Last August, in one fell swoop, New York–based Blackstone Alternative Asset Management opened the once-exclusive world of hedge fund investing to retail investors. BAAM, the world’s largest investor in hedge funds, introduced the Blackstone Alternative Multi-Manager Fund, an open-ended mutual fund, to offer daily liquidity to clients of Fidelity Investments’ Portfolio Advisory Service. “The fund was reverse-engineered from a very substantial market demand,” explains John McCormick, head of global business strategy for Blackstone’s hedge fund solutions group.
BAAM’s ability to flex its $55 billion in assets to meet this demand has helped it tighten its grip on the fund-of-hedge-funds industry while other firms flounder. More than half of the money BAAM has raised over the past five years has come from existing investors diverting capital from competitors with lower returns, giving the firm a greater share of their pocketbooks, according to CEO J. Tomilson Hill.
“We’ve used scale to create a comparative advantage for our platform,” Hill says. “The reason we grow is that we’ve met our customers’ expectations of returns. They’re happy, and because of that, we are capturing an ever-larger presence of the institutional marketplace.”
The picture for the broader fund-of-funds industry is not so bright, according to Alpha‘s 2014 Fund of Funds 50, our annual ranking of the world’s largest multimanager hedge fund firms. The combined $539.6 billion managed by the top 50 at the start of this year is nearly 40 percent below the record $877 billion run by the Fund of Funds 50 firms when 2008 began. Though cumulative assets rose for the first time since the 2008-'09 crisis — up $45.6 billion during 2013 — some 53 percent of the influx came from growth at the top ten firms. As a result, the leading six firms retain their 2013 spots, with BAAM comfortably taking the crown for the third consecutive year. A&Q Hedge Fund Solutions (formerly UBS Alternative and Quantitative Investments), which manages $26.6 billion, settles in at No. 2 for the third time since topping the list in 2007. The Stamford, Connecticut–based firm is followed closely by HSBC Alternative Investments Ltd. (HAIL) at No. 3 and Goldman Sachs Hedge Fund Strategies at No. 4. Grosvenor Capital Management, the world’s largest independent fund-of-funds firm, and New York–based Permal Group round out the top six.
Despite the consistency at the pinnacle, there are notable changes elsewhere in the ranking. FRM, which London–based Man Group acquired in 2012, drops out of the top ten this year after enduring $4.19 billion in losses. The contraction comes primarily from client redemptions out of RMF and Glenwood, Man’s legacy fund-of-funds businesses. Mesirow Advanced Strategies returns to the top ten for the second time in the ranking’s 13-year history, snagging the No. 10 spot with $13.5 billion in assets. While No. 45 Morgan Creek Capital Management’s assets were sliced nearly in half, to $4.3 billion, AXA Investment Managers, the alternative-asset branch of Paris–based AXA, doubled assets, to $8.96 billion, leapfrogging from No. 39 to No. 23.
The distance between the haves and the have-nots within the fund-of-funds industry has widened since the financial crisis. Debilitating capital outflows by liquidity-hungry investors in the immediate wake of the global meltdown wiped out the most-fragile firms and forced the survivors to scramble to appeal to other investors — no easy task. As hedge funds become more institutional, investors fed up with paying double-layer fees for anemic performance are becoming more comfortable with sidestepping funds of funds entirely and investing directly with single-strategy managers. Many are turning to the lower-cost advisory services of industry consultants.
As a result, well-resourced leaders in the fund-of-hedge-funds industry are deviating from the traditional commingled fund model as a way to build scale and remain relevant in the new alternative management landscape. Samuel Belk IV, director of diversifying investments at Boston–based consulting firm Cambridge Associates, describes a “tiering” between the best and worst fund-of-funds firms during the recovery. “In 2014 institutions are investing in the best of the best — those whose returns are steady and whose due diligence is excellent,” Belk explains. “This top tier is growing assets.” The ten largest Fund of Funds 50 firms averaged roughly $2.4 billion in asset growth during 2013. Assets at BAAM alone surged by $10 billion.
Funds of funds’ traditional value proposition of generating highly attractive, risk-adjusted returns that provide diversification to other asset classes is still in demand. BAAM’s Hill, McCormick and CIO Brian Gavin credit their firm’s outstanding growth last year to investors’ hunger for customized portfolios. About $30 billion of BAAM’s assets are managed through separate accounts designed to meet institutions’ specific needs.
Customization is not new: The top firms, including BAAM, A&Q, Goldman Sachs HFS, Grosvenor and No. 7 Morgan Stanley Alternative Investment Partners, have offered custom portfolios for at least a decade. But there’s been an uptick in demand since 2008. Thomas Macina, the newly minted CEO of Chicago–based Mesirow Advanced Strategies, attributes the intensifying appetite for individualized services to institutional investors’ growing familiarity with the hedge fund industry. “A higher fraction of institutional investors are now well into their hedge fund experience, and a much lower fraction are considering adoption for the first time,” he explains. Because of that, many big institutional clients are able to be more deliberate and targeted with what they’re trying to accomplish with their hedge fund portfolios, depending on a range of factors, including funding status, liability horizons, risk tolerance and the makeup of the rest of their investments. This has translated into more tailor-made funds: About 55 percent of Mesirow’s capital is in custom vehicles. Similarly, about 64 percent of its Chicago neighbor Grosvenor’s $24.4 billion in assets are in bespoke funds.
Increasingly, fund-of-funds firms want to participate in the growth of the hedge fund industry by being owners rather than simply investors. Peter Rigg, CEO of London–based HAIL, reckons that small, innovative hedge fund managers have the potential to offer more alpha than big hedge funds. “Large funds often sit with their billions under management, clipping the management fees and being conservative in terms of position size and not wanting to risk the franchise,” he says. “Newer funds typically can be more aggressive and go for higher returns.”
