Funds of hedge funds have traditionally formed an important part of institutional investors’ hedge fund portfolios. Data from Preqin’s Hedge Fund Investor Profiles online service shows that of the Asia-Pacific hedge fund investors currently tracked, more than half (53%) invest in funds of hedge funds, with just 15% investing in hedge funds solely through multi-manager funds. Globally, 62% of active institutional hedge fund investors gain exposure to the asset class through funds of hedge funds, with 30% of them investing exclusively through these vehicles.
While funds of hedge funds will continue to be relevant to institutional investors, data from the Fund Searches and Mandates feature on Hedge Fund Investor Profiles suggests that Asia-Pacific -based investors would prefer allocations to direct hedge fund investments going forward. Of the institutional investors based in the Asia-Pacific region that have issued fund mandate searches, 32% have open mandates for funds of hedge funds. However, only 14% of the Asia-Pacific-based investors with open mandates will invest in the asset class solely through fund of funds structures. One investor looking for new hedge fund investments is Hong Kong Jockey Club; the foundation has recently started direct investments in hedge funds, sidestepping funds of hedge funds as middlemen by carrying out due diligence through its own investment team.
The changing structural preference among investors is not specific to the Asia-Pacific region. Globally, a quarter (26%) of institutional investors that have initiated fund searches are looking to invest through funds of hedge funds in addition to single manager funds, with only 12% favouring investments solely through multi-manager vehicles. Preqin data suggests a continuing trend as institutional investors are gradually shifting away from funds of hedge funds and increasingly view these structures as a complement to direct hedge fund investments.
One obvious reason for this change is the poor performance of funds of hedge funds in relation to single-manager hedge funds. According to data from Preqin’s Hedge Fund Analyst, performance of funds of hedge funds as a whole (net of fees) has consistently lagged behind single-manager hedge funds with annualized three-year returns of 3.16% compared to 6.38% (as of 31 May 2014). This relative poor performance, however, has not been adequately compensated for by lower volatility, with the three-year Sharpe ratio (measured with a 2% risk-free rate) standing at 0.32 for funds of hedge funds and 0.84 for hedge funds. This indicates that multi-manager hedge funds have produced lower risk-adjusted returns than their single manager peers.
With better experience and increased sophistication, the investor base within the Asia-Pacific region is increasingly viewing hedge funds as mainstream alternative investments. Established institutional investors are developing in-house investment teams to evaluate future hedge fund investments. Fund of hedge funds, which perform due diligence and select the best managers in return for an extra layer of fees, face a mounting hurdle in attracting capital from these investors.