Last chance saloon for funds of funds, warns Fitch Ratings

Fund AdministrationInvestors
04 Jul, 2012

Funds of funds have one last chance to reassert their business model as the industry experiences a wave of M&A activity, Fitch Ratings has warned.

The spate of M&A leaves just a handful of funds of funds ripe for acquisition meaning the rest have to focus on organic growth going forward, the report said.  Manuel Arrive, senior director at Fitch Ratings in Paris, said funds of funds have to deliver genuine alpha to their underlying investors so as to justify their worth.

“This will entail focusing on emerging or smaller managers who can generate higher returns. Furthermore, it means concentrating their portfolios on fewer funds while maximising the diversification by risk factors. Over-diversification by number of managers often leads to the asset manager diluting their own skills as fund selectors. This latter strategy may be more risky but will appeal to certain investors, particularly high net worth individuals and family offices,” he said.

Funds of funds have faced immense pressure from investment consultants such as Mercer and Towers Watson. Data from BarclayHedge reveals funds of funds’ Assets under Management (AuM) currently stands at $533 billion, down from its $1.2 trillion peak in 2007. Consultants conversely could control 17% of the hedge fund industry's $2 trillion AuM by year-end 2012, up from 3% in 2007, according to Goldman Sachs Prime Brokerage. Their success has often been at the expense of funds of funds.

“Funds of funds are facing significant pressure from both investment consultants and research consultants. However, funds of funds have skin in the game unlike consultants and their argument to investors should be that their interests are more aligned,” said Arrive.

Fitch Ratings also urged funds of funds to act more like service providers offering advisory services, managed account platforms, co-management of mandates and transparent client risk reporting. “I suspect most funds of funds will become a combination of service providers and allocators,” commented Arrive.

The last year has seen a surge in M&A activity with the most significant deal being Man’s acquisition of the $8 billion FRM creating the largest fund of funds outside of the US. Gottex also acquired Penjing Asset Management as the former sought to expand its reach into Asian markets.

According to Fitch, some multi managers with less than €2 billion could be targets for acquisition although obstacles remain, such as poor financials, legacy issues, key person risk, asset retention risks and cultural differences.