About a decade ago, pension plans and other institutional investors that wanted access to the rarified world of hedge or private equity funds often took an indirect route. Rather than picking funds themselves, they turned to funds of funds, which offer one-stop shopping when it comes to professional due diligence and portfolio management, as well as broad diversification across asset classes, investment styles, managers and more.
In recent years, though, the fund-of-funds model has begun to fall out of favor with institutional investors. That’s partly because many institutions now have the heft and expertise to build their own portfolios of funds, often with the help of consultants and in-house investment teams.
As interest in funds of funds has declined among institutions, the vehicles have found a larger audience among high-net-worth individuals and family offices. Interestingly, the primary investors in the earliest funds of funds were affluent individuals, according to Keith Black, managing director of content strategy at the Chartered Alternative Investment Analyst Association. Over time, however, institutional investors began to crowd out retail investors. Now, that trend is starting to reverse itself — or, as Black puts it, “what’s old is new again.”
UNDER THE HOOD
A fund of funds doesn’t directly own stocks, bonds, real estate or other such assets. Instead, its holdings are the securities of other funds, whether hedge funds, private equity funds, infrastructure funds, real estate funds or private debt funds. Funds of funds investing in alternatives are offered only to accredited investors, or those with a net worth of at least $1 million (excluding a home’s value) or an annual income of $200,000 or more. The restriction is intended to prevent less-sophisticated investors from investing in hedge funds or private equity funds indirectly through funds of funds.
Funds of funds appeal to retail investors for many of the same reasons they first won over institutions. They offer a relatively easy way for newcomers to the esoteric world of hedge funds or private equity funds to diversify across multiple vehicles, rather than hitching their star to any one fund. They also help investors manage risk by delegating the task of deciding where to place bets — in other words, picking the building blocks of a portfolio of funds — to investment managers with expertise in their respective fields. Hedge funds are notoriously secretive when it comes to their holdings and investment strategies, which is why it helps to rely on professionals to evaluate them.
Funds of funds are often managed by “marquee, institutional-quality asset managers,” such as Blackstone, KKR & Co., The Carlyle Group, Fortress Investment Group, Apollo Global Management, Oaktree Capital and Brookfield Asset Management, says Martin Dozier, a lawyer in Alston & Bird’s financial services and products group. “Due diligence can seem daunting for new entrants to the private equity and hedge fund markets because it requires a lot of specific skills and expertise,” explains Thea Diaz, a vice president at Preqin, who heads the firm’s fund-of-funds research team.
DEMAND FOR ALTERNATIVES
Not surprisingly, the growing interest in funds of funds coincides with a stronger appetite for alternatives among affluent investors. Global alternative assets under management topped $10 trillion during 2019 and are expected to exceed $14 trillion by 2023, according to Preqin.
“Advisers have realized that there’s more to a retail investor’s portfolio than publicly traded securities, traditional mutual funds, ETFs and bond funds,” says Dozier. “We’ve been in a secular, low-interest-rate environment for a long time. If you’re someone looking for steady fixed income, simply investing in a bond fund won’t necessarily generate the types of yields that you need in this environment.”
The demand for alternatives may be rising, but building a diversified portfolio of hedge funds or private equity funds is an expensive proposition, even for deep-pocketed investors. According to Black, the minimum investment for the median, single-manager hedge fund is $500,000, which means an investor wishing to build a portfolio of eight funds (across all four investment styles) would have to come with at least $4 million.
For many investors, funds of funds help address the issue of access. Consider, for instance, the minimum investment for a hedge fund of funds is typically $100,000, nothing to sneeze at but a bargain compared to going it alone. A hedge fund of funds may have holdings in as many as 20 underlying funds. Funds of funds may also give investors access to managers that are in high demand. Offerings by top-performing managers often fill up quickly with investors from previous funds run by the same manager, making it difficult for new investors to get a piece of the action.
“A fund of funds can add a lot of value if it has relationships with those managers who are hard to access,” explains Black. “When you invest in a private equity fund of funds, it may also be easier to reach your target allocation more quickly than attempting to build your own portfolio of funds.”
For all its advantages, the fund of funds has what many investors view as a major drawback — and that’s not necessarily its awkward name. Investors in a fund of funds can typically expect to pay a double layer of fees, including a management fee charged by the firm running the vehicle and a management fee for each underlying fund.
