Investment Consultants Outpace Funds of Hedge Funds, Finds Barclays

For the past two years, assets under administration/management by hedge fund investment consultants (ICs) have grown 30%, while AUM for funds of hedge funds (FoHFs) have dropped 5%, and research from Barclays indicates this trend will continue over the next two years.

Barclays determined that hedge fund intermediaries account for two-thirds, or $1.5 billion, of the asset flow into the hedge fund industry, but as investors become more conscious of fees and look to invest directly with hedge fund managers, FoHFs face increasing pressure. FoHFs currently account for about $700 billion of inflows, $600 billion of which come through a discretionary role and the rest in an advisory role. Meanwhile, ICs account for around $830 billion of inflows, but the ratio is flipped with nearly the entirety coming from an advisory position.

“What that is masking is the fact that on a marginal basis, they are competing with each other more aggressively than the data suggests,” says Anurag Bhardwaj, head of hedge fund consulting for Barclays.

FoHFs tend to charge higher fees than ICs, but investors have been less willing to pay a premium for their services.

Smaller FoHFs face the most pressure, as those with less than $500 AUM have lost 17% of their holdings since 2010, while larger firms with over $5 billion AUM have held on, gaining 5% over the last two years. These smaller funds have neither the breadth of products nor the margins, and the pressure to reduce fees even further has created a “death spiral” where “the only alternative to going out of business is to get acquired,” says Bhardwaj.

“We do believe that there is incremental value [offered by FoHFs], but the challenge is they have not made that value proposition completely transparent to investors,” says Bhardwaj.

ICs have fared better due in part to their lower fees, and if investors want to allocate directly to a hedge fund manager, they are more likely to use a consultant for help.

“They’re in a good position because assets in the consultant business are growing,” says Bhardwaj. But even ICs are starting to face pressure on fees, he adds, because investors are starting to realize that there is not much value differential between different consultants.

Still, Barclays estimates that the overall IC fee pool will increase 15% by 2014 due to the growth of assets, while FoHFs will be hit with a 10% drop from a combination of reduced fees and less AUM.

The silver lining for FoHFs could be the emergence of ‘40 Act mutual fund products, which they are now starting to offer.

“I think that is very likely a big story and is likely going to impact the intermediary space,” says Bhardwaj. “Many FoHFs see this as a new product opportunity and, if the product takes off, it could provide a boost to the FoHF business model. For ICs, it’s less clear what the immediate business opportunity is.”