CHICAGO (HedgeWorld.com)–As institutional investors such as pension funds have become comfortable with hedge fund strategies, often through initial investments in funds of funds, more of them are considering ditching the extra layer of fees associated with funds of funds and trying their own direct investments in single managers.
But that way lies trouble for investors without the means to conduct proper due diligence or risk analysis, and without the foresight and ability to get into good managers early.
Those were among the points made by a panel of hedge fund industry veterans that included a single-manager multi-strategy fund, two funds of funds and a brokerage firm at a recent summit for public employee pension funds in Illinois, put on by the Information Management Network.
One of the most talked-about issues of late has been whether the growth of assets in hedge funds has helped choke off returns, particularly in certain strategies that depend on exploiting mispricings, such as arbitrage strategies. One theory holds that as more capital flows into those areas, inefficiencies in the market are squeezed out by managers looking to deploy all that money. Once the inefficiencies are gone, so are the returns. Not everyone buys into that notion, though.
Jean Murphy, a vice president at the Chicago fund of funds firm Grosvenor Capital Management LP, said lower returns have more to do with macroeconomic conditions and, for convertible arbitrage in particular, reduced issuance of securities. Grosvenor studied the correlation between growing hedge fund assets and lower returns after one of its largest and longest-standing investors told the firm it was thinking of reducing its allocation to hedge funds.
Ms. Murphy said the recent tough return environment has highlighted an important hedge fund characteristic: adaptability. A number of distressed hedge funds, she said, which had been long only, have migrated to long/short credit models.
Scott Nelson, managing director at the Minnetonka, Minn.-based hedge fund Deephaven Capital Management LLC, echoed Ms. Murphy's sentiments. "Trades will get crowded," he said. "They will get old and tired. Efficiency will come into a market. Equity stat arb is an example of one strategy that's seen lower returns and lower volume. The job of a hedge fund is to be flexible, to be nimble, and to be more so than many long-only managers are allowed to be."
Another trend noticed by some is one of institutional investors, pension funds and university endowments, especially, having buildt up some experience with hedge funds by making their initial investments in funds of funds, ditching that route and opting to find their own single-strategy or multi-strategy managers. This trend, along with investment consultants' attempts to educate themselves about hedge funds so they can serve the same manager recommendation role they do with respect to traditional investment managers, raises questions about the future of funds of funds.
Ms. Murphy, not surprisingly, said she sees an ongoing role for firms like Grosvenor. Investors may be able to mimic the return dispersion of a fund of funds using a multi-strategy fund, but conducting the necessary due diligence to find good managers can be an expensive proposition for an investor, and a multi-strategy fund still carries manager-specific risks. Multi-strategy fund investors may be okay if one strategy blows up, but if that blowup takes the whole multi-strategy firm down, it really doesn't matter if the other strategies still had good performance. In a fund of funds, one manager blowup won't necessarily drag down an entire portfolio.
Additionally, there are capacity issues with single managers, even those of the multi-strategy variety, Ms. Murphy said. "If you say that in three to five years, there will be a trillion dollars going into hedge funds, the top multi-strategy funds can't absorb that."
Still another issue is finding good managers early. Grosvenor invests in a number of multi-strategy managers, but the firm researched them carefully and got in early, before those managers closed to new investment. That could be a difficult proposition for the average institutional investor, which has to devote resources not just to hedge fund manager research, but to other alternatives and to traditional asset managers as well.
