Hedge Funds Of Funds Are Flavour Of The Month

by Carla Johnson, Investors Offshore, London

20 February 2002

The gentrification of the previously rather racy hedge fund sector has largely involved funds of funds, which purport to offer equity-style stability alongside hedge-fund returns, and have eclipsed their underlying funds in terms of growth in the last few years, as a whole new tranche of investors found their way out of dry-as-dust mutual funds.

Supposedly there at least 1,000 funds of funds in operation, encompassing more than 6,000 individual hedge funds. And the development of 'smoothed', low risk instruments has drawn in institutional investors, who are probably mainly responsible for the continued dramatic growth of hedge fund investment. Japan's Sumitomo Life Insurance, for instance, initially invested nearly $3bn through 28 different funds of funds managers, although it later it pared that number down.

Funds of funds managers also represent an attractive target for conventional managers wanting to extend their appeal: Momentum Asset Management was recently approached by Italy's Unicredito bank, while Financial Risk Management is hoping to sell itself for $150m and Tremont Advisors was recently sold to OppenheimerFunds for $145m.

The trouble for fund of fund managers is that their vehicles are ceasing to be the only place where an investor can get a diversified approach to a hedge fund investment. Groups such as Citadel Investments and Tudor Investment run by star traders adopt a multi-strategy approach which could outperform fund of funds at a lower cost: multi-strategy hedge funds only charge 1 per cent of assets and 20 per cent of fees, without the additional fund of funds fees.

They might also outperform funds of funds. According to most analysts, net of fees, funds of funds struggle to better the performance of the average hedge fund. In other words, investors might be as well off picking a random selection of hedge funds as investing in a fund of funds.

A second faction following a similar strategy are groups such as Frontpoint Partners and Asset Alliance, who provide marketing and management services and, in Frontpoint's case, trading services to a group of hedge funds in order to reduce their overhead costs. They, too, may be able to provide a cheaper alternative to fund of funds.

However, centralised decision-making suffers from the same risk concentration problem as do individual hedge funds, unlike funds of funds, where decision taking is decentralised and independent. There's no free lunch!

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