The fund of hedge funds industry is being forced to reinvent itself after the Madoff scandal and hefty client outflows, and will emerge from the crisis smaller but in better shape than many had expected.
Investors pulled more than $150 billion from funds of funds in 2008 and 2009, according to Hedge Fund Research, but these portfolios, which charge an extra level of fees for selecting a basket of managers, are developing tactics such as changing staff, overhauling risk monitoring or offering investors easier access to cash, to rebuild their reputations and maintain fees.
What you're seeing now in the industry is a whole range of new initiatives and new models as part of a concerted effort to bring investors back, said Omar Kodmani, senior executive officer at Permal Investment Management Services.
Firms that actually invested with Madoff are fighting back with staff cuts and new hires, isolating the part of the business that failed to spot the U.S. fraudster or merging units and focusing more on risk management and transparency.
While clients are still pulling out money, such moves are helping avert the doomsday scenarios some commentators predicted and allowing some funds to stop worrying about meeting redemption requests and start investing once again.
Last month S&P told Reuters that funds of funds were starting to see net inflows for the first time in more than a year.
Many firms without Madoff exposure are moving away from the old model of simply picking a range of complementary funds after damage caused to the industry's reputation by Madoff, as well as by performance losses of 21 percent last year and problems giving clients their money back when demanded.
Some funds of funds that have been impacted by Madoff have adapted, they've reinvented themselves, said one top hedge fund executive who declined to be named. We've seen subscriptions from such funds again.
It's larger firms, who've been able to argue that Madoff didn't affect all their portfolios and that not everyone agreed with the decision to invest. They've been able to isolate the decision-maker.
UBP, which had Madoff exposure of more than 1 billion Swiss francs ($945.2 million) and saw hedge fund assets almost halve in the first half, has revamped its fund selection process by insisting on independent administrators and custodians. It has also cut 10 percent of staff globally this year and named its first ever chief investment officer as well as a head of research in alternatives to oversee the list of approved fund managers.
Meanwhile, Man Group's RMF unit, which took a $360 million Madoff hit, committed to face-to-face meetings with all the decision makers on funds it invests in after the scandal.
RMF has merged with other Man units and while assets are down -- falling to $16.1 billion from $28.7 billion in the year to end-March -- the more than 70 percent drop predicted by Morgan Stanley in February appears to have been averted.
Even funds that avoided Madoff have been hit by negative sentiment toward the industry, as well as difficulty returning money to clients because credit lines used to meet redemptions were pulled in by some banks during the crisis.
While the additional fees are not as high as those on the underlying funds, they nevertheless represent an extra cost, and the very need for funds of funds is now being questioned as some institutions consider cutting out the middle man.
Pension funds' hedge fund databases are getting sufficiently large that you can replicate a fund of funds by buying 50-to-60 funds, said Nick Bullman, managing partner at Bullman Investment Management.
Some funds are beefing up their analysis to determine how easily they can get money back from underlying hedge funds.
Not only that, but some firms are now examining underlying funds' portfolios with a fine tooth comb to see how easily they could be sold if market conditions turned.
People I've talked to have done more work into improving liquidity surveillance systems, said Randal Goldsmith, director of fund research at S&P Fund Services. Some are drilling down to (see) how much money can be raised from what's in the portfolio.
Some firms have responded by developing a range of so-called managed accounts -- tailored and segregated portfolios for individual clients -- which allows them to sell when they want and which are hard for investors to reproduce.
London-based Permal, which runs around $19 billion in fund of funds assets, has expanded its range of managed accounts, including some tailored mandates, between which it can move money more quickly.
Specialist groups and customized products could do quite well. If you focus solely on a customized or country specific product you can justify excess margins, said Bullman. The idea of acting as a gatekeeper to ... funds doesn't work now.
($1=1.058 Swiss Franc)
(Editing by Jon Loades-Carter)