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Is the fund of hedge funds business dying?

Investors in the region, especially institutions, have been avoiding fund of hedge funds (FoHFs) and instead allocating to hedge funds directly, according to Ronnie Wu, co-founder and chief investment officer at Penjing Asset Management.

Globally, inflows to hedge funds remain healthy, with investors pouring $15.4bn into such products this year, according to eVestment’s latest hedge fund asset-flow report.

However, the case is different for FoHFs, Wu believes, adding that institutional investors prefer to allocate to hedge funds directly.

“The business model of FoHFs has been challenged because fees were relatively high. Institutional investors are increasingly getting pressured with the fee they pay to invest in hedge funds,” Wu told FSA.

Ronnie Wu, Penjing Asset Management

There have been issues with hedge fund fees in general. A typical unconstrained hedge fund structure, for example, used to charge 2% of management fees and 20% of any profit, or “2 and 20”. However, poor hedge fund performance has caused investors to withdraw money and put pressure on fees. Now, the weighted average is around 1.7 and 17, according to Goldman Sachs Asset Management.

A FoHF structure may add to those fees, as it generally implies a double set of costs, according to Simon Hopkins, chief executive officer at Milltrust International, in a recent interview with FSA.

“You have the costs of the FOF manager, including administration and custodial fees, and you get those for the underlying funds as well, so you have a double layer of fees,” he explained.

Wu at Penjing Asset Management acknowledged that FoHFs previously had high fees, and the firm now tries to lower what it has to pay by negotiating fee discounts with the hedge funds in which the firm invests. On average, its clients pay around 1.2% in management fees and 15% in incentive fees.

Shift in client base and business

Since institutional investors have been allocating directly to hedge funds, Wu has seen a change in the client base of his firm. In 2008, for instance, around 90% of the AUM came from institutions; today, its $400m in total AUM is equally split between European-based institutional investors and Asian-based family offices.

Wu noted the firm has two family office clients, each with at least $100m in the firm’s products.

“Family offices want some help in hedge fund investing rather than just rely on their private banks,” he added.

He believes that although private banks promote hedge funds to their clients, these products are usually managed by large household names.

In spite of the client shift, the firm has not seen any new inflows from investors over the past three to five years. However, assets continue to grow due to capital appreciation, he noted.

Since then, the firm has developed a new aspect to its business – seeding, or directly investing in, hedge fund managers, similar to how private equity managers invest in companies.

Over the past two years, the firm has backed three hedge funds in Asia, investing around $20m to $30m each in return for a stake.

“Investors will also get a kicker from revenue sharing in addition to the investment return the hedge funds make,” he said.

Next year, the firm expects to seed between five and 10 more hedge funds.

Hedge fund selection

The firm offers four FoHF strategies: market neutral, diversified, long-biased and long-only, according to Wu.

The investible universe includes only Asian hedge funds, which number around 1,000. However, that drops to 400 names, as Wu prefers to invest in hedge funds with assets of $500m or less.

“Over $500m, there is a tendency for returns to start to decline. Managers can no longer manage in the same way as the fund gets bigger. The company can hire more portfolio managers to efficiently manage the fund, but only a handful of them have made that transition successfully,” he said.

Seven of the 16 staff at the firm are in its investment team to help with hedge fund selection.

Besides the usual track record and experience of the fund manager, Wu said the firm has a separate operations due diligence team that examines how a hedge fund manager is operating. This includes checking whether there is a proper division of labour and reputable service providers, such as auditors, lawyers and prime brokers.

“We actively take investment risk, not operational risk,” said Wu.. “If the operations doesn’t pass our due diligence, we will not invest into the fund. He added that around 50 to 100 hedge funds close down every year because they cannot sustain the business.

Part of the Mark Allen Group.