Increased institutional interest in hedge funds and the changing role of funds of funds are two of the major forces affecting the hedge fund space in 2011, according to a recent white paper from Infovest21.
Pension underfunding is leading to increased interest in both hedge funds and fund of funds, according to the paper, with hedge funds increasingly viewed as a surrogate portion of the pension’s entire asset allocation, not just as an alternative asset class. Hedge funds, once used primarily as absolute returns are increasingly used as both fixed income and equity replacements, says Infovest 21.
Moreover, large U.S. pension funds are increasing direct allocations to hedge funds. According to the white paper, of the 10 U.S. public funds with the largest allocations to hedge funds, only two are invested solely in funds of funds, while six are completely invested directly in hedge funds.
The paper cites Massachusetts Pension Reserves Investment Management as an example. The pension recently decided to divert $500 million of the $3.5 billion it has invested in funds of funds to direct hedge fund allocations, saying the move would prevent manager overlap, provide transparency and save about $4.2 million in fees.
“Performance is another reason the large U.S. public pension funds are increasingly allocating directly to hedge funds,” said Lois Peltz, president of Infovest21. “The average hedge fund outperformed funds of funds in six of the seven past years. The largest differentials occurred in 2009 and 2010.”
Despite the trend to direct hedge fund allocations, however, Infovest21 says funds of funds “do serve a function and are here to stay.” The paper suggests, however, that their role is changing and that the most effective funds of funds are those “adapting their business model to accommodate institutional needs.”
For some funds of funds, this means developing advisory business, others provide asset allocation studies, and others risk management. Some funds of funds are hired to identify and vet managers and others are moving into what Infovest21 calls a “subadvisory” business where they transfer knowledge to the pension which may eventually “become more active in the internal management of their hedge fund program.”
The white paper also touches on issues like regulation, closings and the challenging asset-raising environment.