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In 2012, large deals in the funds-of-funds segment of the hedge fund industry became a regular occurrence as fund managers sought out bigger partners in order to maintain their position in a difficult economy. According to Pensions and Investments, five of the top twenty-five hedge funds-of-funds managers have changed their ownership structure this year. This includes big names such as Prisma Capital Partners, FRM Holdings and the Rock Creek Group. As fund outflows continue to put pressure on the industry, all players are finding the need to step up their game in terms of securing reliable streams of future contributions.

Fee Pressures Continue to Weigh on Industry, Drive Transactions

One of the many pressures currently weighing on the hedge fund industry is the demand for lower fees from institutional clients. This is none more applicable than in the funds-of-funds segment. In the current environment of low investment returns, clients are struggling to justify the value of funds-of-funds management fees in comparison to do-it-yourself approaches to hedge fund investing. When it comes to sophisticated institutional investors, many portfolio managers are leaving this segment of the hedge fund industry and investing directly in smaller funds themselves, bypassing the middleman.

In response, hedge funds have actively begun cost reduction strategies in an attempt to make a lower fee environment still viable for their own margins. While in many cases this has meant a reduction in staffing levels, transactions can offer some advantages as well in terms of reducing costs. According to Pensions and Investments, access to Well Fargo’s distribution network was a key reason why Rock Creek sold a 35 percent to Wells Fargo. This sort of opportunistic transaction is becoming necessary for hedge funds to survive in this environment.

Low Fixed Income Yields Offer Opportunity for Hedge Funds

Large scale money managers have been an important and increasingly rare source of support for the fund-of-funds segment over the past year. With fixed income yields currently sitting at historical lows, portfolio managers are struggling to meet hurdle rates without taking excessive equity market risk.

Franklin H. Kettle, Managing Director of Colchester Partners LLC, suggested that traditional money managers need to consider funds-of-funds in order to retain clients in a time where low yields and high equity volatility are common place. “With low-yielding bond portfolios and wildly volatile equity strategies, companies like Franklin Templeton and others absolutely have to be able to offer hedge funds or be prepared to watch an awful lot of money walk out the door.”

Transaction Trend May Continue in 2013

While 2012 certainly saw a lot of new ownership arrangements in the funds-of-funds space, none of the underlying causes of these transactions are going away any time soon. Fee pressure is expected to continue in 2013 and fund managers will need to be creative in finding ways to lower costs while not sacrificing their investment management capabilities. Look for many of these creative solutions to come in the form of partnerships and strategic arrangements as the year continues.

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While hedge funds have suffered publicly in terms of reputation since the financial crisis, portfolio managers have a different view of the asset class. Over the past several years, institutional investors have been feeling the pain of historically low fixed income yields. Pension funds, trusts and endowments are struggling to earn minimum hurdle rates in order to continue their existing program support or meet liabilities. As a result, portfolio managers are being forced to think beyond the typical stock and bond portfolio in order to earn sufficient returns without taking on unacceptable levels of risk. In many such scenarios, such portfolio managers are looking at expanding their portfolio concentrations in traditional alternative asset domains of institutional investors, such as commercial real-estate and private equity type activities. Other portfolio managers are also taking a long look at hedge funds that offer low correlation with equity markets, but that may offer more attractive yields than fixed income products do today.

Hedge Funds an Attractive Option for Nobel Prize Fund

One such institutional investor feeling the pain of low fixed income returns is the Nobel Foundation, the investment portfolio that supports the annual award of Nobel prizes in physics, chemistry, medicine, peace and literature. In 2012, these award payments will be cut for the first time since 1949, due to a sharp 18 percent decline in the funds value since 2007. This year’s winners will take home 8 million kronor ($1.2 million US), down 20 percent from the 10 million kronor award last year.

According to Bloomberg Businessweek, the Foundation is looking to hedge funds to provide a boost in returns beyond what the portfolio is currently seeing from its debt holdings. In speaking about the inclusion of hedge funds into the fund’s portfolio, Executive Director Lars Heikensten said, “When we look at the analysis, we see that we can get more return with less risk by doing that. If we can choose hedge funds that we trust, then we can get better returns for given risks.”

The Nobel Foundation has attempted to preserve the original purchasing power of the award since the first laureates received it in 1900. The Nobel Prize in economics was added later through a contribution by Riksbank of Sweden in 1968.

Hedge Funds may not be the Cure All Solution to Institutional Troubles

While selective use of hedge funds within a portfolio may certainly offer better return for risk than some fixed income choices today, hedge funds certainly are not the total answer to weak portfolio returns. In fact, on average, hedge funds significantly underperformed stocks globally in the first 11 months of this year. The HFRX Global Hedge Fund Index earned only 2.4 percent through November, while the MSCI World Index posted a much stronger 11 percent return.

However, it’s important to remember when assessing hedge funds that equities are not always an appropriate comparison or benchmark. Certain hedge fund strategies have risk profiles much more similar to fixed income investments, and accordingly, should not be expected to outperform riskier stock indices every year. For portfolio managers looking to add return while reducing correlation with equities, hedge funds are an increasingly attractive option in a world of low fixed income yields.

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