To Use a Fund of Funds, Or Go Direct? That Is the Question for Institutions by Greg Fedorinchik, Mesirow Advanced Strategies

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InvestHedge investor view To use a fund of funds, or go direct? That is the question for institutions By Greg Fedorinchik, Mesirow Advanced Strategies

decade ago, investors were ask- of-one). ing whether they should invest in • In the case of commingled investments, the hedge funds at all. Today, while size of the commingled fund (which helps de- there remain a few holdouts, the fray other expenses across a larger investor and majority of institutional investors asset base). A have made the leap to hedge funds • The scale the FoHF manager has in negotiating as an improved model for seeking active returns. better fees with underlying managers. Hedge funds have recently reached a record This last point is one of the most important and high $2.245 trillion in assets, according to least considered areas when comparing these HedgeFund Intelligence. We estimate that the various paths. FoHFs with scale can negotiate adoption rate of hedge funds by sophisticated meaningful cost reductions in the form of better institutional investors has reached almost 70%, terms with underlying managers, which often and allocations are likely to grow rapidly, in part include lower management fees and incentive due to the low yields offered today in the fixed- fees, as well as use of incentive fee hurdle rates. income asset classes. Hedge fund strategies re- In many cases, these cost reductions are not main complex, with at least 50 unique sub-strat- Greg Fedorinchik available to direct investors, because of limited egy classes, each with its own unique alpha, beta size. In our model, we create an underlying hedge and risk characteristics to understand, monitor performing cost-benefit analyses, consumers fund ‘fee/cost offset’ that is based on the differ- and incorporate into active portfolio construc- often overlook indirect costs. ence in expected hedge fund management fees tion. With the benefits of hedge funds now rec- We will attempt to address all of the direct paid by FoHFs vs direct investors of smaller scale. ognised by institutional investors, the question costs and explore many of the indirect costs and On the next page are our cost model has changed from ‘if’ to ‘how’ they are accessed. benefits of the different paths of accessing hedge outputs for two scenarios, a $100 mil- Most commonly, investors are asking: “Should funds as we look at four approaches to making lion hedge fund programme, and a $500 we use a fund of hedge fund (FoHF) manager or hedge fund allocations: million hedge fund programme, each make direct hedge fund investments?” 1) Investment in a seasoned FoHF commingled assuming weighted average manager returns of There have been loud dissenting voices from fund product. 8.5% (before fees paid to FoHF or consultant). many circles about the double layer of fees 2) Investment in a single investor fund (fund-of- The other key assumptions used for the $100 charged by FoHFs, but there has been little real one) managed by a FoHF. million scenario are: analysis of the all-in costs of the different ap- 3) Direct investment in hedge funds with the • Two internal staff hires required at plan (one proaches. Similarly, there has been little docu- help of a generalist consultant. administrative, one professional). mented consideration of the different benefits 4) Direct investment in hedge funds with the • Effective fees to underlying managers when offered by the different paths to hedge fund help of a specialist hedge fund consultant. going direct are 1.80% management fee and exposure. Being unaware of any comprehensive 20% performance fee vs FoHF fees paid to un- cost-benefit analysis addressing this topic, my The direct costs derlying managers of 1.5% and 17%. colleagues and I have recently undertaken such For the direct hedge fund path, the key cost Based on our direct cost estimates in the $100 mil- analysis that suggests that from a pure direct model inputs are: ion scenario, a commingled FoHF compares very cost perspective, FoHFs are actually a less expen- • The amount invested in the programme and favourably to the direct investment options and sive path to executing a hedge fund programme the number of managers – since these will may actually be the cheapest option, depending in many instances because the additional costs have an impact on the marginal costs for on the fees paid to advisors in the direct model. of consulting services, custody, administration, direct consulting fees, legal, custody and ad- The other key assumptions used for the $500 legal work and additional staffing that are often ministration expenses, as well as search and million scenario are: not explicitly considered. And that says nothing monitoring costs. • Four internal staff hires required at plan (two about the benefits of scale in manager fee and • The level of service provided by the consultant administrative, two professional). term negotiations that most institutional quality and its associated fees. • Effective fees to underlying managers when FoHFs bring to the table. • Marginal staff needed