Funds-of-funds falling out of favour?

Recent Towers Watson research, which reviewed the total assets managed by the top 100 alternative investment managers globally, found that funds-of-funds account for 10% of the combined $3.1tn managed by these firms, overseeing $315bn in investment vehicles. By way of comparison, real estate managers control the largest share of assets with 34% – more than $1tn – followed by private equity houses with 23% ($717bn), and hedge funds with 20% ($612bn).

However, when ranked by amounts invested by pension funds, funds-of-funds are only surpassed by real estate managers with the largest share of pension fund assets of 39%, while funds-of-funds make up 20% (followed by private equity at 14%). These figures make it clear that pension funds prefer funds-of-funds over investing directly in private equity vehicles.

Despite the inclination for funds-of-funds, Craig Baker, global head of investment research at Towers Watson, says: "We expect a continuing shift towards investing via individual managers rather than funds-of-funds – particularly in hedge funds and private equity – as these managers improve their structures and are seen as a more efficient implementation route than fund-of-funds vehicles."

Eric Warner, executive director of Altius Associates (pictured), points out that the research only looks at the top 100 managers, therefore providing a very limited view of the alternative investment world. Unlike Baker, Warner believes there is a strong case for not only the survival of, but the prosperity of funds-of-funds. "They are designed for investors who do not have the resources to select appropriately or shrewdly," he explains.

The future of funds-of-funds is reliant on three key factors: first, whether or not they offer value for money; second, the development of institutional investors; and third, most importantly, returns.

When determining value for money, the extra layer of fees incurred by investing through funds-of-funds can only be justified if it is more cost effective than hiring an in-house team to select private equity investments.

In response to Baker's prediction that pension funds will move towards investing directly into private equity, Warner believes this is dependent on the pension fund's size and experience with the asset class. "Historically, when institutional investors get started in alternative assets they have limited knowledge, which is why large pension funds initially invest through funds-of-funds. These funds act as training, allowing LPs to get to know how the industry works and become familiar with some of the private equity houses," says Warner.

Going it alone
While funds-of-funds can provide an introduction to the asset class, Warner partially agrees with Baker in the sense that large pension funds will likely turn to investing directly. When large pension funds are comfortable with private equity and the types of investments made through funds-of-funds (typically to more obvious large-cap houses such as Blackstone and KKR), they are likely to make these investments themselves. "Setting up internal investment teams is an expensive and time-consuming effort, and is really only an option at the larger end of pension funds," says Warner. "There is a plethora of other institutional funds without the resources to build up internal alternative investment teams."

Warner believes funds-of-funds are provided a level of protection through their longstanding relationships with LPs. "If an LP is happy with performance and wants to stay in funds-of-funds then they are most likely to stay with the same one. That's not to say there won't be any turnover but there will be a core investor base of around 60-70% that will remain solid investors. Of course, this is only as long as returns are above public market equivalents."

Outside of large pension funds developing their own investment teams, funds-of-funds with a limited focus are in danger. Those focusing exclusively on one geography or investment size are likely to lose favour with pension funds. "LPs want funds-of-funds to provide more exposure and greater diversification through different geographies and strategies. Funds-of-funds with a narrow focus are increasingly at risk of not raising new capital," believes Warner.

A recent trend for larger funds-of-funds has been to diversify their offering and move into consulting – advising investment teams within pension funds on where and how to invest in the asset class. Smaller funds-of-funds have a longer history of offering this sort of service to large clients, and Warner believes it will be tough for those launching consultancy services now to break into that market.

It is impossible to deny the threat to funds-of-funds, especially as limited partners' needs change and the hunt for healthy returns becomes ever more challenging. There has undoubtedly been a realisation among large pension funds that making their own selections, or even in some cases, investing directly (such as Canadian pension fund Omers Private Equity) can produce better returns and removes an extra layer of fees.

But, as new types of institutional investors seek exposure to the asset class, such as family offices and private wealth managers, funds-of-funds will provide a necessary function. Therefore, funds-of-funds that also offer consulting services, which provide a significant level of diversification through their investment selections, with good relationships on both the LP and GP side and that typically cater to smaller institutions, have a reason to exist and will likely prosper. However, those that have historically worked with large pension funds could well be at risk. "Going forward, yes, we are likely to see a concentration in providers, but not a complete removal," says Warner.

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