By Susan Barreto
There was a time years ago when consultants leaned on funds of hedge funds (FoHFs) as a vehicle to give their clients that initial taste of hedge funds. Now it seems that the game keeper has turned poacher as these same consultants have learned from their teachers to become the de facto experts in absolute return strategies.
In fact, the tables have turned so far that consultants have gained almost guru-like status and some FoHFs have been left picking up the crumbs in their wake. That said, the transfer of knowledge has not been one-way, as some FoHF groups have evolved to emulate the business model of consultants to be able to provide specialist advice to institutional investors for a flat fee.
InvestHedge surveyed nine diverse investment consulting firms in the area of hedge fund strategies, and found a growing pot of institutional money was flowing into the strategies. For the year ending 31 December 2012, approximately $464 billion in hedge funds and funds of funds were overseen by this group of nine, compared to $590 billion invested in hedge funds by the 101 largest funds of funds in the world (see InvestHedge, March 2013).
The firms in this group, which comprises Aksia, Albourne Partners, Callan Associates, Cliffwater Associates, Mercer, NEPC, Pension Consulting Alliance, Redington and Towers Watson, have won the hearts and minds of the institutional investor more often than not due to their unique position as voyeurs, if not actually advisers, across the entire investment portfolio – not just the hedge fund allocation.
While this trend of specialist hedge fund consulting has been more than five years in the making, this past year saw consultant assets increase by 18% on average, when the InvestHedge Billion Dollar Club saw its assets decline by 1.69% on average.
In terms of performance, there was a great divergence among FoHFs in 2012, from Aetos Capital growing its assets by 54.5% to the former FoHF business of Key Asset Management seeing outflows of 32.7% – with the latter seeing its chief investment officer, Chris Jones, and chief risk officer Toby Goodworth moving to set up an implemented consulting business for bfinance.
The majority of the consultant assets in the InvestHedge survey are advisory oriented, which is the source of some conflict between traditional FoHFs and consultants. Consultants traditionally provided inroads to the pension fund marketplace for FoHFs, as the FoHFs in turn provided an entrée to esoteric hedge funds. Now, in many instances, FoHFs are offering advisory services for a flat fee of less than 1% of assets, to retain business that consultants are taking over.
There seems to be no cookie-cutter approach as to how this money is divided up between managers and strategies (see consultant profiles on page 12), as some firms still choose FoHF products for clients, while others maintain sizeable hedge fund manager databases totalling more than 20,000 funds. Most of the single-manager hedge funds selected are brand names, with Bridgewater by far the most popular, or spin-outs from larger hedge fund shops.
Over the next 12 months, strategies such as long/short equity, opportunistic credit, macro trading and hedge fund beta are all in demand by consultants as their clients look for ways to avoid market risk. Hedge funds have led the way among alternative investment strategies as the best method of diversifying portfolios, dampening volatility and boosting returns in institutional portfolios.
The most popular practice for ERISA pension funds to reduce their funded status risk has been to use set formulas to automatically move funds from growth assets, like equities, to fixed-income assets, according to consulting firm Cambridge Associates. The issue has been that, in a low-interest-rate environment, such moves in themselves can be risky.
Consultants such as Cambridge are approaching hedge funds as part of the solution to this problem. A recent white paper issued by the consultant calls for a more holistic approach that not only looks at the amount allocated to growth assets, but also defines and controls the risk within the growth assets.
It does this by using growth assets that emphasise active strategies that rely on manager skill and non-traditional sources of beta (such as distressed credit, hedge funds and private investments) rather than directional equity market exposure. Strategies included in this type of growth portfolio are low-beta hedge fund strategies, very active long-only strategies and select private investment opportunities, when appropriate.
Cambridge notes that because the holistic approach usually involves higher exposures to alternative asset classes and strategies, it also entails implementation complexity as well as higher investment management fees.
A focus on fees on the part of trustees is one of the reasons why specialist consultants are increasingly becoming hedge fund portfolio advisers. In the case of Albourne Partners, it implemented a transparent and simplified structure early on that sparked a significant change in what clients were willing to pay for services.
The UK-based firm, founded by Simon Ruddick, oversees $290 billion in client assets in hedge funds as a specialist consultant that provides non-discretionary investment advice to sophisticated clients on alternative investments. Its services include portfolio construction, manager monitoring, manager selection, investment and operational due diligence, strategy/industry research, portfolio performance monitoring and risk management. Clients accessing hedge fund advisory services are charged either $240,000 per year or $400,000 per year. Clients that pay the higher fee gain access to due diligence on a broader number of funds and receive interactive risk tools and as well as greater customisation of risk-monitoring services.
