CHICAGO (HedgeWorld.com)–As institutional investors such as pension funds have become comfortable with hedge fund strategies, often through initial investments in funds of funds, more of them are considering ditching the extra layer of fees associated with funds of funds and trying their own direct investments in single managers.

But that way lies trouble for investors without the means to conduct proper due diligence or risk analysis, and without the foresight and ability to get into good managers early.

Those were among the points made by a panel of hedge fund industry veterans that included a single-manager multi-strategy fund, two funds of funds and a brokerage firm at a recent summit for public employee pension funds in Illinois, put on by the Information Management Network.

One of the most talked-about issues of late has been whether the growth of assets in hedge funds has helped choke off returns, particularly in certain strategies that depend on exploiting mispricings, such as arbitrage strategies. One theory holds that as more capital flows into those areas, inefficiencies in the market are squeezed out by managers looking to deploy all that money. Once the inefficiencies are gone, so are the returns. Not everyone buys into that notion, though.

Jean Murphy, a vice president at the Chicago fund of funds firm Grosvenor Capital Management LP, said lower returns have more to do with macroeconomic conditions and, for convertible arbitrage in particular, reduced issuance of securities. Grosvenor studied the correlation between growing hedge fund assets and lower returns after one of its largest and longest-standing investors told the firm it was thinking of reducing its allocation to hedge funds.

Ms. Murphy said the recent tough return environment has highlighted an important hedge fund characteristic: adaptability. A number of distressed hedge funds, she said, which had been long only, have migrated to long/short credit models.

Scott Nelson, managing director at the Minnetonka, Minn.-based hedge fund Deephaven Capital Management LLC, echoed Ms. Murphy’s sentiments. “Trades will get crowded,” he said. “They will get old and tired. Efficiency will come into a market. Equity stat arb is an example of one strategy that’s seen lower returns and lower volume. The job of a hedge fund is to be flexible, to be nimble, and to be more so than many long-only managers are allowed to be.”

Another trend noticed by some is one of institutional investors, pension funds and university endowments, especially, having buildt up some experience with hedge funds by making their initial investments in funds of funds, ditching that route and opting to find their own single-strategy or multi-strategy managers. This trend, along with investment consultants’ attempts to educate themselves about hedge funds so they can serve the same manager recommendation role they do with respect to traditional investment managers, raises questions about the future of funds of funds.

Ms. Murphy, not surprisingly, said she sees an ongoing role for firms like Grosvenor. Investors may be able to mimic the return dispersion of a fund of funds using a multi-strategy fund, but conducting the necessary due diligence to find good managers can be an expensive proposition for an investor, and a multi-strategy fund still carries manager-specific risks. Multi-strategy fund investors may be okay if one strategy blows up, but if that blowup takes the whole multi-strategy firm down, it really doesn’t matter if the other strategies still had good performance. In a fund of funds, one manager blowup won’t necessarily drag down an entire portfolio.

Additionally, there are capacity issues with single managers, even those of the multi-strategy variety, Ms. Murphy said. “If you say that in three to five years, there will be a trillion dollars going into hedge funds, the top multi-strategy funds can’t absorb that.”

Still another issue is finding good managers early. Grosvenor invests in a number of multi-strategy managers, but the firm researched them carefully and got in early, before those managers closed to new investment. That could be a difficult proposition for the average institutional investor, which has to devote resources not just to hedge fund manager research, but to other alternatives and to traditional asset managers as well.

Chris Pesce, managing director and head of global prime brokerage at Bank of America, confirmed another trend noted by panel moderator Tom Dodd, president of the Chicago consulting firm Clark Strategic Advisors Inc., and that is single-strategy managers turning into multi-strategy managers. “You’re already seeing it,” Mr. Pesce said. “Both single-strategy and multi-strategy managers have room to grow and exist.”

Neither necessarily poses a threat to funds of funds; consulting firms might, however. “More traditional asset management consulting groups will threaten funds of funds as they grow in their manager knowledge,” Mr. Pesce said.

As might be expected at a conference for public pension funds, there was one pointed question about the perception that hedge funds charge high fees, posed by Mr. Dodd in a sort of playfully accusatory way: He suggested that hedge funds appear to be immune to the laws of supply and demand.

Steven Koomar, managing director at New York fund of funds Treesdale Partners LLC, said plenty of mediocre hedge funds are willing to negotiate fees; it’s the good performers who won’t deal. But investors seem willing to pay for performance. “Clients are demanding performance first. If the fund has good performance the investor will pay 2-and-20,” he said, referring to the 2% management and 20% performance fees often levied by hedge funds.

Mr. Pesce said that in fact, the fee situation shows that the laws of supply and demand are being followed, not ignored. “Clearly supply has grown rapidly, but demand has grown faster.”

Ms. Murphy said the current hedge fund fee climate resembles the situation with private equity funds years ago. Top-tier private equity funds charged high fees, but investors were willing to pay those fees in exchange for gaining access to good performers. It’s the same story in the hedge fund space today, she said.

In terms of transparency, something pension funds often demand either directly from managers or by insisting on separately-managed accounts, views among the panelists ranged from Mr. Koomar, who said Treesdale receives “pretty much full position-level transparency” from its managers to Deephaven’s Mr. Nelson, who said his firm provides no position-level transparency. “Investors have a right to understand our risk exposure,” he said. “But do they have a right to see what securities we own? I think not.”

Mr. Pesce said transparency is only as useful as an investor’s ability to analyze the information. “Asking for position-level data and not being able to analyze position-level data is nonsensical.”

The hedge fund panel attracted a decent crowd, its only competition being a panel on international investing and the bright, warm spring day that attracted throngs of shoppers and gawkers to the nearby Michigan Avenue shopping district. But, as Mr. Nelson pointed out afterward, many small and mid-size municipal pension funds in Illinois can’t even invest in hedge funds. Their statutes don’t allow it.

CClair@HedgeWorld.com