By Martin de Sa'Pinto and Tommy Wilkes
ZURICH/LONDON (Reuters) - For funds which market themselves on their ability to spot the sharpest hedge fund minds, it could be their greatest challenge yet. Investors who once trusted them to find the best returns are gaining the expertise and confidence to do it themselves.
U.S. pension funds like the giant $240 billion California Public Employees Retirement System (CalPERS) have picked single hedge fund managers for years. Now smaller players are following suit.
Massachusetts' $48 billion state pension fund for instance recently completed a $500 million direct investing program, moving to cut its reliance on funds of funds.
Meanwhile, in Europe, pension funds for companies such as ABB
"Even some medium-sized pension funds are investing (in hedge funds) directly, while others have cut hedge fund investing entirely," he said, noting many investors had not returned after access to assets was restricted or blocked during the credit crisis.
The issue is significant because funds of funds, allowing investors to spread their risk, have hitherto helped channel billions of pounds in the direction of hedge fund managers.
And if the pool of fund of hedge funds shrinks, many smaller pension funds and less sophisticated investors could find it more difficult to access the returns generated by the $2 trillion hedge fund industry.
Also, a large block of sell orders from pensions invested in the same managers could force those managers to suspend withdrawals - a widespread occurrence during the 2008-2009 financial crisis.
"There is a great deal of pension fund investment overlap which may create issues if a consultant takes a manager off their buy list," said Max Gottschalk, co-founder of $8 billion fund of hedge funds Gottex.
Fund of funds charge their investors fees for selecting and then investing in hedge fund managers, and have proved popular with clients making their first move into these so-called alternative investments.
But the sector has also faced criticism for high fees and is yet to recover from redemptions during the financial crisis.
Returns have also been questioned. The average fund of funds is up 3.11 percent this year, less than the 4.38 percent gain for the average single manager, Hedge Fund Research shows.
With the trend towards direct pension fund investing gathering pace, smaller fund of funds houses even face the possibility they will not have enough assets to carry on, forcing them to shut down or merge with bigger rivals.
One large London-based manager, speaking on condition of anonymity, said its assets under management had stayed stable this year only by pulling clients away from smaller houses.
Fund of funds typically charge their investors an annual 1 percent management fee and 10 percent of performance over a certain benchmark - often the return on cash - on top of the fees underlying hedge fund managers charge.
By contrast, pension funds can pay less than the standard 2 percent management and 20 percent performance fee by negotiating directly with managers eager to pull in their cash.
But direct investing isn't free, as pension funds need to build in-house teams to assess manager records and run due diligence. Many also use fee-charging consultants to advise them on their investment choices.
Tushar Patel, managing director of fund of funds Hedge Fund Investment Management, believes cost-conscious pension funds underestimate the difficulty of shaking up a poorly performing internal team rather than switching fund of fund providers.
"People don't realize that if you have your own internal team it's going to cost you at least $2 million, and if they don't perform you can't sack them in the same way you can pull your money from underperforming funds," Patel told Reuters.
The issue of hedge fund selection has come to the fore because pensions are increasingly turning to alternative assets as a way to help them fund huge liabilities in future years - a task made increasingly difficult by rock-bottom interest rates and volatile equities.
But in choosing hedge funds, U.S. and European pension managers have tended to buy into a select group of established names such as Brevan Howard and Winton Capital, which have performed well in wider market slumps like last year's.
Massachusetts state for example will invest directly in big-name single managers such as Pershing Square Capital Management, Och-Ziff Capital Management
While overall hedge fund industry assets have clawed their way back to more than $2 trillion since the financial crisis, funds of funds have struggled to lure back lost clients and current assets of $650 billion trail the 2008 peak of $800 billion.
Some have tried to boost their business by acquiring smaller rivals. Earlier this week Man Group
Others are expanding into Asia, where institutions in the region eyeing their first investment in alternatives are keen to begin by using fund of funds providers.
Last week Gottex said it was buying Hong Kong-based Penjing Asset Management, a year after co-founder Gottschalk moved to Asia to accelerate the firm's expansion there.
Funds of hedge funds have been pronounced dead as often as South Park's Kenny, taking their most recent hits from the Madoff scandal, the financial crisis and the challenge from tightly regulated and more transparent and liquid UCITS funds.
To be sure, the vast majority of funds of hedge funds avoided Madoff, and a few managed to stay more liquid through the financial crisis than single hedge funds, winning kudos even as panicked clients swept in to redeem their money.
But as sovereign risks continue to rage in Europe, asset classes are becoming increasingly correlated, zeroing out the benefit of diversification, said Aureliano Gentilini, managing partner at Rome-based hedge funds consultancy Matema Srl.
"Because of that, it is imperative for funds of hedge funds to go back to basics; reverting to unbiased allocation models featuring true uncorrelated return patterns," Gentilini said.
To win back business, say market participants and experts, fund of funds need to demonstrate they can offer something distinct to what pension funds can increasingly do on their own.
Many believe this lies in spotting smaller, nimbler managers which pension funds do not have the time or expertise to assess - a sector which has often outperformed the bigger, better-known hedge funds facing capacity constraints.
"Funds of funds still give large institutions access to niche strategies, smaller managers, emerging managers or regional products where they just don't have the resources or expertise to do research," said Gottex's Gottschalk.
(Additional reporting by Svea Herbst-Bayliss in Boston and Nishant Kumar in Hong Kong; Editing by David Holmes)