In a world in which the Chief Risk Officer of the formerly free capital markets, Ben Bernanke, has made any downside hedges obsolete (and as a result hedge funds have posted 5 years of returns without outperforming the S&P500), the first casualty has emerged: fund of funds. These parasitic, fee-soaking institutions, which merely collect a fee on top of the fees already charged by hedge funds, are rapidly on their way to extinction as the following charts from Eurekahedge prove conclusively.
As Hedge Fund Insight says, the divergence of the paths since the Credit Crunch of the single manager and multi-manager hedge fund businesses is well known, and is reflected in the time series of aggregate AUMs for the two sectors, shown below.
Comparative growth in funds of hedge funds & hedge fund assets under management since Jan 2008
The beginning of the end for the FOF industry started in 2008: before the watershed of 2008 each year there were more launches of funds of hedge funds than closures. Since 2008 there have been more closures of funds of funds than launches of funds of funds. So the number of funds of funds continues to shrink, though at a slightly slower rate in 2013 than 2012. The current AUM of the industry is 38.6% below its 2008 peak and stands at US$507.6 billion managed by a total of 3,214 funds.
Launches and closures of fund of hedge funds pre and post Credit Crunch
Furthermore, recent trends confirm that it is only a matter of time before Fund of Funds go the way of the dodo: the table of monthly flow data shows some changes in the last three years in seasonality, consistency of flows and total flows to funds of hedge funds. In 2011 and 2012 there were two months of net subscriptions in the Winter. In 2013 there were no inflows in February and March. Taking a diffusion index approach: in 2011 there were five months with inflows, in 2012 there were three months of net subscriptions, and in 2013 there has been one month out of nine in which investors added to the capital managed by funds of funds. Net subscriptions have become much less frequent.
Monthly flows in fund of hedge funds industry in last three years ($bn)
Naturally, the FOF industry which generates massive fees for its "value adding" managers, will not go down without a fight. And as Pensions and Investment reports, the FOFs have found a way to strike back: convert hedge funds into long only, idiot money, and we do enjoy the irony that in this centrally-planned market the idiot money is outperforming the smart, nimble asset managers by orders of magnitude.
Among the industry's best-kept secrets is that hedge funds-of-funds heavyweight managers Black-stone Alternative Asset Management and The Rock Creek Group LP between them run nearly $7 billion in long-only strategies using hedge fund portfolio managers in manager-of-managers structures.
Industry sources contacted for this story were slightly aware of Blackstone's migration into long-only approaches, but none had heard of Rock Creek's endeavor.
By contrast, a number of respected hedge fund managers have been fairly open about the launch of long-only versions of their strategies just this year.
These firms include CQS (U.K.) LLP, Lansdowne Partners LP, Lone Pine Capital LLC, Maverick Capital Ltd., Tiger Global Management LLC, Viking Global Investors LP and Winton Capital Management Ltd.
Institutional investors, dissatisfied with the returns they are getting from their traditional active equity and fixed-income managers, have been the primary drivers behind the launch of long-only strategies by hedge fund and funds-of-funds firms, sources said.
A surprisingly high percentage — 44% — of institutional investors invest in long-only strategies run by hedge fund managers, according to data from Deutsche Bank Markets Global Prime Finance, the finance unit of the investment bank.
A majority of hedge fund companies — 67% — said demand from all client types was among the top three reasons for offering long-only strategies.
Hedge funds... only in name:
A very tough environment for shorting stocks and fixed-income instruments over the past few years led to hedge fund managers deciding to separate their skill on the long side of their investment approach into stand-alone strategies.
“It's a function of low alpha production on the short side since 2008 until about September this year. Short-selling as a stand-alone strategy or as part of a long/short equity portfolio was basically written off,” said Scott C. Schweighauser, partner and president, Aurora Investment Management LLC, Chicago.
There is still hope that shorting may come back:
Over the past two to three months, “shorts have come back” and “2014 is setting up to be very good for absolute positive returns and alpha generation,” said Mr. Schweighauser, but he said it's doubtful that institutional investors will abandon their hedge fund managers' long-only portfolios.
“Hedge fund managers, even if they are managing a long strategy, are oriented toward absolute returns. They are not guided by having to hew to an index benchmark as a traditional active manager and that tends to produce less correlated and idiosyncratic returns,” Mr. Schweighauser said.
Unfortunately, since the only signal for "alpha" generation is the consolidated balance sheet of the world's central banks, any hope that a sustained market correction and/or return to normalcy, can take place will have to wait for the post-CB era, which may or may not come now that the world is completely habituated to operating under the umbrella of central banks. And until that time comes, if ever, fees for hedge funds, the highest in the industry, are about to tumble and become comparable to those charged by their "idiot money" peers.
The 20% performance fee charged by many hedge fund managers is dependent on generating a positive absolute return above the fund's high-water mark. In bad years, hedge fund firms don't get paid, which means they can't pay bonuses and start getting nervous about losing staff, he said.
Yes, but dumb money funds also don't charge a performance fee, which as the move toward global equivalency accelerates, will mean that only the most stellar hedge fund performers will be able to collect the kinds of returns that allowed the Teppers and Paulsons of the world to generate billions in bottom line profits for themselves every year. Everyone else will be washed under the great mediocrity of being a long-only stock picker, until such time as shorting is not only required but becomes the only strategy again. By then it will be, as always, too late.