Mehraj Mattoo, Global Head of Alternative Investment Strategies (COMAS) at Commerzbank Corporates & Markets, highlights the challenges facing FoHFs.
Speaking this week at an industry conference, Mattoo noted that the overall growth of the industry has outstripped growth in the underlying hedge funds over the past five years, and highlighted the steady decline in net inflows into funds of hedge funds.
Mattoo asserts that one of the key drivers has been the perceived danger of hedge funds and wariness surrounding the potential disruption the collapse of a fund could trigger in financial markets.
He said: 'The upward trajectory of funds of hedge funds has its roots in a lack of knowledge amongst investors of the hedge fund industry. The complexity of underlying trading strategies and a perceived lack of regulatory oversight of hedge funds have all clearly boosted nervousness amongst retail and institutional investors. In addition, there has been a steady increase in the demand for greater diversification in terms of both managers and strategies as investors begin to question the steep cost of due diligence.'
As investors consider the levels of risk attached to underlying hedge funds, said Mattoo, they are increasingly moving towards the benefits of greater diversification and a more competitive fee structure found in the more flexible fund of hedge funds.
'There is an alignment of interests between the investor and the fund manager with the introduction of hurdle rates and a competitive fee structure, especially when fund of hedge fund managers are often invested in the fund of funds themselves. Within an institutional framework this means enhanced due diligence, process driven investing, greater risk control and a stronger operational infrastructure.'
For Mattoo, however, the new paradigm for funds of hedge funds lies in an open architecture, wider investment opportunities, active asset allocation, active risk management and a greater use of technology.
He explained: 'In our view, investors are more likely to benefit from a flexible fund of hedge funds platform that is geared for tailor-made solutions with the particular needs of retail or institutional investors in mind. An open architecture platform provides the ability to create a wide variety of alternative investment products, with access to a broader spectrum of alternative asset classes providing tailored solutions by way of managed accounts, hedge funds and private equity.
'In terms of active asset allocation, there should be a continuous focus on market opportunities, a better understanding of return/risk drivers with an active use of risk overlays.
'Active risk management,' he concluded, 'is the ability to identify, quantify and manage underlying risk drivers, but it is the use of cutting edge innovation - technology and analytics to enhance portfolio construction and portfolio management processes, which will really set successful fund of hedge fund managers out from the crowd.'