Fund of Hedge Fund Dis-intermediation
|May 2nd, 2010||
|Contributed by: Simon Kerr|
|Following up on the prospects for funds of hedge funds, which I have covered earlier in the month, I neglected to mention dis-intermediation by investing institutions. This is a natural phase of development for institutional investors of scale.|
First the institutions use small allocations as a percentage of assets and tap into third party expertise to implement the strategic allocation. This first toe-dipping willl typically utilise a fund of hedge funds, or for the larger institutions, several funds of funds to keep them all honest. A minority of new investors in hedge funds will use a third party advisor, like Albourne Partners, and allocate directly to single managers, or these days look to use replication, like USS of the UK.
The investing institution then gets used to working with hedge funds, gains experience and understanding, and they often move onto increased strategic allocations and change to a new mode of implementation. This may involve making strategic bets on particular hedge fund investment strategies, say emerging managers, credit hedge funds, or directional managers. Moving from diversified mandates to using more specialised mandates (in addition) might also be implemented via specialist funds of hedge funds, but is as likley to involve active selection of single managers.
So it is natural for investing institutions of scale, with sufficient in-house expertise, to progress to selecting hedge funds individually. There is an extra incentive to do this, a negative motivation, when the foundation exposure to hedge funds (via funds of funds) is seen as disappointing. To a significant degree this has been the case for the last two years, to the downside and then the upside, by turns. There are good reasons for the significant under-performance of funds of hedge funds, particularly in 2009, but it can have commmercial impacts through changes in underlying investor attitudes. A recent example was the change in approach of the South Carolina Retirement System. Formerly the allocation to hedge fund strategies was 70% in funds of funds and 30% directly in single manager funds: that split is to be reversed in future. This trend to dis-intermediation is also being reflected in Japan.