CHAPTER After the Crisis: The Withering of the Funds of Hedge Funds Business? R McFall Lamm, Jr Stelac Advisory Services LLC, New York, NY, USA Chapter Outline 1.1 Introduction 1.2 Institutional versus Private Investor FoHFs 1.3 The Bubble Bursts 1.4 The Aftermath of Crisis 1.5 The Excess Cash Problem 1.6 Could FoHFs Problems Have Been Prevented? 1.7 The Role of Performance Decay 1.8 Outlook 10 Conclusion 12 References 13 1.1 INTRODUCTION From the early 2000s up to the financial crisis, the funds of hedge funds (FoHFs) business was one of the most rapidly growing sectors of the financial products world Indeed, FoHFs assets under management (AUM) multiplied 10-fold from the turn of the century to a peak at well over US$2 trillion at the beginning of 2008 Growth in FoHFs assets even exceeded the pace of expansion in the underlying hedge fund industry with the FoHFs market share rising from around a third of total hedge fund assets in 1999 to half at the market crescendo (Figure 1.1) The feeding frenzy driving asset flows into FoHFs was in large part due to the stellar performance record of the 1990s, when returns significantly exceeded those of plain-vanilla stock and bond portfolios This point was made by Edwards and Liew (1999), Lamm (1999), Swensen (2000), and others who increased awareness of the advantages of hedge fund investing However, the key event sparking industry expansion was the bursting of the technology bubble from 2000 to 2002 As investors watched the NASDAQ and S&P 500 fall 78% and 49% from peak to trough, hedge funds and FoHFs collectively delivered positive returns Very soon afterward, institutional consultants began to bless Reconsidering Funds of Hedge Funds http://dx.doi.org/10.1016/B978-0-12-401699-6.00001-0 Copyright Ó 2013 Elsevier Inc All rights reserved SECTION Due Diligence and Risk Management 2500 2000 Total (including CTAs) Fund-of-funds Billion 1500 1000 500 Source: BarclayHedge Data for 2012 are through the first quarter 19 19 98 19 20 00 20 20 02 20 20 04 20 20 20 20 08 20 20 20 20 12 FIGURE 1.1 Hedge fund industry AUM allocations to hedge funds as suitable investments This unleashed a massive flood of inflows from pension funds, endowments, and foundations that continued unabated until the financial crisis The original business proposition put forward by FoHFs was very enticing and offered extraordinary value for investors FoHFs provided hedge fund due diligence, manager selection, and portfolio management in one convenient package Costs were reasonable with most FoHFs charging a 1.5% management fee, which was about the same as that of active equity managers Less popular were FoHFs incentive fees of as much as 10e15% However, incentive fees were typically applied only when a cash hurdle rate was exceeded, making the charges more palatable especially when investors believed they would receive a superior return stream with downside protection during adverse market developments Furthermore, because it was costly and time-consuming for investors to build their own hedge fund portfolios in what was an opaque and highly specialized field, FoHFs offered institutions an easy first step and immediate exposure FoHFs also provided a doorway for private investors e many of whom lacked sufficient scale and expertise to construct adequately diversified portfolios e into hedge fund nirvana Another competitive advantage often promoted by FoHFs was that they had access to the best hedge fund managers who often would not accept money from new investors FoHFs could easily meet the larger minimum investments often required by very successful hedge funds and often qualified for better terms e ‘most favored nation’ status e because they brought large amounts of assets to eager recipients Investors could not hope to receive the equivalent treatment on their own 1.2 INSTITUTIONAL VERSUS PRIVATE INVESTOR FoHFs The surge in institutional investments after the 2000e2002 market crash led to a sharp polarization of the FoHFs industry Some firms such as Grosvenor, After the Crisis: Downturn in FoHFs Business CHAPTER Blackstone, Blackrock, Lyxor, Mesirow, and Pacific Alternative Asset Management concentrated on serving the nascent institutional market Others such as Permal and GAM, as well as banks such as Credit Suisse and JP Morgan, specialized in satisfying private investor demand The institutional and private investor segments of the FoHFs industry operate quite differently Institutionally oriented FoHFs tend to have lower fees due to economies of scale and intense competition for the large pools of money typically available Furthermore, because US institutions traditionally made larger allocations to hedge funds than their counterparts in Europe and elsewhere, the institutional FoHFs business became very US-centric In contrast, FoHFs focusing on the private investor market segment needed large distribution networks, which required higher fees to compensate sales staff In addition, because US private investors are subject to substantial taxes on FoHFs returns, they tended to limit hedge fund allocations in preference to tax-advantaged assets.1 This was not the case for investors with money stashed in the European tax havens As a result, FoHFs based in Europe came to control a disproportionately large share of private investor assets The US institution-dominated FoHFs segment evolved into a fairly sophisticated and professional enterprise However, less regulation in Europe gradually led to an erosion of standards in private investor FoHFs Naăve high-net-worth individuals in European tax havens were a particularly inviting target since they were largely captive, not well-informed, and could not loudly protest mismanagement in public Fees escalated