The overarching fee compensates the fund-of-funds manager for the expertise and effort involved in picking a wide array of suitable investments. Seems fair enough, but with a double layer of fees, the costs to investors can add up and ultimately weigh on returns. Hedge funds of funds may also levy fees on profits beyond a specific threshold.
“Hedge funds are exclusive clubs. So, with a hedge fund of funds, you get access and diversification. That sounds great, but these funds of funds generally don’t do well,” says Robert Jenkins, global head of research at Refinitiv Lipper. “As an industry, they’ve largely disappointed because of the layers of fees, not to mention the fact that hedge funds haven’t been stellar performers over the past decade.”
On the whole, hedge funds of funds, which have some $600 billion in assets under management, returned nearly 9 percent last year. But their three-year annualized return, through March 2020, was less than 1 percent, according to HFR’s Fund of Funds Composite Index.
Interestingly, one of the perceived advantages of the fund-of-funds model, broad diversification, can sometimes be a liability, says Diaz of Preqin.
“Investments aimed at broad diversification can sometimes have the tendency to underperform during times when one or two market sectors or asset classes are performing well,” she explains.
INVESTORS EYE NEW PATHS
Private equity funds of funds have generally performed well in recent years, but the gap between the best- and worst-performing of them has widened for recent vintages (2015-2017), according to Preqin.
Overall, the private equity fund-of-funds market saw assets under management grow by nearly 50 percent during the 10-year period ending in 2019, Preqin reports. But it did not keep pace with the growth of the broader private equity market, which saw assets under management swell by more than 150 percent over the same period.
Why are funds of funds coming to represent a smaller slice of the broader private equity market? Investors’ cost concerns are just part of the equation, explains Diaz.
“The challenging environment for private equity funds of funds has been partially driven by investors’ reconsideration of the costs and benefits of the fund-of-funds model and the increasing prominence of alternative methods of accessing private equity,” she says.
The private equity secondary market, for instance, has picked up in recent years. Through the secondary market, investors can purchase interests in private equity funds from existing investors in the funds. The transactions allow sellers to exit early, and potential buyers get shorter holding periods than initial investors, more performance data on which to base their investment decisions and, in theory, a quicker return on capital. The holding period for a private equity fund may be 10 years or more.
Consider the experience of Boston-based HarbourVest, which got its start as a private equity fund-of-funds manager but has expanded well beyond its roots. Through its secondary market platform, investors can buy pre-existing interests in private equity and real asset funds, sometimes at a discount to intrinsic value. HarbourVest also makes direct investments in companies alongside private equity firms and packages those co-investments into funds offered to high-net-worth individuals, family offices and institutions.
“All three businesses have had a lot of appeal in the high-net-worth market because they offer broadly diversified private equity,” says HarbourVest managing director Vinay Mendiratta.
How does he expect these platforms to fair now that post-financial crisis expansion has come to an end?
“I think there will be a greater interest in these strategies,” says Mendiratta. “There has been a feeling that a diversified portfolio of funds is less exciting than investing in one, two or three managers. The challenge with doing that is: if you pick the wrong ones, you can significantly impact your portfolio, whereas our diversified portfolios have 20-plus managers in them.”
Earlier this year, HarbourVest turned heads when it announced a partnership with Vanguard, a pioneer of low-cost index funds, to provide access to private equity to institutional investors advised by Vanguard. What’s perhaps most interesting about the partnership is that it may eventually open the door to private equity to some of Vanguard’s retail clients.
“While this strategy will be initially available to institutional advised clients, we aim to expand access to investors in additional channels over time,” says Vanguard CEO Mortimer “Tim” Buckley, in a press release issued by HarbourVest. “For individual investors in particular, this partnership will present an incredible opportunity — access and terms they could not get on their own.”
THE ROAD AHEAD
Even as some investors eschew funds of funds, the Securities and Exchange Commission appears to be evaluating whether such vehicles might be appropriate for a wider audience. In a recent request for public comment, the SEC said it was seeking input on whether the limitations on who can invest in “certain exempt offerings” provide an appropriate level of investor protection or pose “an undue obstacle” to access to investment opportunities.
“There’s a real possibility that sophisticated, institutional-quality investment management strategies will no longer be accessible just by high-net-worth investors,” says Dozier of Alston & Bird.
What about the fees that have turned off some investors? Dozier believes fees in the fund-of-funds space will eventually fall, as they have in other corners of the investment management industry.
“It’s part of the overall fee-compression story, in both asset management and investment distribution, that we’ve seen before,” he says.
Anna Robaton is a freelance business journalist based in Portland, Ore.