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Large funds of funds are in a strong position in the current environment

Tuesday, November 26, 2013
Opalesque Industry Update - Since the financial crisis, funds of funds as an industry have been pressured by a series of challenges: Pensions bypassing funds of funds and directly investing in hedge funds, deteriorating margins while manufacturing costs increase, lackluster performance, competition from hedge fund beta strategies, encroachment from consultants, and general branding issues from continued negative press.

Some large funds of funds have been innovative as they adapt to the changing environment. A growing number are offering a suite of products characterized by customization and consulting. Some are focusing on areas that can't be easily disintermediated by low-cost consultants such as an expertise in managed accounts, emerging managers, private credit or private equity. A large number of funds of funds have launched retail liquid alt products. Some are taking a hybrid approach to asset allocation as asset category barriers break down.

As one looks ahead for the funds of funds industry, some predictions are:

The importance of scale; 20-30 mega funds of funds

Lois Peltz, president of Infovest21 and author of the just-released special research report, said: "Size and distribution challenges have led to the rise of large multi-product firms. Select funds of funds will grow stronger as they are a brand. Perhaps, the end result will be 20 to 30 mega-funds of funds.”

Large funds of funds, given their scale and expertise and ability to provide a suite of products, are in a strong position in the current environment. Firms that have product flexibility will be able to manage their growth to compensate for fee compression going forward.

Execution is important in a slower growth environment. Firms that will survive and thrive over the next five years are those that can execute well i.e. align interests of key clients, recruit the best people, innovate product etc.

Enormous growth potential for '40 Act fund

Retailization presents an opportunity for a firm to build enterprise value. The fund of funds business will be more valuable with different distribution channels in place.

The acquisition of large funds of funds by mutual fund companies is a harbinger of this theme.

Despite some of the unknown challenges, many of the hedge fund managers and funds of funds involved in '40 Act funds feel the game is just beginning: Only about 1.1% of all mutual fund assets i.e. $108 billion are currently in alternative '40 Act funds, according to Morningstar.

One manager predicts that ten years from now, there won't be clear dividing lines between hedge funds and mutual funds. Money management firms will offer both. Another suggests that in ten years, alternative mutual funds could account for one-third to one-fourth of mutual fund assets. "We will see more categories in alternative mutual funds - there will be more choices because this is where traditional asset management business is focusing.”

Hybrid approach to asset allocation /Barriers breaking down

Existing barriers are starting to break down. The world isn't as simple as hedge funds are long/short and mutual funds are long-only vehicles. Gray area exists. Increasingly going forward, investors will want funds of funds to advise them on getting exposures to the strategies they want. The question of vehicle is of secondary consideration. Funds of funds should look at strategies and exposure more holistically.

The ultimate goal for many alt firms developing a '40 Act presence is to make inroads into the defined contribution plan sector. This will require time, a track record and a concerted effort but many think this objective is worth the effort.

Up until now, most of the defined contribution assets have been invested in long-only equity. At the start of one's career, the ratio is usually 75% equities to 25% fixed income. As the individual gets older, the percentages reverse so that by the time of retirement, 100% of the portfolio is in fixed income.

But the issue for target date funds and glide funds is what happens as the 31-year bull market in fixed income ends and interest rates move up? The managers of those funds have a conundrum on their hands. This provides an opportunity for hedge funds, low volatility funds, and multi-strategy managers. Daily liquidity characteristic fits well with these funds.

Funds of funds make gains in turf war with consultants

The consultants' business model is difficult to maintain because of low margins which is why some consultants are moving into asset management.

The name of the game, longer term, for pensions is what resources they are getting access to versus what they are paying for. They'll compare the number of investment staff at the consultant organization with that at large funds of funds. Many large funds of funds will thrive due to the resources they have at their disposal.

Fees

Fees will continue to come down but it is unlikely that there will be a total elimination of the incentive fee. The supply of product is increasing while demand is stagnant. Firms that can put resources in those areas where there is the greatest demand will probably gain the most market share.

Excert from Infovest21 Special Research Report: Evolving Funds of Funds - An Industry in Change

Infovest21, founded in 2000, is an information provider to hedge fund investors, managers, funds of funds and service providers. Led by Lois Peltz, president, the firm provides news, research, surveys, white papers as well as organizes seminars and conferences.

infovest21.com

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