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Fund of hedge funds industry is all about niches

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Don Steinbrugge, managing member of third-party marketing firm Agecroft Partners, says that in a highly competitive marketplace with more than 2,000 funds of hedge funds, firms can defy current industry headwinds and raise assets successfully by identifying a market niche within three areas: strategy focus, fund structure and investor segment.

The fund of hedge funds marketplace has experienced net redemptions four years in a row. This trend is expected to continue in 2012, but Agecroft Partners has observed that some funds of hedge funds have thrived during this time period by focusing on a specific niche in the marketplace.

There will always be a place for funds of hedge funds within certain sectors of the hedge fund investor community, and those funds of funds that can change with the evolving landscape will be the most successful going forward. We will examine some major trends in the industry along with three niche areas that some funds of hedge funds have leveraged to raise assets successfully: strategy focus, fund structure and investor segment.
Over the past decade most flows into the fund of funds industry have come from large institutional investors. In the past, this group of investors has been more focused on the perceived security provided by the size, brand and infrastructure of a firm as opposed to pure performance.
Many larger institutions invested in multiple funds of funds in an attempt to diversify their exposure, but they did not realise that many of the largest fund of funds may have had a significant overlap in underlying managers. In addition, investment performance from some of these large organisations has not always met expectations.
As large institutional investors continue to increase their knowledge of alternative investments, two major trends are developing within the fund of funds industry. The first trend is for multi-billion-dollar pension funds to save on fees by moving away from multistrategy funds of funds and invest directly with funds, with the help of a hedge fund consultant.
This trend is the primary reason why fund of funds assets have been declining, but it typically only affects the largest funds of funds that were able to raise significant capital from large pension funds. These large funds of funds will continue to bring in significant business, but not necessarily enough to replace the assets that are being redeemed.
The second trend within the pension fund industry is the growing use of a hub-and-spoke approach to fund of funds investing, involving a hub investment in one of the largest funds of funds as the core hedge fund allocation, with the spokes consisting of niche fund of funds strategies.
These niche funds of funds will also be tapped as best-of-breed managers in other parts of institutional investors’ portfolios in addition to the hedge fund allocation. The growth of niche fund of funds investing should have the effect of increasing the number of funds of funds, with a larger percentage of assets flowing to mid-sized firms.
Although the largest pension funds will more frequently bypass funds of funds, a majority of pension funds will continue to get their hedge fund exposure there. In addition, we expect strong inflows from retail investors.
Strategy focus
It is very difficult for investors to differentiate between funds of funds unless there is a clearly-defined advantage to adding them to the portfolio. Some managers have been very successful in raising assets by focusing on niche strategies with limited competition. Billions of dollars have been flowing to firms that focus on:
Global macro/CTA. After the significant drawdown in performance for investors in the fourth quarter of 2008 and early 2009, investors took notice of the lack of correlation of these strategies relative to other hedge fund strategies as well as long-only benchmarks.
To increase downside performance protection and protect against tail risk, investors have significantly added to these strategies. While industry-wide hedge fund assets today are slightly above 2007 levels, assets dedicated to the global macro/CTA space have increased from USD288bn to USD433bn at the end of the September 2011, according to HFR.
Commodities. Growing concern among investors that the purchasing power of their investments will be eroded by rising inflation is being driven by two primary factors, the weakening of the dollar and increased competition for commodities.
The weakening of the dollar stems from growing trade and federal deficits. At some point these pressures could be greatly enhanced if other countries lose faith in the dollar. Large selling by China and Japan would be devastating to the currency.
Global competition for commodities is steadily increasing as developing nations, notably China and India, modernise their economies, which will put upward pressure on prices. A strong trend by institutional investors is to allocate a portion of their portfolio to real assets, including commodities. A few funds of funds dedicated to commodities have greatly benefited from this trend.
Seeder/accelerator funds. Many investors require a hedge fund to have a minimum of USD100m in assets under management before they will consider investing in it, prompting significant demand by smaller hedge fund managers for seeder or accelerator capital. Seeders/accelerators agree to invest a large amount of assets into the fund and, in return, they receive both the performance generated by the fund on their investment and a quasi-equity position in the firm, usually by sharing in the revenues on all assets of the fund.