internally by an inves- going direct are 1.75% management fee and The cost-benefit analysis, where value equals tor to effectively execute the programme and 19% incentive fee vs FoHF fees paid to under- benefits minus costs, is a pretty simple equa- monitor managers. lying managers of 1.5% and 17%. tion. Unfortunately, because benefit is so hard For FoHFs, the key cost model inputs are: In the $500 million scenario, FoHFs are now to assign value to (and dependent on investor • The amount invested in the programme that im- a slightly more expensive option. A key factor preference), consumers are often encouraged to pacts management fees and certain other costs. here is that the $500 million programme in- focus their evaluation on costs alone. Further, in • The type of structure (commingled or fund- vestor is able to negotiate underlying manager

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Cost model output for $100m hedge fund programme Cost category FoHF FoHF Specialist Generalist fund-of-one Commingled consultant consultant (20 managers) (45 managers) (10 managers) (10 managers) FoHF manager or consultant fees 0.95% 0.95% 0.40% 0.18% Custody and administration 0.05% 0.04% 0.05% 0.05% Legal and compliance 0.05% 0.00% 0.07% 0.07% External oversight 0.03% 0.02% 0.00% 0.00% Internal staff management costs 0.00% 0.00% 0.27% 0.27% Hedge fund fee/cost offsets -0.45% -0.45% 0.00% 0.00% TOTAL 0.62% 0.56% 0.78% 0.56% Source: Mesirow Advanced Strategies fees to a greater extent. However, what may be allocation, manager selection or overall expo- sourcing, monitoring, portfolio construction surprising to some is how narrow the cost dif- sure decisions? and risk management. If an investor has plans ferences remain between the FoHF and direct Answers to these questions should be specified to insource these functions, appropriate costs models. In this case, the FoHF options are only in advance to properly track and evaluate deci- should be taken into account. approximately 20 basis points more in direct sion making. For FoHFs, absolute returns, along In general, many of these costs are higher in a costs than the direct models. This is a much low- with beta-adjusted peer and pre-specified bench- direct allocation model, but all may be effectively er cost differential than commonly considered. mark returns, are all potential evaluation meas- managed. That said, managing them effectively ures. For direct programmes, assigning clear may create other direct costs, like additional le- Indirect costs to consider accountability for decision making is critical, as gal, compliance, oversight, technology and staff- Indirect costs of the various models are impor- is developing and using metrics for success in ing cost. We have not explicitly assigned dollar tant and also very difficult to estimate and quan- manager selection and allocation. costs for these indirect variables, but all of them tify. And in fact, what one investor considers a • Fiduciary risk: With each additional manager should be considered and formulated into an in- cost another may consider a benefit. Below we hired comes additional fiduciary risk to all par- vestor’s analysis when making decisions about list and describe some of the key indirect costs ties involved in selection, implementation and which path of hedge fund investing to follow. that should be considered. monitoring. At the same time, use of consult- • Complexity and implementation risk: Com- ants mitigates this risk – given their knowl- Direct benefits plexity of the programme creates additional edge of the broad marketplace and execution The key direct benefit that is explicitly most support burden and communication costs be- of best practices. important to institutional investors that I speak yond directly measurable costs – including • Headline and peer risk: With multiple man- with is the future return that will be experi- requiring additional cash flows across custo- agers headline risk increases for plan sponsors enced. Thus, the key question investors at the dy accounts, data management, data sharing if they have direct and publicly disclosed asso- $500 million level should ask is: do I believe and reporting to other service providers and ciations with underlying hedge fund manag- the FoHF manager is likely to generate 20 basis plan trustees. ers. With a FoHF approach, the headline risk points of return more than the direct model? • Time to programme implementation: how exposure is with the FoHF manager typically The problem with answering this question long will it take to implement and what are the and not the underlying hedge funds. clearly is that future performance is unknowable opportunity costs incurred over the implemen- • Service provider and internal staff turnover: in advance. That is true not only of the absolute tation timeframe? Presumably, implementation How long will it take to recruit and train inter- level of the return, but also its volatility and cor- time is longer for the direct models that require nal staff? Who will train them? How important relation profile relative to other asset classes in multiple investments vs turnkey FoHF solutions. is the loss of a key person or senior staff turno- which the