Another consulting firm catering specifically to institutional hedge fund investors is Aksia, which oversees $42.7 billion in client hedge fund assets. Founder Jim Vos, who once ran the FoHF business at Credit Suisse, believes strategies that fill the void left by banks due to the gradual implementation of Basel III are the most promising for the coming year. He emphasises that Aksia, unlike other consultants, is not a generalist investment consultant and does not get involved in the decision to allocate to hedge funds or not, nor the decision of whether to employ a FoHF or go direct.
Often Aksia is in competition with generalist consultants, which also pitch for hedge fund specialist consulting work, according to Vos. Aksia works for a fixed annual fee regardless of assets under management, or whether or not the portfolio has both direct hedge fund holdings and FoHFs. This means there is no fee incentive to push clients to invest more in hedge funds or push the mix around, he adds.
Traditional investment consulting firm NEPC recently began offering discretionary services with respect to hedge funds and, according to officials, it is one of the fastest-growing areas of the firm with $3.4 billion in assets. Unlike Aksia, NEPC still advises clients on allocating to FoHFs.
The Cambridge, Massachusetts-based firm has $695 billion in client assets, of which $30 billion-plus is in hedge funds. Over the next year, NEPC is watching managers in equity strategies, the shadow banking system, European special situations and emerging markets.
The firm has been touting equities since the end of last year and remains positive on the category, although developed markets have had quite a run; the greatest type of arbitrage right now is time-period arbitrage, officials say.
Meanwhile, the shadow banking system also presents an opportunity for hedge fund investors, as banks have scaled down proprietary desks creating opportunities for hedge funds, according to NEPC. The consultancy firm is keeping an eye on structured securities, middle-market lending, bank loans and opportunistic investing across the capital structure. In Europe, Basel III and other regulations are also providing investor opportunities. While these special situations are slow to materialise, NEPC sees these as opportunities as European banks sell assets.
The performance of emerging-market equities have lagged, but growth rates of emerging markets are still higher than many developed markets. NEPC points out that credit markets in emerging economies are becoming increasingly investable and attractive, too.
Mercer, on the other hand, is a traditional investment consultant that has worked diligently in recent years to attain hedge fund expertise. The firm had $29.8 billion in client assets in hedge funds at the end of 2012. Just over four years ago it set about expanding its alternatives manager research boutique. In 2010, Mercer appointed Bill Muysken to a new role as chief investment officer for alternative alpha strategies. The following year, the firm bought St Louis-based Hammond Associates, bringing in hedge fund knowledge and adding an endowment and foundation client perspective.
The majority of Mercer’s clients’ hedge fund assets are handled in an advisory capacity by the consulting firm. Mercer’s 2012 ‘Global Manager Search Trends’ report revealed an increased appetite among investors for non-traditional fixed income. These debt instruments were seen to present investors with opportunities while sovereign government bonds were perceived to have limited investment potential and higher risks.
According to Mercer’s Andy Barber, while investors are looking to reduce their equity exposure they have been reluctant to add to traditional fixed-income holdings at current yield levels. The result is a variety of different fixed-income mandates – notably absolute return and emerging-market debt. Search activity across a range of alternative asset classes was also robust, particularly with infrastructure, private equity and multi-strategy hedge funds. Meanwhile, in the UK and Europe there has been interest in non-traditional mandates such as absolute return fixed income.
The Mercer survey of more than 1,200 European pension funds found that plans in the UK had made a meaningful shift out of equities over the past 12 months, with the average equity allocation falling from 43% to 39% (the comparable figure was 68% in 2003). UK schemes have traditionally been among the most equity-heavy in Europe, but now sit behind Ireland, Belgium and Sweden in terms of equity exposure.
Around a quarter of respondents suggested that they expect to increase their allocation to alternatives, with only 7% expecting to reduce the size of the portfolio. Within the alternatives portfolio, there remains appetite for growth in fixed-income assets and multi-asset portfolios, and in particular diversified growth funds.
At Towers Watson, the expectation has been that large institutional funds are likely to continue to invest in hedge funds directly for most alternative asset classes rather than via FoHFs as investors continue to focus on better fee structures and greater transparency. Indeed, at the recent EuroHedge Summit in Paris, Towers Watson’s Chris Redmond pointed out that, as a business, the firm was seeing an increase in demand for hedge funds and a relative decrease in demand for FoHFs from their clients.
Also foremost on investors’ minds is risk and how to lessen it across equity and bond markets. A recent survey compiled by UK consultant bfinance found that the focus on risk management and mitigation had risen exponentially since the beginning of the financial crisis and continues to grow: more than two-thirds (69%) of investing institutions saw risk management as being ‘very important’ in the fund-manager selection process, while 47% said it was essential to the design and implementation of portfolio investment strategy.
