The fund of hedge funds business – the manager of managers, hedge funds that invest in other hedge funds — has witnessed significant growth from 200 to 2008 as well as a leveling off of hedge fund inflows, a May Eurekahedge report notes. From its participation peak in 2007, when over 3,700 individual fund of funds shared over $800 billion in assets under management, the 2017 landscape sees near 1,800 fund of funds, with smaller funds bearing the brunt of the reduction. The overall Hedge Fund of funds business has seen significant asset declines while investments in the underlying managers has risen.
Asset declines: $46.4 billion pulled from Hedge Fund of funds
In 2016, investors pulled $46.4 billion from fund of funds investment structures as the Eurekahedge Fund of Funds Index lost -0.12% on the year, underperforming their hedge fund and long-only counterparts who gained 4.50% and 7.65% respectively.
“Recently investors have questioned the viability of investing into a funds of hedge funds given single digit returns from underlying hedge funds and the double fee structure inherent to the multi-manager model,” the Eurekahedge report noted, pointing to competition from liquid alternative products and hedge fund replication products, some of which are categorized as “smart beta.”
The fund withdrawal has hit smaller funds without significant negotiation power or advanced technical prowess the hardest. “Investors have increasingly shunned the smaller funds of hedge funds and sought direct exposure into hedge funds instead.” To wit, 98% of the fund of funds that closed their doors managed less than $500 million in assets.
“The larger players in the funds of hedge funds industry continue to retain and attract investor allocation given their sound pedigrees, access to elite hedge funds, negotiating advantage on fees and the subsequent cost economies that can accrue to investors,” the report noted.
After a dynamic trend of fund of funds launches significantly eclipsing closures – with 2006 seeing more than 500 launches and less than 100 closures — that trend reversed in 2011 and continues into 2017.
Following the financial crisis, investors grew cautious of their underlying investments into funds of hedge funds and strong redemption pressure remained a key theme in the industry. Closure activity continued to climb between 2010 and 2013 with roughly 300 liquidations on average per year. Since then fund liquidations have tapered off following the prior period of culling. Launch activity on the other hand has been steeply declining since the global financial crisis, falling to a low of 42 fund launches in 2016 while closures were more than thrice the number of funds launched during the year. This trend has continued in the first quarter of 2017, with muted launches while closure numbers far outpace that of fund launches.
Hedge Fund of Funds – Macro and Long Short fund of fund managers see asset declines while same underlying managers see advances
Over the past five years, as assets under management have contracted by $172.2 billion, it has been globally mandated hedge funds that were most impacted. Global fund of funds shed $97.2 billion since 2012 while North American fund of hedge funds lost $22.2 billion. European, Asian and emerging market multi-managers witnessed assets fall by $17.6 billion, US$17.5 billion and US$17.6 billion respectively, the report noted.
From a strategy standpoint, fund of funds managing Macro managers saw their assets decline by the most, down $50.7 billion. Investors might have switched to individual fund allocations, as assets allocated towards single macro mandated managers saw their assets increase by US$24.5 billion over the same period of time.
Similarly, Long/Short equities fund of hedge funds, the largest fund of funds category, saw their assets under management fall over the past five years. This occurred as the underlying individual Long / Short hedge funds witnessed their assets rise by $208.8 billion over the same five-year period. “Much of the depressed assets under management is attributed to redemption pressure from investors allocating into the fund of hedge fund industry as a whole,” the report noted.
While fees have been a significant headwind for fund of funds managers – the fund of funds charges a fee on top of the underlying hedge fund manager’s fees – 2017 is witnessing a reversal of sorts.
Fund of funds management fees, which were 1.3% in 2005, dropped to 1.06% in 2016. Then in early 2017, the management fee was dramatically cut, to 0.81%, the largest change since 2005. While the management fee was cut, the performance fee average increased on the year from 6.9% to 10%, potentially a move to reward alpha outperformance.