Wednesday, 20 October 2010

Testing Time Ahead for Funds of Hedge Funds

Flows into the hedge fund industry turned positive in the third quarter of last year. There have been monthly blips, but a positive trend of quarterly inflows has been in place since. This year there was a net investment of $13.7bn into hedge funds in the first quarter, followed by $9.5bn of inflows in the second quarter. In the last quarter Hedge Fund Research calculate that a net $19bn of new capital came into the industry.

The third quarter of 2010 was also a period of decent return from hedge funds, most of the gains coming in September. The positive returns for the year to date on top of the recovery of assets through net subscriptions has taken industry assets back to their previous peak of one and three-quarter trillion dollars.

It has been well recognised that flows have turned positive and that the majority of those flows have been captured by the largest single manager hedge fund groups - those overseeing $5bn or more. Some funds of hedge funds received new money in the second quarter - nearly a third of funds of funds had positive inflows then - but still in aggregate funds of funds have been losing capital for two years. Up to now. In the third quarter just finished, funds of hedge funds had a net inflow of $250m, according to HFR.

Net Subscriptions for Funds of Funds

The timing is indicative of the new reality of institutional investing in hedge funds. Just over a year on from net new subscriptions to single manager funds, multi-manager funds as a group received positive net subscriptions. The buyers of single manager hedge funds to this point were experienced institutional investors. If the first phase of taking hedge fund exposure is institutions getting exposure to the investment strategies through replication (not recommended, but it happens) or diversified funds of funds, then there are naturally other phases to follow. The second phase is likely to be the development of selection by the investing institution. This could be expressing a preference for a particular investment strategy, say distressed, or emerging market hedge funds, through selecting individual hedge funds, or allocating to a specialist fund of hedge funds.

Sometimes stage two is driven by a fee reduction exercise, or to utilise growing internal expertise, or sometimes even to put into practise an increase in allocations to alternatives or hedge funds specifically. Whatever the motivation, stage two is as likely to result in a reduction in the size of mandate managed by a fund of funds as an increase.

Institutions new to investing in hedge funds would be wise to utilise the services of a fund of hedge funds provider. So neophyte institutions and those adding to strategic allocations within their plans will have used funds of hedge funds in the growth phase of the industry to mid 2008.

In the last year we have moved from the trough of disillusionment* and are onto the slope of enlightenment for the hedge fund industry. In that time the investing institutions that are seasoned hedge fund investors have been pulling money from funds of funds to put the capital into single manager funds in aggregate.

We seem to be entering a new phase now. The recent positive net capital allocations to funds of hedge funds suggest one of two causes: that new buyers are coming into hedge funds and/or the more conservative of those existing institutional investors in hedge funds have started to add to their allocations. It is widely appreciated that the due diligence process has lengthened. So if it took 6 months from first meeting to filling in subscription documents it now takes 9 months. Starting a new hedge fund investment programme for an institution via a fund of funds might take a year or more as there is double diligence to complete, at the fund of funds level and at the single manager level.

If this hypothesis is correct funds of hedge funds should have more and larger mandates heading their way from here on. This will be tested over the rest of 2010 (particularly in December, a key month for redemptions) and will be confirmed by positive flows in the first half of 2011.

Additional: Pictet & Cie, the Swiss private bank, confirmed that it had had net inflows of $340m into its fund of hedge funds this year bringing the total AUM to $8.2bn at the end of September.


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