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.