as some private banks even began to apply sales charges to initial FoHFs investments Some FoHFs managers became overly aggressive and began to charge costs to the fund that should have been absorbed in management fees A few FoHFs began to employ leverage to amplify performance (and help offset high fees) while others took to investing directly in other assets such as stocks using investor funds supposedly earmarked for hedge funds Perhaps most egregious was the emergence of fund-of-fund-of-funds (i.e., fund managers created portfolios of FoHFs while extracting yet another layer of fees) For sure, such shenanigans were atypical in the private investor segment e adverse publicity could potentially damage reputations and ultimately harm business Nonetheless, there was a dark tint around the edges of the European FoHFs business The problem was compounded by woefully inadequate transparency For example, many FoHFs did not disclose the names of the hedge funds held in the portfolio, much less the rationale behind manager engagements or terminations In many cases, investors received no more than a monthly statement accompanied by a one-page A common rule-of-thumb is that approximately 80% of FoHFs returns are short-term capital gains, which are taxed at ordinary income rates that approach 50% in high-tax states SECTION Due Diligence and Risk Management newsletter that contained little except vague jargon describing why industry returns were up or down Imagine investing in a hedge fund portfolio and knowing virtually nothing about how your money was invested, but this was commonplace If that is not enough, FoHFs marketing was often less than candid Sales personnel often touted hedge fund exposure via FoHFs as offering good returns, low volatility, no or little downside risk, and zero correlation with stocks Left unsaid was the fact that hedge funds could deliver substantially negative returns or even ‘blowup’ and that correlation with equity markets had reached uncomfortably high levels 1.3 THE BUBBLE BURSTS As everyone is aware, the collapse of Lehman in 2008 precipitated a sharp drop in financial asset prices that proved the most extreme since the Great Depression Hedge funds were caught up in the maelstrom and the majority experienced unprecedented drawdowns with even some icons such as Citadel and Farallon faltering FoHFs passed through the sharp losses on their underlying hedge fund portfolios directly to investors The reactions to large FoHFs losses by institutions and private investors were quite different For example, Williamson (2010, p 1) reported that the assets of the top 25 FoHFs declined 37% from mid 2008 to the end of 2009 while FoHFs managers with a majority of assets owned by institutions experienced a decline of only 23% In this regard, ‘institutions were a life raft for FoHFs managers’ except for a few firms ‘like Union Bancaire Privee and Man Group, which had exposure to the Madoff Ponzi scheme.’ For institutions, there was no rush to redeem In stark contrast, private investors were shocked by the sharp losses sustained by FoHFs e losses that many had been led to believe could never occur Panic ensued and private investors began to redeem in droves As the rush to exit intensified, FoHFs managers were ensnared in a situation where numerous hedge funds in their portfolios had suspended redemptions and their capital was locked up indefinitely This in turn made it impossible for FoHFs to honor redemption requests from their investors Of course, most FoHFs did their best to meet redemption demand by exiting from hedge funds that were not locked up However, this approach left FoHFs holding the worst-wounded managers, and their portfolios soon became topheavy with near dead and dying hedge funds burdened with illiquid assets where no one knew how long the work-out process would take Furthermore, in cases where exit was possible, FoHFs often had to pay pejorative early redemption charges, thus reducing liquidation proceeds and exacerbating losses The only option available for most FoHFs managers was to exit when they could and wait for struggling hedge funds in their portfolios to begin to return capital After the Crisis: Downturn in FoHFs Business CHAPTER 25% FIGURE 1.2 Composite hedge fund industry return versus FoHFs Year-over-year returns 20% 15% 10% 5% 0% -5% -10% Composite FOFs Averages of reported returns from HFR,HFN and BarclayHedge through first quarter 2012 -15% -20% -25% 2004 2005 2006 2007 2008 2009 2010 2011 2012 As a result, FoHFs performance dipped substantially below that of the hedge fund industry during the redemption hiatus in 2009.2 For example, FoHFs losses were more or less in line with the hedge fund industry in 2008 e a negative 21.4% for FoHFs versus losses of 19.0% for the hedge fund industry according to Hedge Fund Research (HFR) However, in 2009 e a strong performance rebound year e HFR reports that hedge funds gained 20.0% while FoHFs returned only 11.5% The 8.5% underperformance gap was unprecedented Hedge Fund Net (HFN) and BarclayHedge report even larger differentials of 9.9% and 13.5%, respectively (Figure 1.2) By 2010 most hedge funds were again making redemptions and FoHFs were gradually able to unwind frozen positions and rebalance their portfolios Nonetheless, an unusually wide underperformance gap persisted with the hedge fund industry returning 10.6% in 2010 while FoHFs delivered only 5.2% based on an average of returns reported by HFR, HFN, and BarclayHedge.3 1.4 THE AFTERMATH OF CRISIS The mass exodus by private investors caused the share of hedge fund industry assets held by FoHFs to decline during and after the crisis BarclayHedge data show that FoHFs assets peaked at 51% of hedge fund industry assets