Fund of Hedge Fund Dis-intermediation – Evidence from Japan

By Simon Kerr

Following up on the  prospects for funds of hedge funds, which I have covered earlier in the month, I neglected to mention dis-intermediation by investing institutions. This is a natural phase of development for institutional investors of scale.

First the institutions use small allocations as a percentage of assets and tap into third party expertise to implement the strategic allocation. This first toe-dipping willl typically utilise a fund of hedge funds, or for the  larger institutions, several funds of funds to keep them all honest. A minority of new investors in hedge funds will use a third party advisor, like Albourne Partners, and allocate directly to single managers, or these days look to use replication, like USS of the UK.

The investing institution then gets used to working with hedge funds, gains experience and understanding, and they often move onto increased strategic allocations and change to a new mode of implementation. This may involve making strategic bets on particular hedge fund investment strategies, say emerging managers, credit hedge funds, or directional managers. Moving from diversified mandates to using more specialised mandates (in addition) might also be implemented via specialist funds of hedge funds, but is as likley to involve active selection of single managers. 

So it is natural for investing institutions of scale, with sufficient in-house expertise, to progress to selecting hedge funds individually. There is an extra incentive to do this, a negative motivation, when the foundation exposure to hedge funds (via funds of funds) is seen as disappointing. To a significant degree this has been the case for the last two years, to the downside and then the upside, by turns. There are good reasons for the significant under-performance of funds of hedge funds, particularly in 2009, but it can have commmercial impacts through changes in underlying investor attitudes. A recent example was the change in approach of the South Carolina Retirement System. Formerly the allocation to hedge fund strategies was 70% in funds of funds and 30% directly in single manager funds: that split is to be reversed in future.  This trend to dis-intermediation is also being reflected in Japan.

Japanese life comapnies have amongst the longest experience of exposure to hedge funds amongst investing institutions. In the middle of the last decade Japanese pension funds allocated to hedge funds too. The core of the exposure has always been by fund of hedge funds. The status of funds of hedge funds as the core means of obtaining exposure is under threat. For the last five years Daiwa Institute of Research has surveyed Japanese pension funds regularly on their hedge fund investment intentions. Historically the most common intended allocations to hedge funds were to funds of hedge funds in the surveys. In the lastest survey, and for the first time, the most common intended allocations were to a hedge fund strategy other than fund of funds, in fact more pension funds of Japan intend to allocate to managed futures funds than funds of funds.

There is some anecdotal evidence that Japanese investing institutions intend to allocate more directly to single manager hedge funds, but the key point is that the share of capital in the hedge fund industry that has been routed via fund of funds will only continue to decline. Funds of funds willl increasingly be dis-intermediated at the industry level, though individual firms may grow through taking market share.