institution invests. If we look at his- • Switching costs: How easy or difficult is it to ver, and what effect might it have on the pro- toric returns, we see that it is easily possible that unwind the programme? What are the internal gramme success? Thinking in advance about a FoHF manager could generate well in excess and external operational and approval hurdles? the recruiting, training and succession issues re- of 20 basis points of additional return over the How quickly can service providers be changed? lated to key staff is an important consideration. direct model. But without clairvoyance, an insti- • Measurement and accountability: Who owns, • Systems and infrastructure: FoHFs and tutional investor cannot count on past perform- or is responsible for, any and all decisions? consultants have varying competencies and ance being indicative of future results. What What are the return targets or appropriate investment in systems and infrastructure to is knowable, and what we focus on below, are benchmarks? Who is accountable for strategy improve efficiencies in hedge fund manager more ‘indirect benefits’. Cost model output for $500m hedge fund programme Cost category FoHF FoHF Specialist Generalist fund-of-one Commingled consultant consultant (20 managers) (45 managers) (20 managers) (20 managers) FoHF manager or consultant fees 0.75% 0.75% 0.08% 0.13% Custody and administration 0.05% 0.04% 0.04% 0.04% Legal and compliance 0.01% 0.00% 0.02% 0.02% External oversight 0.01% 0.02% 0.00% 0.00% Internal staff management costs 0.00% 0.00% 0.11% 0.11% Hedge fund fee/cost offsets -0.34% -0.34% 0.00% 0.00% TOTAL 0.47% 0.47% 0.25% 0.29% Source: Mesirow Advanced Strategies

Indirect benefits to consider liquidity and rebalancing constraints involved liquidity. Underlying investments are not Some of what we call indirect benefits may in with managing hedge fund portfolios. 100% quarterly even though the fund provides fact influence the direct benefit of achieved -fu • Experience: Experience in differentiating skill quarterly liquidity. The best way to manage ture return. Because future investment perform- from luck in nuanced investment approaches, this risk is for investors in commingled FoHFs ance of a FoHF manager or a direct programme risk management experience, and operational to monitor their size relative to the overall cannot be predicted with certainty, an investor due diligence experience are critical com- fund and other investors within the fund. must rely on philosophy, process and conviction, ponents of successful hedge fund investing. • Customisation and service evolution: Which among other things, to justify decisions. That Experienced analysts and risk managers are potential partner or programme has the broad- is often a complicated effort driven by many aware of industry best practices. Experienced est and deepest knowledge, willingness and unique personalities, decision processes and analysts can often negotiate the best liquidity, ability to customise the programme to your oversight dynamics. The question for institution- transparency, fee and governance terms with needs as they evolve? Does the provider bring al plan sponsors is: “What are the most impor- managers which can dramatically improve economic, investment, liability and other ex- tant criteria that will or should drive our invest- incentive alignment and mitigate the risk of pertise and a full set of potential solutions? On ment decision making – and give us confidence poor outcomes. this front, generalist consultants tend to have in future performance?” Potential benefit criteria • Diversification: Under most of our assumed the broadest knowledge and skill set, while Fo- important to consider are described below. Here scenarios, a FoHF will provide more immediate HFs have the deepest skill set in hedge funds again, it is worth mentioning that one person’s and appropriate diversification across manag- specifically. Specialist consultants probably lie benefit may be another person’s cost. ers, betas and alpha types. For a typical multi- somewhere in between. • Alignment of interests: Incentive issues are of strategy FoHF this can be anywhere from 20 to • Systems, reporting and infrastructure: Dif- extreme importance in hedge fund investing. 100 managers. The flip side of this argument is ferent consultant and FoHF firms have dif- In our experience, capital co-investment is the that many perceive FoHFs as potentially over- fering levels of access to transparency from most powerful incentive alignment technique diversified. This excessive diversification is -be underlying funds. In some cases, FoHFs and and one that most consultants and FoHFs tend lieved to eliminate a great deal of the available consultants utilise internal or external risk to require from managers with whom they alpha. Our studies on the topic demonstrate aggregation services to provide better trans- invest. This is also common with FoHF com- that the issue of over-diversification is highly parency into underlying holdings and risk mingled investments where principals of the dependent on the portfolio construction, the exposures. These in turn enhance reporting FoHF firm invest alongside clients. In our