Funds of hedge funds are now pension funds’ preferred route into hedge fund investing. Of the €1.2bn invested in hedge funds by Europe’s 50 largest pension funds, €920m is in the hands of funds of hedge funds, according to Boston-based research consultancy Cerulli Associates.
One effect of this has been to turn most funds of hedge funds into mainstream investment vehicles, producing average rather than exceptional performance.
As a result pension funds have to look elsewhere for their active risk. Alain De Coster, former head of Credit Suisse Asset Management’s alternative investment team, who left CSAM in 2002 to co-found ABS Investment Management, a fund of hedge funds manager specialising in long/short equity strategies, says the fall in performance was inevitable. “If you increase the level of players you basically reduce the type of opportunity available. At the same time markets have generally become more difficult over the past four years than they were in the late 1990s.”
The fund of hedge fund industry has split into two camps, he says. In one camp are the asset management-driven managers and in the other are the performance-driven managers. “The big institutions that have taken over the fund of hedge funds business and basically moved away from performance fees, preferring to generate asset management fees and structuring fees. In some respects, the fund of hedge funds are beginning to resemble mutual funds with their reward structure, he says. This has important implications for institutional investors, he says. “Managers who generate most of their revenue from management fees are less aligned with the interests of their investors. Managers that generate more revenue from performance fees are much more aligned.”
Some institutional investors are now looking at a core satellite arrangement that, in effect, combines the approaches of the asset management-driven managers and the performance-driven managers. The satellite managers are likely to be the specialist, niche fund of hedge fund managers. Randall Dillard, founding partner of Liongate Capital Management, a London based multi-strategy fund of hedge funds, says the best risk-return opportunities now are in niche sub-strategies where there are fewer hedge funds deploying capital, and where there is a very low correlation to capital markets.
“Pension fund managers who are thinking outside the box could decide to invest in a portfolio of funds of hedge funds rather than just the one,” says Dillard. “They could choose funds of funds that are allocating to mainstream hedge fund managers with traditional hedge fund strategies, and combine them with specialist funds that are seeking out market inefficiencies and pockets of performance, which others are not finding.”
However, he acknowledges that this would demand a level of active management of risk that is beyond the capability of many pension funds. “They are moving in that direction but they are just not there yet.”
For their part, large investment banks acknowledge that their role is likely to be as core managers in any core satellite asset allocations to funds of hedge funds. Danny 1ll, a managing director of Goldman Sachs Asset Management (GSAM) says: “We are certainly seeing arrangements where institutions use the GSAM fund of hedge funds as their core hedge fund exposure, and then seek to add either individual strategy or often specialist hedge of hedge funds in order to supplement that. Some of the work that we do for clients is seeing how the combination of those strategies will help the exposures in their portfolios.”
1ll says he expects an increasing number of pension finds to choose a core satellite approach to fund of hedge funds investing: “As pension funds increase their exposure to alternative investments, you will see more people going down that route.”
Such a strategy would need active management, he suggests. “You need to analyse your strategy carefully because you could be concentrating risk rather than diversifying it. And it is possible for pension funds to end up over-diversified by having too big a range of providers.”
An obvious candidate for a core or passive fund of hedge funds is a fund of hedge funds that invests in an investable hedge fund index, says Mark Ellis is co-founder and director of MSS Capital, a London and Guernsey-based alternative multi-fund asset management company that manages the FTSE Fund SPC, which invests in the constituents of the FTSE Hedge index, representing a portfolio of diversified, globally based hedge funds.
Ellis says institutional investment in funds of hedge funds is following the pattern of investment in equities. “In their equity investments, many large investors have taken the view that a core/satellite approach is appropriate because, although they are looking for outperformance, they have so many billions of dollars to invest in equities that they end up diversifying back to the index.
“A not dissimilar process is evolving in hedge funds. In a core satellite approach, satellites would be either single managers or specialist fund of fund managers, while the indexed fund of hedge funds would provide a natural core investment, with cheap and liquid exposure to the hedge fund world.
“The investable indices, and FTSE in particular, do speak very clearly to that type of approach.”
A core/satellite approach can also provide investors with a better understanding of risk. The original multi-strategy fund of hedge funds can be characterised as a blended approach, says De Coster of ABS Investment Management.
“They took the traditional approach to invest with fund of hedge funds, allocating among different strategies, the multi-strategy approach, in which macro funds, CTAs, equity long/short, and relative value arbitrage are all put together in a pot, so that they have a little bit of everything and each part balanced the other. That is where the huge growth in assets has occurred over the past four years.”
Although this may have appeared to be a diversified investment strategy, it did not necessarily diversify risk, says De Coster. “The average investors in hedge funds had very little understanding of the risk they were taking in the portfolios. In the blended approach people were mixing different types of bets or different types of risk.”
By focusing on a single, simple investment strategy such as long/short equity, he suggests, investors have a better understanding of the risk they are taking.
“Investors take a long/short equities approach because they do not want to take a view on market timing. In that way they have some exposure to the upside and a buffer on the downside.”
A long short equities strategy is an ideal strategy for the satellite component of a core satellite asset allocation, De Coster says. “Many institutional investors would consider using our long short strategy as a satellite for their own blended approach because they need to provide something more in terms of returns.”
Satellite fund of hedge fund strategies include the use of leveraging. Geneva-based Alternative Asset Advisors (3A) has launched a leveraged fund of hedge fund that can be leveraged up to three times. The fund has returned 40.74%-plus since it was launched in September 2003.
Jean Keller, chief executive officer of 3A says: “A leveraged fund of hedge funds is another type of fund that can form part of a diversified fund of hedge funds portfolio of an institution seeking to boost returns as part of a core satellite allocation.”
3A also manages a fund of hedge funds that is differentiated by strategy. This allows investors to take their own view on strategy, while leaving the fund of hedge funds allocation to 3A.
“The fund gives investors an extremely high level of choice,” Keller says. “They can either select a particular investment strategy while still benefiting from the diversification that a fund of hedge funds offers, or they may prefer a multi-strategy product spreading assets across the whole range of investment strategies.”
A further twist to the core satellite approach to fund of hedge fund investing is to diversify the core itself. John Alderman, a managing director at Merrill Lynch Investment Management, has proposed allocations to non-directional and directional funds of hedge funds as the core of a core satellite alternative investment strategy.
“The non-directional funds tend to be market neutral, well-diversified funds of funds with exposure to multiple strategies, while the directionals are well run and potentially more concentrated biased funds that may provide opportunities for enhanced return,” he says.

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