Is the fund of hedge funds business dying?

Global hedge fund inflows remain healthy this year, with investors committing $15.4bn into such products according to eVestment's latest hedge fund asset-flow report. The fund of hedge funds segment, however, faces structural challenges. Ronnie Wu, of Penjing Asset Management, told Fund Selector Asia (FSA) that the FoHF business model has been challenged because fees were relatively high, and that institutional investors, under growing fee pressure, increasingly prefer to allocate to hedge funds directly.

Hedge fund fees have already come down. The traditional unconstrained structure of 2% management and 20% performance fees has eased under pressure from poor performance and investor redemptions, with the weighted average now around 1.7 and 17, according to Goldman Sachs Asset Management. Simon Hopkins, chief executive of Milltrust International, noted that FoHF structures add a second layer of costs, covering the FoHF manager's administration and custodial fees on top of those charged by the underlying funds.

Penjing has responded by negotiating fee discounts with the hedge funds it invests in. Its clients on average pay around 1.2% in management fees and 15% in incentive fees. The firm's client base has shifted considerably: around 90% of AUM came from institutions in 2008, while today its $400m in total AUM is split equally between European institutional investors and Asian family offices. Wu said the firm has two family office clients, each with at least $100m in its products, adding that family offices want help in hedge fund investing rather than relying solely on private banks, which typically promote large, well-known managers. Penjing has not seen new inflows over the past three to five years, though assets have grown through capital appreciation.

The firm has also begun seeding hedge fund managers, investing around $20m to $30m in each of three Asian hedge funds over the past two years in return for stakes, and offering investors revenue-sharing in addition to fund returns. It expects to seed between five and 10 more funds next year. Penjing offers four FoHF strategies (market neutral, diversified, long-biased and long-only) and draws from roughly 1,000 Asian hedge funds, narrowing to about 400 that manage $500m or less, since Wu believes returns tend to decline above that size. Operations due diligence is handled by a separate team, and Wu said the firm will not invest in a fund that fails that review. He estimated that 50 to 100 hedge funds close each year because they cannot sustain the business.