ex- availability of quality managers with capacity and risk management capabilities. In addition perience, this is one of the most important and in the desired strategy segments, and the na- firms employ teams of operational experts and powerful benefits to consider. Because consult- ture of alpha produced by managers in differ- accountants – providing economies of scale ants and internal employees typically cannot ent strategy segments. Simple models of stock in accounting for and reporting on underly- invest alongside the plan, this type of align- diversification greatly oversimplify this issue, ing hedge fund investments. These can often ment is harder, if not impossible, to achieve and our work suggests that portfolios of 20 to be leveraged by investors and are key benefits in a direct investing model. Another benefit 50 managers may in fact be optimal, depend- and should be analysed and compared across of the FoHF model is the ability to negotiate ing on the objectives. As such, we perceive potential advisory partners. a management fee plus incentive fee (typically ‘day-one diversification’ as a key benefit of the over a hurdle) so that investors will pay less FoHF approach. Conclusion when performance hurdles are not achieved. • Access: Access to closed or unique managers All-in cost differences between the models are • Research depth and quality: While ex-post and new ideas: FoHFs often have long-term not as great as many commonly believe. While performance ultimately determines research capital that has been invested with high- much investor attention is paid to the ‘double quality, given the greater degree of specialisa- quality managers, often for many years. Many layer of fees’ in the FoHF model, the correspond- tion and resources, FoHFs generally score high- FoHFs also negotiate capacity with managers ing incremental direct staffing and other ex- est on these metrics. For example, a typical given their history with managers and scale penses incurred in employing the direct model mid-to large FoHF manager might employ one in fund allocations. In addition, FoHFs’ well- is often ignored. In addition, because FoHFs have research analyst for every three to six manag- developed sourcing networks are valuable in greater asset scale, they are usually in a position ers covered, and could have an additional oper- seeking out new, small or unique managers. to negotiate more favourable terms with under- ational due diligence analyst assigned to only Often these smaller or more unique manag- lying managers, offsetting a significant portion 10 to 12 managers per operations analyst. This ers are more willing to provide advantageous of the underlying manager fees relative to the depth of coverage is hard for other types of or- terms to large established day-one investors other models. ganisations to match and may be closer to 40:1 that help provide business stability and access From a pure cost perspective, a $100 million for organisations with fewer dedicated hedge to insights and best practices. hedge fund programme may in fact cost more to fund resources. In addition to research ana- • Liquidity: Liquidity is similar for most options implement via a direct programme model than lysts, FoHFs tend to have larger teams focused with the exception of commingled FoHFs. through a FoHF. At the $500 million level, we on data management, portfolio construction, The benefit is that if one investor comes into estimate the FoHF model is only roughly 20 ba- and risk management. a fund while another investor goes out, those sis points more expensive than a direct model. • Observable track records: A live historical moves can be offset with no disruption to the The question of which is a greater value, how- track record often instils confidence in decision investment programme. Further, commingled ever, relies on the net return achieved in the makers. It is relatively easy for FoHFs to show FoHFs have ‘seasoning’, meaning some capi- future (which is an unknown) and each inves- live track records attributable to their team tal invested under lock-up arrangements with tor’s own assessment of the value of the indirect and process. This is a more difficult proposi- managers will likely have matured past lock- costs and benefits. tion for a nascent direct programme. One can up dates. In addition, most FoHFs offer quar- The benefits brought to bear by things like construct a hypothetical performance stream terly liquidity in commingled funds that is a incentive alignment, experience, research cover- based on a set of proposed managers and al- benefit in normal periods. The problem is that age and quality, observable track records, diver- locations, but that process is fraught with bi- quarterly liquidity can be a problem in crisis sification, liquidity, systems, risk management ases. We would argue that live track records periods, since departing investors can have ad- expertise, reporting and infrastructure should be are more critical in the hedge fund space than verse effects on remaining investors in a fund. explicitly analysed. In the end, it’s simple: V=b-c. in traditional investments given the nuanced That is true because most FoHFs intermediate Or, sort of simple… maybe.