their assets under management and investment style. In addition to the tables published in these pages, more information about these funds of funds, including performance statistics, can be found at II's first annual Fund of Hedge Funds 50 is a natural companion to last June's Hedge Fund 100, which charts the world's biggest single-manager hedge funds and is also available online.

Leading the field in terms of assets managed is Man Group, headquartered in London, which runs $12.4 billion through its subsidiaries, Chicago-based Glenwood and RMF Investment Group of Pfäffikon, Switzerland. It is followed by Zurich's UBS, with $9.9 billion, and Geneva's Union Bancaire Privée, with $6.8 billion. These three (and five of the top ten) are all located in Europe, reflecting the fund-of-funds industry's roots in private banking. Our top 50 managers run a total of $168 billion.

We also examined fund-of-funds performance over one and three years through June 30, 2002. Not all the funds on our list gave us performance data for the periods requested, and not all the firms provided data on all of their funds. Of those that did provide annual performance for the 12 months through June 30, however, the leader of the pack, Perseus Partners, achieved returns of better than 21 percent by focusing on short-sellers. All available performance data for the funds in the ranking can be found here.

Selecting individual hedge funds takes a lot of resources; just keeping up with the thousands of hedge funds out there is a big task. The fund-of-funds manager must winnow this crowd down to an attractive pool, then conduct due diligence by visiting firms, evaluating investing styles and their sensitivities to various types of risk, checking references and following performance. "Today there are thousands of managers; they close very quickly, and that requires more resources to do due diligence in less time," says Scott Metchick, EIM's New York­based chief investment officer.

Indeed, part of the fund-of-funds manager's job is to secure access to attractive hedge funds over time. "We have been able to develop capacity relationships with the top hedge funds," says J. Tomilson Hill, president of New York­based Blackstone.

Because of the number and complexity of hedge fund investing styles, most plan sponsors appreciate professional help in evaluating the funds' managers. "We needed someone to source and screen hedge fund opportunities: Conduct due diligence, research, performance reporting and monitor risk," says spokesman Brad Pacheco at the $151 billion CalPERS, which hired Blackstone in 2001 to advise it on constructing its hedge fund portfolio. "Our staff still have discretion over decisions to invest, but we need the help with the rest." Adds Jeffrey Geller, who leads pension consulting firm Frank Russell Co.'s nascent fund-of-hedge-funds effort, "The interest in funds of funds is in getting the proper level of diversification and oversight."

All this checking isn't cheap: Fund-of-funds investors pay extra fees that direct investors in single-manager funds don't have to contend with. A fund of funds will typically charge a 1 percent management fee plus as much as 10 percent of profits, according to a UBS Warburg study. That's on top of the hedge fund fees of 1 to 2 percent of assets and 20 percent of profits. Many funds of funds have posted attractive returns (see our Top Performers table); overall performance of funds of funds for 2002 through the end of October was ­0.58 percent, according to HFR. Over the same period, the Standard & Poor's 500 index fell 22.85 percent. Investors must decide whether the difference is worth the money.

For additional stories in our extensive hedge fund coverage, please go to www.institutionalinvestor .com/hedgefunds.