Funds of hedge funds (FoHFs) have been the traditional entry point for many institutional investors. However, much has changed since the global financial crisis, including how investors use (or don’t use) funds of funds. In this article, Robert Howie, European Head of Mercer’s Alternative Boutique, explores the evolving role for FoHFs – including recent case studies across Europe.

Why have FoHFs been traditionally popular?

Hedge funds started out as something of a cottage industry and remained that way until 2008. They typically cannot advertise themselves like traditional managers – and there are relatively fewer data sources to identify and compare hedge funds. Further, until recently, traditional investment consultants did not have large practices directly evaluating hedge funds. For these reasons, FoHFs have always been a relatively simple way for institutional investors to gain a diversified exposure to hedge funds. FoHF managers are effectively the link between institutional investors and hedge funds, many of which were not set up to service institutions.

FoHFs performed the critical role of sourcing hedge funds. They usually did a much better job than the in-house staff at an investor because the FoHFs had far greater resources and it was their full-time job. Most commonly, FoHF managers create off-the-shelf pooled funds for investors. These provide ready-made diversification – and the investor can fully outsource the selection, portfolio construction and monitoring of hedge fund managers to the FoHF manager. Hedge funds usually have more operational and business risk than traditional managers, and FoHFs also play an important role in evaluating these risks.

FoHFs provide other advantages to investors, including access to “closed” hedge funds and negotiating power on fees and terms. They can also offer investors liquidity terms that are a “blend” of the liquidity terms of the underlying managers – however, if a FoHF manages liquidity risk well, it will be constrained in the allocations it can make to underlying managers that are significantly less liquid than the liquidity terms the FoHF offers its investors.

That said, there are several disadvantages to FoHFs. Clearly, the key drawback of FoHFs is the “extra” layer of fees they charge over and above the underlying manager fees. That said, investing directly in hedge funds without a FoHF will also incur additional costs; and the governance and advisory costs associated with a well-managed hedge fund portfolio are not insignificant. Another drawback of a FoHF that investors perhaps did not anticipate is a distancing from the underlying investments. Because of full outsourcing, after years of investing in a FoHF, many investors have felt that their knowledge and understanding of hedge funds have not developed further than when they made the initial investment. Nevertheless, until the financial crisis, the better FoHF managers generally delivered good returns to investors (after all fees) combined with a fairly low correlation to equities.

About the author
Robert Howie is a Principal and European Head of Mercer’s Alternatives Boutique, a unit within the Investment Consulting business. He leads the manager research and generation

of intellectual capital for alternative assets in Europe, ranging from liquid hedge fund strategies to private market strategies such as infrastructure and private equity. He is

also global Lead Researcher for FoHFs.