Hedge Funds' Institutional Potential Leans on Funds of Funds: Mercer

CHICAGO (HedgeWorld.com)--Investment consultants have kept constant watch over the growth of hedge funds in recent years. Mercer Investment Consulting US now is providing its commentary on hedge funds' "institutionalization" dilemma and the greater role of funds of funds in institutional allocations.

The firm says that while specialist firms still tend to dominate the hedge fund business, traditional institutional managers also are making their mark in a growing number of hedge fund programs.

In a newsletter on hedge funds published this month, Mercer officials said that of the 25 largest mangers in its investment management firm database, 17 firms offered hedge funds. Concurrently, some hedge funds are offering long-only programs as lines begin to blur between the alternative and traditional sides of the money management business.

SEC Registration Helps

From Mercer's perspective, manager registration with the Securities and Exchange Commission will only help boost hedge funds as investors realize the added procedures and audit processes that provide legitimacy to the industry.

So far experts say that 30% of all hedge fund managers have registered with the U.S. regulator, Mercer officials wrote in their brief newsletter.

Most of the hedge fund managers Mercer reviewed have been registered with the SEC for some time. According to the consultants, managers that choose longer lock-ups to avoid registration are leaving investors at a disadvantage.

"As hedge funds become more and more institutional in approach and structure, Mercer clients have asked whether sufficient opportunities remain for hedge fund managers to generate alpha, a manager's return that cannot be attributed to the market," said Jeff Gabrione, a research consultant based in the firm's Chicago office, in a statement.

While funds of funds have become popular among institutions, Mr. Gabrione said it is important to focus on how managers are able to put that new money to work.

Adapting to a Changing Landscape

Mr. Gabrione said that a well-managed fund of funds offers broader diversification than a multi-strategy program. In turn, that diversification is key to performance in a variety of different market environments.

Mercer officials warn, though, that funds of funds aren't the perfect oasis for beta-weary investors. As funds of funds demand more capacity from their underlying managers, performance can often suffer.

Funds of funds already have been criticized for their fee structures, but Mercer also is concerned about shortcuts being taken in the due diligence process as a fund of funds manager eagerly invests with the latest "hot" hedge fund managers.

On the path to optimal performance, Mercer emphasizes three critical elements in a fund of funds manager--strategy, experience and quality.

Strategy means that managers invest in the widest range of underlying strategies and in turn have greater capacity because they have more candidates available for fresh assets, Mercer officials say. Clients should see growth in the number of underlying strategies as assets increase in the fund.

Experience of the investment team at a fund of funds also is taken into consideration. Mercer generally looks for a firm that limits the ratio of underlying managers to researchers to 20 to 1.

Quality always is sought. Mercer officials say higher-quality organizations have better resources and are more willing to reinvest in the business and in turn demonstrate a greater commitment to the future.

Funds of funds are becoming more professional in their operations. They can offer access to popular hedge fund managers and in some cases even managers that no longer accept new investment.

As with any investment decision, Mr. Gabrione said, the selection must fit within the client's overall objectives and constraints. Mercer's client base includes pension funds, foundations and endowments.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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