in 2007, but fell to 26% by the end of 2011 HFR data show a lower peak e at 45% of assets in 2006 e and a milder decline to 34% of assets at the end of 2010 Regardless of the exact amount, it is clear that the FoHFs industry shrank drastically more than the broad hedge fund industry While many FoHFs permit quarterly redemption with 45 days’ notice, others require longer Most investors did not become aware of the carnage in FoHFs performance until after the September stock market collapse This meant that the peak in redemption demand did not come until the end of the year and in the first quarter of 2009 HFR, HFN, and BarclayHedge data are used because these sources report performance for both hedge fund industry composite and FoHFs, have the longest track records, and also make their data publicly available via website SECTION Due Diligence and Risk Management What accounts for the extreme shrinkage of the FoHFs industry? First, as already discussed, much of the decline in FoHFs assets was clearly due to the departure of private investors who were not prepared by their brokers and bankers for the significant losses experienced in 2008 These investors learned the truth the hard way and voted with their feet Most will likely never return to FoHFs investing Second, while institutions were not in the vanguard of FoHFs investment liquidations, they nonetheless suffered from the significant underperformance of FoHFs versus the hedge fund industry To avoid a repeat of this in the future, institutions that invested in FoHFs in anticipation of eventually managing their own hedge fund portfolios were no doubt spurred to expedite the process For example, Williamson (2011) reports numerous examples of institutions shifting from FoHFs to direct hedge fund investing In addition, Jacobius (2012) shows that for the top 200 defined benefit plans, FoHFs investment fell sharply from nearly 50% of institutional hedge fund holdings in 2006 to approximately 25% in 2011 (Figure 1.3) An added motivation for direct investing in hedge funds by institutions in lieu of using FoHFs was that doing it yourself became significantly easier after the financial crisis Hedge funds made a concerted effort to improve transparency and communication e important institutional requirements e in a conscious effort to acquire stickier pension fund money to rebuild their asset base Moreover, the available talent pool of professionals knowledgeable about direct hedge fund investing swelled after many FoHFs reduced staff This allowed institutions to recruit their own in-house experts or hire consultants at more reasonable fees Why settle for potential FoHFs illiquidity and underperformance when you can eliminate the intermediary through direct investment? Paradoxically, it now appears that the FoHFs underperformance gap was largely a temporary phenomenon arising from the severe conditions experienced during the crisis Indeed, HFR reports that the hedge fund industry lost 5.3% in 2011 while FoHFs posted a negative 5.5% e the wide underperformance differential of 2009 and 2010 had shriveled to almost nothing 120 Via FOFs 100 Direct investment 80 Billion 60 40 20 Source: Pension & Investments 2006 FIGURE 1.3 Top 200 pension FoHFs assets 2007 2008 2009 2010 2011 After the Crisis: Downturn in FoHFs Business CHAPTER 100% FIGURE 1.4 Estimates of FoHFs hedge fund exposure 90% 80% Hedge fund investments 70% Cash and other 60% 50% 40% 30% 20% 10% 0% 2006 2007 2008 2009 2010 2011 2012 1.5 THE EXCESS CASH PROBLEM While the redemption mismatch between FoHFs and hedge funds initially played a role in causing the underperformance gap, FoHFs were also at fault in 2009 and 2010 by allowing cash holdings to accumulate to inordinately high levels Ostensibly, the rationale behind cash accumulation was to meet future redemption obligations and to provide a safety net to protect against ongoing duress in the global financial system This miscalculation proved costly My estimates indicate that FoHFs investments in hedge funds may have fallen to almost half of total assets at the nadir in December 2009 Cash holdings, the monetization of early redemption fees, and other factors account for the remaining exposure based on a sample of 42 prominent FoHFs (Figure 1.4).4 These high cash holdings and the payment of early redemption fees clearly represented a drag on performance at the time and were major contributors to the performance gap Now, with the investment environment stabilized and redemption stress ended, FoHFs have redeployed liquidity into hedge funds and reverted to more normal cash levels 1.6 COULD FoHFs PROBLEMS HAVE BEEN PREVENTED? To some analysts, it is not surprising that hedge fund and FoHFs performance deteriorated significantly in 2008 The reason is that the hedge fund world changed dramatically during its evolution from the small cottage industry of the The estimates of FoHFs hedge fund exposure are derived using an algorithm that produces the best fit between average reported returns for 42 FoHFs presuming that each held an underlying portfolio that delivered the average of HFR, HFN, and Barclay composite hedge fund returns The algorithm used is: rtFOF ẳ wt dt f l ịrtHF ỵ wt ịrtC f F ỵ t , where rtFOF is the average 42-FoHFs return, rtHF is the hedge fund composite return, rtC is the cash return (3-month Treasuries), wt is the portion of FoHFs assets invested in hedge funds, f I is the incentive fee, f F is the fixed FoHFs fee, and εt is measurement error The binary performance fee variable dt equals zero if the underlying hedge fund portfolio’s return is negative and unity if the underlying hedge fund return is positive year-to-date The relationship is estimated via restricted least squares subject to wt