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 Disclaimer: This publication is for information purposes only. It is not investment advice and any mention of a fund is in no way an offer to sell or a solicitation to buy the fund. Any information in this publication should not be the basis for an investment decision. InvestHedge does not guarantee and takes no responsibility for the accuracy of the information or the statistics contained in this document. Subscribers should not circulate this publication to members of the public, as sales of the products mentioned may not be eligible or suitable for general sale in some countries. Copyright in this document is owned by HedgeFund Intelligence Limited and any unauthorised copying, distribution, selling or lending of this document is prohibited. InvestHedge investor view 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.