Should FoHFs follow the regulated RIC road?

December 06, 2013  

As the DC pension plan, the retail and the HNW investor travel towards the Emerald City of absolute returns, who will Toto discover behind the curtain?

By Niki Natarajan

"We’re off to see the Wizard
The Wonderful Wizard for FoHFs
We hear he is a Whiz of a Wiz
If ever a Wiz there was
If ever, oh ever, a Wiz there was
The Wizard for FoHFs is one because
Because, because, because, because, because
Because of the wonderful things he does
We’re off to see the wizard
The Wonderful Wizard for FoHFs"

With apologies to ‘Yip’ Harburg for the desecration of his lyrics and L. Frank Baum for the liberties taken with his novel The Wonderful Wizard of Oz, but it seemed an appropriate analogy as retail investors in the US skip merrily down the regulated road to buy funds of hedge funds.

FoHFs might be considered mud by the Winkie Guards trying to control the assets of the largely closed defined benefit market, but for eight mutual fund FoHFs to raise $3 billion in less than a year in an entirely new market – one that had $13 trillion in assets under management at the end of 2012 – surely some wizardry is involved?

As 67% of those assets have been raised by just two groups – Arden Asset Management and Blackstone Alternative Asset Management, both in partnership with Fidelity Investments – the question to ask is Fidelity a Good Witch worth knowing?

The answer depends entirely on whether or not you are the Tin Man (retail investor) looking for a heart to tell you that you are making the right decision, or a defined contribution pension plan like Hartford Healthcare – the Scarecrow that has found its brains – that has made the choice to offer its members access to Neuberger Berman’s Absolute Return Multi-Manager Fund.

Munchkins say beware, the DC market is still protected by the consulting Winkie Guards shouting “Pay no attention to the man behind the curtain.” But Hartford’s choice gives hope of their defeat. Looking at the -5.21% in outflows from the $23 billion high net worth registered investment company industry, however, it is obvious that the Cowardly Lion (the burnt-out HNW investor) needs the Wizard’s touch in its quest for courage to return to hedge funds.

The US daily liquidity FoHF market has certainly taken off like Dorothy’s house in the tornado, but it is still too new to know whether or not the performance will match the traditional unconstrained registered investment company FoHFs, which are up 5.6% compared to the InvestHedge composite that was up 4.48% (page 36).

The new funds in the US could potentially come crashing down like UCITS FoHFs in Europe might do, should the Alternative Investment Fund Managers Directive create regulated multi-manager products like those in the US. This move could inadvertently kill the Wicked Witch of UCITS in the process if the performance lag disappears, as Kevin Gundle of Aurum Fund Management believes could happen.

With the AIFMD set to dominate the stage in Europe in 2014, can FoHFs learn something from the American experience? The directive is designed to offer greater investor protection against an ambush of the flying monkeys (frauds) and in the US it looks like performance-wise this regulated wrapper actually works.

Aurum is hoping to be the first off the mark with its AIFMD compliant FoHF, having explored the UCITS market but wanted its investors to have the ability to access the whole unedited hedge fund experience, without the various restrictions imposed on UCITS.

Although, just like SEC registration, AIFMD does not protect against all risks such as the FoHF picking the wrong manager, only picking the ‘right’ FoHF in the first place can help in this respect. But the underlying manager transparency that the RICs have to give via their N-CSR Filings can help prospective investors see which FoHFs have made poor choices and found themselves in a special purpose vehicles or side pockets.

“A baby has brains, but it doesn’t know much. Experience is the only thing that brings knowledge, and the longer you are on earth the more experience you are sure to get,” booms the Wizard of Oz, as Haussmann celebrates its 40th birthday. Clearly if one had had the courage to invest $10,000 in December 1973, they would now have $2.5 million.

So as the DC pension plan, the retail and the HNW investor travel towards the Emerald City of absolute returns, who will Toto discover behind the curtain? In a similar anticlimax to the novel itself, it turns out that it’s just a normal asset manager magnified by a powerful retail distribution system.

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