HAIL, which Rigg has headed since January 2013, has seeded more than ten early-stage hedge fund managers in the past two years through its HSBC Next Generation Fund. The firm, which turns 20 this year, has long been committed to its seeding program: It was an early investor in what are now some of the largest and top-performing hedge fund firms in the world, including $15 billion Lansdowne Partners (2001) and $40 billion Brevan Howard Asset Management (2003). BAAM also has an active seeding program and believes in the potential of smaller hedge funds: More than 60 percent of its assets are with firms that manage $3 billion or less.
Like much of its competition — including Morgan Stanley AIP, No. 18 K2 Advisors, No. 20 Rock Creek Group, No. 22 Aurora Investment Management and No. 36 Arden Asset Management — Goldman Sachs Asset Management has introduced funds to address clients’ concerns over daily liquidity and demand for alpha–based strategies. Christopher Kojima, head of GSAM’s alternative-investments and manager selection group, and Kent Clark, CIO of GSAM’s $25 billion hedge fund strategies group, oversaw the launch of the $366 million Goldman Sachs Multi-Manager Alternatives Fund last April. “We manage a pretty full suite of mutual funds,” Clark says.
William Ferri, global head of alternative and quantitative investments at UBS, and A&Q CIO Bruce Amlicke are more cautious about expanding into the retail sector. The No. 2 firm hasn’t marketed hedge funds below the $2 million high-net-worth cutoff. “Going that step down to daily liquidity is under construction for us,” says Ferri. “We have to be very confident we can provide something differentiated and something that people understand.”
Managing these new products can be tricky, but according to Mesirow’s Macina, the key is finding a sweet spot. “Complexity is driven less by the amount of dollars that you have and more by the number of investments that you have and the number of portfolios you are running,” he says. Mesirow has investments with 80 to 90 hedge fund managers globally. The firm’s clients are almost entirely institutional; two thirds of them are pension funds.
James McKee, director of hedge fund research at Callan Associates, a San Francisco–based consulting firm, observes a bifurcation in the makeup of portfolios, based on the size of the fund-of-funds firm. His research suggests that firms with limited scale and resources often forsake diversification for practicality. “A more concentrated roster is necessary [for smaller firms] to lower operating expenses, even though it increases the risk of performing dramatically different from peers,” he explains. “In contrast, larger investors able to properly vet a wide array of managers can afford the luxury of broader diversification while avoiding the risks of ‘diworsification’ by delivering lower-cost solutions.”
AXA Investment Managers fits into the smaller-firms category. The London–based head of its fund-of-hedge-funds practice, Francisco Arcilla, doesn’t think that broad diversification is relevant in the new financial landscape. Since joining the firm in October 2011, he has sliced the number of underlying managers in AXA’s fund-of-funds business from 60 to 30 and increased the size of its individual investments. “We have downsized to focus on the highest-conviction ideas, not just to provide diversity,” says Arcilla, adding that one of the biggest challenges for the fund-of-funds business before the crisis was its lack of adaptability.
For funds of funds striving to remain relevant, technology is an enormous consideration. Well-resourced firms are investing millions of dollars annually to build out sophisticated front-office systems to source the best investment opportunities, construct portfolios, efficiently manage risk and interact with clients transparently and quickly. Proprietary technology gives firms a leg up against competitors: It serves as a repository for in-house research and exclusive information that isn’t available to the public and can be used to generate risk reports that quench investors’ growing thirst for hedge fund transparency.
According to Cambridge’s Belk, this tiering of the best and worst firms in the fund-of-funds business will intensify as the more fragile firms, with limited access to underlying managers, struggle to attract assets and cover costs. “The barriers to entry are higher now than ever before,” Belk points out. Callan Associates’ McKee also foresees greater bifurcation between “niche, capacity-constrained opportunities [and] scalable, large-tier, fund-focused solutions priced aggressively enough to make large investors question the fee savings from going direct.”
The old industry model is becoming less germane. BAAM — which offers advisory services in addition to its commingled funds, customized portfolios, hedge fund seeding and retail products — hasn’t considered itself a fund of funds for at least seven years. Lisa Fridman, London-based head of European research for Irvine, California-based Pacific Alternative Asset Management Co. (No. 9, with $15.7 billion in assets), thinks that “fund of funds” remains an appropriate name for the industry, as investments still tend to be represented by portfolios of funds or managed accounts. But what it means to be a fund-of-funds partner to institutions has changed. “As investors build in-house programs for direct hedge fund allocations, the traditional select-and-compile fund-of-funds model becomes less relevant,” Fridman says. Instead, institutional investors increasingly want funds of funds to add value by tailoring additional portfolios to complement their internally managed hedge fund allocations.
A&Q’s Amlicke, who was CIO of BAAM from 2004 to 2009, admits that end investors are becoming more sophisticated and hiring consultants over funds of funds to make “safe” direct investments in larger hedge funds. Direct investors wanting to find excess returns, however, are going to have to expand their workbench by using fund-of-funds providers that are fiduciaries. This is pushing A&Q to be not just an allocator but an active investor. BAAM’s McCormick notes a similar trend: “What we’re seeing from our clients is a real dissatisfaction with this set-it-and-forget-it, pick-a-manager-off-a-list model. This is not a passive asset class.”
The fund-of-hedge-funds industry collapsed in only a matter of months following the crisis; the recovery is going to be a much longer process. BAAM spent three years developing what ultimately became its new, $1.2 billion multimanager mutual fund. “It takes time and a lot of resources” to perfect and introduce a new product, explains CEO Hill, but once the groundwork has been laid, “it’s a very scalable platform from there.”