The quest for diversification is the key to risk-management strategies, bfinance found. Officials say that the growing interest of investors in real assets and absolute return strategies is creating additional challenges for pension fund risk departments.
In its pension fund asset-allocation survey, bfinance surveyed institutional investors in Europe, North America and the Middle East. It found that alternatives including infrastructure, private equity and absolute return strategies (such as dynamic asset allocation and diversified growth) will be the key beneficiaries in the first half of this year and over the next three years.
Nevertheless, FoHFs will continue to face challenges, with a net 7% of investors decreasing their allocation to this asset class over the next three years, according to bfinance.
Another UK firm, Redington –with roughly $1.5 billion in client assets in single-manager hedge funds – sees significant opportunities available within illiquid credit, including direct lending, real estate debt and distressed debt and liquidations. This position appears to fly in the face of the perceived lack of value within the public credit markets. Trend-following CTAs and risk-parity strategies are becoming more mainstream as investors focus increasingly on systematic risk premia investing.
Redington, like a number of other consultants in our survey (notably Cliffwater and Aksia), does not allocate client capital to FoHFs. Officials there say that, while they believe FoHFs can add value, they have found them as a whole to be “over-diversified and without the downside risk management that one should expect”. They believe that change is afoot and there are pressures within the industry to make it happen.
With 30 mandates in the past year and $20 billion in client hedge fund assets, Cliffwater is capitalising on that change, and is catering to US pension funds’ greater appetite for direct hedge fund portfolios. The flexibility that the firm demonstrates is an example of an emerging trend in the consulting industry.
Steven Nesbitt formed Cliffwater in 2004, after more than 20 years at traditional consulting firm Wilshire Associates. His firm’s approach was strictly alternatives and his expertise in using a manager investment approach at Wilshire was crucial in attracting public pension fund clients including New Mexico Public Employees Retirement Association; Massachusetts Pension Reserves Investment Management Board; Connecticut Retirement Plan and Trust Funds; New Jersey Division of Investment; and Ohio Public Employees Retirement System.
Pension Consulting Alliance also has a significant presence in the public pension fund community, but the Portland, Oregon firm has taken on less high-profile or sizeable clients. With just over $15 billion in client assets in hedge funds (a small subset of the $900 billion in plan sponsor assets that it oversees), the firm is agnostic when it comes to FoHFs versus direct hedge fund programmes. The firm is not a specialist in hedge fund investing and in fact at the Rhode Island State Investment Commission, Pension Consulting Alliance and Cliffwater work together – with Pension Consulting Alliance handling the overall portfolio, and Cliffwater focusing on the hedge fund part. Colorado Fire and Police Pension is another example of this, where Pension Consulting Alliance conducted the asset-liability study and Albourne picked up the hedge fund part of the portfolio as an adviser and due diligence consultant.
Pension Consulting Alliance’s philosophy is that consulting is a problem-solving process, not a commodity. Over the last year, its clients have allocated $1.4 billion to hedge funds. This number will undoubtedly rise as more pensions look to hedge the growing market risks in their portfolios.
The most long-standing firm in the InvestHedge survey is Callan Associates, which was founded in 1973 and, like Pension Consulting Alliance, is often brought in as a general investment consultant. With just under $15 billion in client assets in hedge funds, the firm primarily allocates to FoHFs. Some of the FoHFs selected by the consulting firm include: Blackstone Alternative Asset Management, Diversified Global Asset Management and The Rock Creek Group.
In some cases, clients invest directly at their discretion or with assistance from an external specialist consulting firm, says Jim McKee, senior vice-president and director of Callan’s hedge fund research group. He adds the firm only assists with monitoring performance and events affecting such direct investments.
The institutional marketplace beckons hedge funds large and small. For example, in its latest survey, Citi foresees institutional investment in hedge funds rising from $1.5 trillion last year to $2.3 trillion by 2017. Proportionally, these estimates will increase institutional investors’ share of the hedge fund industry assets under management from 66% to 71% as flows from institutions continue to gather pace.
How these dollars are put to work will largely depend on investment consultants who act as fiduciaries for trustees and investment workforces that are not large enough in most cases to handle the due diligence or research to allocate to hedge funds independently.
FoHFs and consultants have been fighting behind the scenes over the advisory dollars up for grabs, but the biggest test for any firm offering hedge fund advice is it must be able to produce the results necessary to satisfy institutional purchasers of alternatives – many of which are underfunded pension funds that are relying on hedge funds for their very survival.