Smaller institutions have conventionally looked to fund of funds (FOF) managers to fulfill their hedge fund allocations. Similarly, emerging managers have looked to FOFs for capital to grow their businesses. But these views ignore advantages of investing directly in hedge funds, and with Emerging Managers (as defined herein) specifically. We define "small institutions" as those in the $100 million to $1 billion range. They are large enough to make value-adding hedge fund allocations but may not have the resources or needs of larger institutional investors.
Also, we define Emerging Managers as those systematically overlooked by larger investors due to the manager's size, lack of track record or other reasons. Direct hedge fund investments do require a different kind of due diligence than do FOFs. However, the act of identifying compatible managers, investigating their investment and operational acumen, selecting a winner and monitoring that winner takes a similar amount of work whether one is considering a FOF or a single direct hedge fund investment.
The argument that FOFs are "cheaper" than going direct because less research is involved is debatable. Furthermore, FOF investments sacrifice control, liquidity, transparency and fit within one's portfolio. The operational risk increases with the number of sub-managers in a FOF and is compounded by the operational risk of the FOF manager itself. Direct investing in Emerging Managers offers further benefits because they often can invest in opportunities and respond to market events that a larger manager cannot, offer favorable terms and provide more customized service. For these reasons, smaller plans should involve Emerging Managers in a direct hedge fund program.
From experience, I am skeptical that substantial differentiation exists among many larger flagship FOFs. They tend to choose many of the same underlying hedge funds, reaching similar conclusions on which ones are good, and have exposures to the same underlying investments. On the results side, many FOFs effectively shoot for the same high-single-digit returns. A plan with $10 million or more to invest in hedge funds is better off picking the best manager it can find within its parameters and should consider the additional benefits of Emerging Managers. In doing so, institutional investors will likely pay lower fees with greater liquidity, greater transparency, lower operational risk, better access to the manager and more diversification in its overall portfolio. These investors will probably enjoy better long-term performance as well.
Lesson Learned: With even a small allocation, direct investing in hedge funds can pay.
Matthew V. Steffora, CFA
NexTier Companies, LLC
NexTier Companies, LLC