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Eric D. Schwerin
Rosemont Seneca Partners, LLC
1010 Wisconsin Ave., NW
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(202) 333-1880
eschwerin@rosemontseneca.com
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http://www.economist.com/news/finance-and-economics/21603464-reviled-form-investment-trying-reinvent-itself-not-dead-yet

Not dead yet


WHAT is the least loved corner of high finance: hedge funds, with their plutocratic managers who so seldom match stockmarket returns, or private equity, where bosses pile debt onto companies to enrich themselves? Trick question, to which the answer is funds of funds—firms that charge heavy fees to put investors’ money into an assortment of private-equity or hedge funds. Maligned as purveyors of “fees on fees” (levied by the funds of funds and then by the underlying funds), they have for years seemed destined for extinction. But new models point to some kind of future for the sector, albeit as a shadow of its former self.

News has long been grim for funds of hedge funds, now in their seventh consecutive year of outflows. Their number has dwindled from nearly 2,500 in 2007 to fewer than 1,800, according to HFR, a research outfit, even though ordinary hedge funds are attracting ever more money. As hedge funds have gone from novelty to established asset class, those who invest in them (now mainly institutions, as opposed to the billionaires that fuelled their early rise) have ditched the middlemen they once needed to guide them through the murky world of alternative investments.

Lacklustre performance has not helped. Both funds of hedge funds and of private equity have consistently fallen short of the benchmarks they would hope to beat (see chart). That is largely due to the fees they charge: “1-and-10” used to be typical, meaning that the managers cream off 1% of assets invested plus 10% of profits. This comes on top of the “2-and-20” demanded by the funds they invest in. A fee cocktail of “3-and-30” is a tough sell given low investment returns these days.

Funds of hedge funds have responded by becoming more specialised and cheaper. Many promise to eschew investing in superstar funds, which savvy investors can approach directly. Instead, they are working to unearth the next generation of investing talent, often in Asia, which they hope (against all hope) can beat the average. Many offer to craft bespoke portfolios for their clients, instead of lumping all their investors into a single all-purpose fund. They will do all this for a fraction of the “1-and-10” of yesteryear: deals of “0.5-and-0” are not unheard-of for large investments. This is in part to fend off the rapid rise of specialist consultancies that help investors pick hedge funds for a flat fee.

Funds of private-equity funds have fared somewhat better, though they are now raising only half the amounts they did before the crisis, according to Preqin, which tracks buy-outs. Again, having started off needing funds of funds to get going, most investors are now comfortable making their own selections.

Some amalgamators are doing well: once a niche, funds of funds that raise money to buy stakes in buy-out vehicles partway through their decade-long investment mandate are thriving. This is because banks (and others) that originally committed money are often looking for someone to buy them out. But that opportunity, though large, is surely finite, and plenty have piled into the space.

Many funds of funds have closed down, or hurriedly merged with rivals as assets dwindled. Ever-rising compliance costs, and the need to have relationships with the world’s biggest investors, mean the sector is increasingly dominated by behemoths such as Goldman Sachs, Blackstone or BlackRock. They maintain that paying a modest fee to them is cheaper than running an in-house team to monitor hedge-fund investments. Whether true or not, it is a less racy pitch than that made by the first fund-of-funders, tanned socialites who hunted for investors at cocktail parties in Monaco and on the slopes near Gstaad. Funds of funds may well have a future, but it will be duller than their past.