Comment: Funds of hedge funds defy predictions of extinction

_*Funds of hedge funds were widely predicted to become one of the
principal casualties of last year's annus horribilis for the hedge
fund industry. While most hedge fund indices reported average declines
in 2008 of up to 20 per cent, fund of funds benchmarks did even of
poorer quality.*_

That double layer of fees, it turned out, did not buy sufficient
diversification to shield investors from hedge fund managers'
miserable performance; investors found themselves deprived of
liquidity because fund of fund managers' were unable to redeem
underlying investments; funds of funds that had leveraged up to boost
returns found it was losses that had been turbo-charged; and to cap it
all some managers had placed significant slugs of their investors'
money with Bernard Madoff.

The demise of funds of hedge funds has been forecast for years,
prompted by the lower fees and supposedly superior performance of
multistrategy funds as an alternative as well as the increasing
sophistication of institutional investors who, it was predicted, would
shift their capital from funds of funds to single-manager vehicles as
they became more comfortable and knowledgeable about alternative
investments. Surely last year's slump would deliver the coup de

It remains ahead of schedule days, but it seems that the death of
funds of hedge funds may have been greatly exaggerated. Many funds of
funds ran into distress last year, of course, but anecdotal evidence
suggests that investors are often keen to go along with restructuring
proposals rather than settle for grabbing what they can from the
wreckage. Last year's outflows of capital have slowed to a trickle,
and there are even reports of the odd new fund of funds being

Why should this be? A lot of the lustre came off multistrategy funds
last year. By some reckonings they underperformed both funds of hedge
funds and single-manager funds; certainly there was modest evidence of
consistent ability to reallocate capital successfully in response to
market conditions. At the same time, the events of 2008 did modest to
reassure smaller institutions in particular about their ability to
make their own choices of strategy and manager.

So there still seems to be a place for funds that offer somewhat
diversified exposure to the hedge fund universe, although investors
will be demanding superior evidence of due diligence on underlying
managers and may well require fund of funds managers to get by on a
lower level of fees.

Place together, these trends point to consolidation in the sector, as
only managers with a substantial asset base will have the resources to
research and investigate underlying funds with the thoroughness that
will be required. Many members of Switzerland's substantial fund of
funds industry, much of which consists of vehicles with less than
USD100m in assets under management, will need to seek merger partners
to survive, according to Peter Meier, head of the centre for
alternative investments and risk management at the Zurich University
of Applied Science.

Swiss fund of funds do face problems that are not universal in the
industry; some of them have extremely low smallest investment
thresholds, which bring them within the ambit of more onerous and
constrictive retail investment regulation. Fund of funds managers as a
whole are facing up to significant changes to their business models as
they seek to regain investors' trust and also to start earning the
level of fees required for their firms to thrive. Still, it's better
than the alternative.