When pension plans began to employ hedge funds five years ago in the wake of the stock market collapse, they did so primarily via funds of funds (FoFs). One hypothesis on why the institutions took this approach was that since the plans didn’t know much about hedge funds, they figured they’d cut their teeth on funds of funds and then progress to direct hedge fund investments. The opposite argument said funds of funds would always be the preferred vehicle. Indeed, many institutions continue allocating through FoFs. But increasingly, pension investments include direct allocations to hedge funds–a long/short equity manager here, a couple of global macro managers there, or their current favorite–multistrategy funds.

“We still believe funds of funds have a role for some clients, but more often our clients are investing in direct strategies,” says Roger Fenningdorf, partner at Rocaton Investment Advisors, a consultant to institutions.

Determining whether a plan sponsor is better served by funds of funds or a direct strategy depends on the needs and policies of the specific institution, says Fenningdorf. One key factor is the amount to be allocated: Typically, funds of funds can take larger amounts than individual funds. In the past two to three years, Rocaton’s clients have been primarily going for portable alpha programs to enhance returns on traditional investments, and for that purpose they are using direct single- or multistrategy hedge funds as well as funds of funds.

Other institutions add hedge funds to a fund of funds investment to get the particular return and risk features they want. Bill Ferrell of Ferrell Capital Management, a fund of funds manager, knows the roles for his clients: he manages the risk, sniffing out hidden market correlations that can endanger a portfolio of hedge funds. He calls it looking for Waldo–otherwise known as a sudden change in correlation.

For instance, last year Ferrell noticed that the portfolio was becoming more correlated to the Standard & Poor’s 500 stock index. But the increased stock market exposure was not coming from equity managers. Analysis revealed the culprit: a global macro fund. Its correlation to the S&P 500 had fluctuated widely, first going from about 25% to nearly zero and then abruptly zooming up to nearly 80%. The global macro manager had apparently become a strong devotee of the stock market. With the problem identified, the portfolio was cleared of the hazard. That’s one way a fund of funds manager can earn his keep.

Every Strategy Has Its Place

Remember, though, that an FoF has to deliver returns while also modulating the risks. Last year, fund of fund returns in general were lukewarm. Brad Miller, a director at Ferrell Capital, said some funds of funds don’t have the right tools and end up becoming index funds. Ferrell said there are always new opportunities–as well as risks.

Take the immense growth in credit default swaps in recent years. It creates potential for crashes, but also for portfolio diversification. “I’d love to find people who really know the business and understand the pitfalls,” Miller said.

No doubt there is a place for funds of hedge funds as institutions become more particular about hedge fund investing. Fenningdorf admits there is a such a role, but he believes it’s not a large one.

Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (www.hedgeworld.com), a global provider of hedge fund information and investment products. Chidem Kurdas is New York bureau chief for HedgeWorld.

Have a question about hedge funds? Feel free to contact Jeff Joseph by e-mail at jjoseph@rydexfunds.com.

For inquiries about HedgeWorld’s services, e-mail inquiry@hedgeworld.com.