By François Buclez
Published: August 1 2010 09:16 | Last updated: August 1 2010 09:16
The fund of hedge funds model has been pronounced dead many times. Reports of its death are usually exaggerated.

What we are seeing is the evolution of fund of funds, from the old, passive, index-linked model – called “concierge” FoFs – to a new, more dynamic active type of fund of hedge funds. While active funds remain a powerful tool, concierge FoFs hit a nadir in 2008-2009, brought down by poor performance and undermined by their passive approach, which left them exposed to leveraged and illiquid funds.

The real value of active managers – Jul-25

Investment industry set for big shift into passive management – Jun-27

Index-based investing mars stewardship – Jun-13

Passive funds are tops with UK pensions – Jun-06

Passive management continues to win favour – Jun-06

When paying fees is good – Jun-06

The active model is one where responsibility for risk management is taken at the FoF level: managers spend time evaluating the global macro environment and strategically positioning the portfolio.

To a large extent, the FoFs that survived the financial crisis were active, with robust risk management, well-managed cash positions, better liquidity matching and considered strategic allocations to limit downside in a difficult environment. These funds have also shown an ability to re-risk their portfolios to take advantage of the market bottoming out.

A survey released this month by research group Preqin stated that an increasing number of institutional investors were making direct allocations to single manager funds, bypassing FoFs (“Investors plan to flee funds of funds,” FT, July 16).

To say investors are shying away from FoFs is too broad a statement. Investors such as private banks which were significantly exposed to the larger concierge funds, and which suffered losses and were burned by high profile frauds, are wary.

However, other larger institutions continue to see the value of FoFs and have been keen to allocate, with a number of mandates coming to market since the second quarter of the year.

Other investors, especially pension funds, are still looking to allocate to FoFs to boost returns and meet liabilities, particularly as equity and bond markets remain depressed.

The idea that some institutions will make their own allocations to single managers is nothing new.

In the past, larger investors used both direct hedge fund investing as well as indirect investing through FoFs. Today, some larger investors have brought their entire alternative allocation in house, but that is the exception, not the rule. In most cases, investors who can afford it have created in-house teams to replicate the concierge model strategy – passively investing in the larger, branded single manager hedge funds. In doing so, they’ve taken out the extra layer of FoF fees.

Smaller institutions do not have the resources in house for proper hedge fund research and will still look to outsource. They are typically now looking at the more active, dynamic FoFs that earn their fees with decent long-term performance.

These active FoFs offer attractive returns as they add value from their risk management and their manager selection. They identify the key risks in an investment, and to allocate to funds that are attractive on a risk-adjusted basis, taking into consideration all factors, including size and track record.

In addition, the widely publicised Madoff fraud caught out several large and formerly respected old-style FoFs. Madoff was avoidable: a robust due diligence process starting with a basic common-sense initial evaluation would have raised red flags.

Actively managed FoFs also outperform. There is, of course, no index for active funds of hedge funds, but looking at a peer group of active FoFs, their returns since the start of the 2003 market cycle have been in the 10-12 per cent range, with a volatility of roughly 6 per cent. By contrast, the HFRX Global Index has delivered a meagre 1 per cent with a volatility of 6.7 per cent over the same period.

So while it is true that the concierge model is probably dead, funds of funds offer flexibility to allocate across regions, cycles and asset classes so as to be able to benefit from movements in either direction and they still afford good opportunities to institutional investors.

François Buclez is founding partner and chief executive of Cube Capital, a London-based hedge fund investment firm

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