Institutions Increasingly Prefer Direct Investment in Hedge Funds

As the hedge fund industry emerges from the financial crisis, institutional investors are reshaping the industry with demands for transparency, liquidity and better fee terms. Funds of hedge funds (FoFs), in particular, have experienced a loss of institutional support--for reasons related to both the recent downturn and longer-term trends, according to a survey released by Preqin on Thursday, July 8.

Preqin asked 50 large global institutions in June about their hedge fund portfolios and their appetite for FoFs and single-manager hedge funds. The wide range of respondents included public and private sector pension funds, asset managers, family offices, insurance companies, banks, foundations and endowments.

Preqin found that some institutional investors have been allocating to hedge funds for many years, starting in 1985, with the average entry date 2001. Sixty-four percent of respondents initially invested through FoFs. Today, however, only 35% invest in hedge funds solely through FoFs, while 31% do so directly and 34% use both methods.

FoFs' image suffered heavy damage during the financial crisis, according to the survey, because of generally poor performance compared with direct investments in hedge funds, gating of assets and exposure to high profile fraudulent products.

The survey identified three main reasons why institutional investors have moved away from FoFs and begun investing directly in hedge funds, especially during or after 2008. Sixty percent cited lower fees (avoiding the extra cost of using FoFs). More than half said they preferred to have more control over their hedge fund portfolios, something a typical comingled FoFs structure does not allow. As well, conducting due diligence on individual managers in-house seemed wise after several large FoFs were revealed to have invested in fraudulent products, most notably Madoff vehicles.

A third reason some investors prefer direct investments in hedge funds is that they have learned a lot since their entry into the sector through FoFs, and now are confident they can construct their own portfolios. (FoFs have long been known as "training wheels" for first-time hedge fund investors.) Some respondents said they had built up their in-house investment teams and added resources over time, allowing them to make direct investments.

Still, a significant number of institutions are satisfied with their portfolios and plan to continue their FoFs investments going forward, according to Preqin. Despite the extra fees, they cited diversification as their main reason for sticking solely with multimanager vehicles. In addition, FoFs enable investors with limited assets to access certain star managers who might be closed to new investors or whose minimum investment charges would otherwise be out of reach. Some FoFs-only respondents also cited lack of internal resources to vet individual managers and create a diversified portfolio.

Preqin found that many first-time investors still make their initial foray into hedge funds through multimanager vehicles. It listed, for example, Metropolitan Government of Nashville & Davidson County Employee Benefit System and Illinois Student Assistance Commission in the U.S. and Powys County Council Pension Fund in Wales as among institutions that have recently released FoFs mandates or made their first investments in hedge funds through FoFs.

This suggests, Preqin said, that as the institutional market for hedge funds matures, first-time hedge fund investors may be the most appropriate audience for sales pitches by FoFs managers.

Michael S. Fischer (msf7@columbia.edu) is a New York-based financial writer and editor and a frequent contributor to WealthManagerWeb.com.

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