Seeders can generate significant returns if they pick a fund that performs well and grows its asset base significantly. Many funds of funds that allocate a percentage of their assets to feeder funds have generated good returns and seen positive asset flows.
Emerging and mid-sized managers. This area is beginning to see increased investor focus because some studies have shown that smaller managers consistently outperform larger ones. These managers are much more difficult to identify and perform due diligence on than the largest, best-known managers.
Fund of funds managers with particular skill in this space should see increased demand. This type of fund also adds diversification to pension fund portfolios, since most pension funds are investing either directly or indirectly into the largest hedge fund managers.
Other niche strategies. We expect many other niche strategies in the marketplace today to see large flows going forward, including focuses on long/short equity, credit and emerging markets.
Fund structure
Being a first mover in adopting a new fund structure can lead to significant asset flows with little competition. Over time these structures are adopted by more funds, increasing market competition, but still providing the first movers with a sustained advantage due to their market share. While assets have declined across the fund of funds marketplace as a whole, funds with various structures – each of which has strengths and weakness for investors – have seen assets surge. These include:
Managed account platforms. Following the Madoff fraud and the proliferation of gates and redemption suspensions by hedge funds in 2008, demand for managed account platforms has exploded. Many platforms offer daily liquidity, full transparency of underlying investments and sophisticated risk analytics. Several hedge fund platform providers not only t offer heir own funds of funds but allow investors to customise their portfolios.
Ucits. Funds established within one European Union country an be sold within all EU member states. These funds have also seen a significant increase in popularity after the market meltdown of 2008. They typically offer daily liquidity with low minimum investment requirements, opening up the hedge fund marketplace to retail investors.
‘40 Act funds. These are mutual funds that comply with the US Investment Company Act of 1940 and are often sold by leveraging the retail client base of large broker-dealers. A few firms have raised billions of dollars in assets over the past few years, but the number of new players entering the marketplace is increasing exponentially.
Tax advantaged structures. These hedge funds with insurance wrappers allow US taxable investors to defer paying taxes on gains well into the future.
Fund of one. This model creates a feeder fund into a large hedge fund. The feeder fund typically has a low investment minimum that provides some high net worth investors with an opportunity to invest in a hedge fund for which they would not ordinarily meet the minimum. Investors are given a choice of which hedge funds they would like to participate in.
Investor Segment
Some funds of hedge funds have developed very focused marketing strategies that target specific market segments, allowing them to develop strong brands within targeted investor segments. Certain investor groups find it reassuring that other investors of their type are also investing with the manager.
Insurance Companies. The assets in this market are huge, and many companies are increasing their allocations to hedge funds to increase the return on their investment portfolios, which have declined due to falling interest rates. Knowing the regulatory issues faced by insurance companies and having a fund structured to address this industry-specific need gives a manger a strong advantage over its competition.
A successful marketing campaign also requires the fund of funds to identify which companies to call on and the correct contact at each company. While this includes a significant investment in time and research, the pay-off can be large. This is a market where many people know each other and share ideas between companies, which can magnify a focused marketing campaign.
Regional Focus. Some firms have developed strong brands by focusing on a specific country or region. In a particular country these firms have the advantage of similar language and culture, which provide a feeling of trust. Other US firms focus on the cities where they are located and build strong networks with local accounting firms, trust attorneys and advisory firms. Many less investment knowledgeable high net worth individuals like to keep their money locally. This business model is beginning to see increased competition from the proliferation of endowment model managers and fund of hedge funds wholesalers.
Retail financial advisors. The largest brokerage firms dominate the wealth management space, but independent regional firms are catching up. Most of these firms have an approved list of funds of funds that their advisors can recommend to clients.
To gain assets effectively from this distribution source, funds of funds must get on the approved list of each firm and provide a very focused ‘wholesale’ sales approach involving continually travelling to the brokerage firm’s larger offices and meeting with top producers. This is a relationship and trust business where long-term repeat visits can lead to sales success.
This marketplace is highly competitive with more than 2,000 funds of funds. Unless a fund of funds firm is one of the largest in the industry or has generated a top historical track record, it is imperative to identify a market niche within which to excel. Although the industry is facing headwinds, firms able to create a differential advantage should be able to raise assets effectively.


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