The case for hedge funds of funds – it’s all in the research

In a world where funds managers of all descriptions are under increasing pressure to demonstrate added value, the role of hedge funds-of-funds (FoFs) is being continually scrutinised.

In Australia, big super funds have shown a recent tendency to favour single-manager multi-strategy funds over the FoFs, and the view has emerged that, in future, the FoFs will tend to be the domain of smaller institutional investors, first-time users of alternatives and the retail market. However one of the most successful hedge FoFs in the Australian marketplace, Mesirow Financial, has put a compelling case for the well-resourced hedge FoFs. Mesirow has raised about $2.5 billion from Australian institutional investors since it entered a distribution arrangement with Warakirri Asset Management in 2000. It launched its first Australian-domiciled fund the following year. It also has some Australian investors in a separate private equity group offering. Mesirow has 35 investment professionals who research between 500 and 1,000 hedge funds a year. They will select and invest in between 15-20 and terminate between 10-15. The firm currently has 80 managers in its portfolios. Unlike most US-based hedge FoF managers, slightly more than half the firm’s $US15.5 billion in assets have come from offshore. And one-third of the funds have gone into customised accounts, rather than the usual co-mingled vehicles. Marty Kaplan, Mesirow’s chief executive, said last week on a visit to Australia that the biggest difference between the firm’s US and Australian clients is the extent to which the Australian funds have reduced their fixed interest exposures – “literally to zero, you don’t see that in the US”. He said that Australian funds’ investment strategies were probably more similar to those of the US endowments than pension funds. They were pioneers in some asset classes, such as infrastructure, and probably generally more aggressive. Mesirow does not view hedge funds as an asset class. “They are a grouping of strategies designed to accomplish certain objectives,” Kaplan said. The role of a FoF was to “scour the world to find the best available talent” and then to construct a portfolio according the client needs – at least for the larger clients. “It’s a lot of work,” Kaplan said. “We do quantitative and qualitative analysis and backoffice and operational reviews.” He said: “This requires a huge amount of talent and staff. Just in understanding the backoffice (of a manager) we have four people looking at that. We have never had a manager who has committed fraud. We spend millions on quantitative tools to make custom benchmarks for each manager … We dissect all managers’ portfolios to identify true skill.” Mesirow looks at the long part of portfolios separately from the shorts. “It’s very rare in the total universe that managers can add value on both sides,” Kaplan said. Mesirow does not invest in highly leverage funds, nor any fixed interest arbitrage managers. It does not believe it has any comparative advantage in evaluating global macro managers, and so leaves them alone too. Similarly, it does not research commodity trading advisers. Nor does it see the burgeoning style of ‘activist’ managers as a “strategy”. “It’s a tool that managers can use to enhance returns,” Kaplan said.