During the week of April 5, there was a pronounced increase in the number of investors looking to funds of funds to gain exposure to emerging markets. Compared with the prior week when no fund of funds investors were targeting emerging markets, last week almost 15 percent were searching for emerging-markets-dedicated funds.

One week is a very short time period from which to draw any serious long-term trends, but it does make sense that investors have begun targeting these types of fund of funds. Investor interest in emerging markets has increased during the past year, however, there is volatility associated with emerging countries’ economies. By diversifying through funds of funds vehicles, investors can have exposure to an array of emerging markets while mitigating the risk of investing in any one specific country.

A wealth advisor in Monaco is pursuing this approach. It is looking for well-known funds of hedge funds that are dedicated to global emerging markets. The reason this investor is looking to funds of funds is two-fold. First, as expected, they allow the firm to gain exposure to various emerging markets such as Latin America, Asia, and MENA. Second, they give the firm exposure to a number of underlying strategies, which currently present good opportunities within the specific country or region it is focused on.

Using a fund of funds approach also makes sense for smaller investors that may not have the resources to conduct due diligence on specialist funds. By investing in funds of funds, they gain the peace of mind that comes with knowing the underlying managers have gone through a rigorous due diligence process by a larger, more capable institution.

In all, based on the increased interest in emerging markets, it makes sense that many investors, particularly smaller ones, have begun looking to funds of funds. These vehicles provide investors with the emerging-market exposure they seek while diversifying their portfolio and minimizing the risk associated with single-manager funds that are targeted with a regional and strategy focus.

Single-strategy funds of hedge funds have not been the fund structure of choice among investors. So far this year, BHA has received 94 funds of hedge fund mandates. Of those, 70 have been for multi-strategy funds of hedge funds. Although the multi-strategy structure continues to be preferred among investors, single-strategy funds of funds are extremely useful and essential for investors to gain the proper diversification within certain niche areas of the alternatives industry.

A good example of a niche area is commodities. As I wrote in “CTA/Managed Futures Interest on the Rise, But Will It Continue?” (Investor Monitor, October 30, 2009), CTA/managed futures funds became a popular strategy among hedge fund investors because of the funds’ strong performance during the economic recession. This was made clear by the HFN CTA/Managed Futures Index’s outperformance of the broad industry index by 25 percent during 2008.1 Many investors have used multi-strategy funds of hedge funds to achieve proper portfolio diversification. However, single-strategy funds of hedge funds can also provide diversification when it comes to complex strategies such as CTA/managed futures.

An advisor at a family office based in Geneva, Switzerland, explained to a BHA analyst that she has been intrigued by CTA/managed futures funds after seeing how well they navigated the economic recession when compared with other funds. The advisor also voiced a strong interest in CTA/managed futures funds of funds because they would allow her clients to have proper diversification with funds that have varying holding periods and exposure to hard and soft commodities as well as trend and non-trend following approaches. She also wants to gain exposure to both discretionary and systematic managers in the space. This advisor has decided to research CTA/managed futures funds of hedge funds in addition to seeking top performing single-manager funds.

With the varying structures seen among CTA/managed futures funds, it is a formidable task to properly diversify a portfolio using single manager CTA/managed futures funds. It is a job that involves much due diligence and tracking of numerous funds with varying tendencies. By allocating capital to CTA/managed futures funds of funds, an investor can get the proper diversification through the underlying funds. Also, asset managers such as family offices will benefit from the additional research: in addition to conducting their own in-house due diligence, the funds of funds will also be performing due diligence and portfolio management.

Investors looking for true diversification within a particular segment of the hedge fund space can do so at the funds of funds level. Although multi-strategy funds of funds are the most popular and well-known type of funds of funds, single-strategy funds of funds cannot be overlooked when seeking optimal performance and diversification within a particular niche of the industry.

1 HedgeFund.net, “Strategy Focus Report: CTA/Managed Futures,” October 2, 2009.

Private equity and real estate investments are not new to many sovereign wealth funds (SWFs), but hedge funds are. This year, the Chinese Investment Corporation (CIC) committed $500 million to funds of hedge funds managed by The Blackstone Group and Morgan Stanley. This is an encouraging sign for many funds of hedge funds that have found it difficult to raise capital.

It will be interesting to see if CIC’s venture into funds of hedge funds will trigger other Asian SWFs to follow suit. Funds of hedge funds have received a good deal of negative press since the Madoff scandal; many had invested significant amounts of capital in Madoff’s fund. However, large institutional investors typically look to begin their allocations to hedge funds through funds of funds investments because of the diversity offered.

CIC had established a relationship with Blackstone and Morgan Stanley well before this year. Its investment shows its confidence in these firms and in the funds of funds market in general. Coincidentally, the Korea Investment Corporation stated recently that it wants to begin an alternative investment program that will include allocations to hedge funds.

With prominent institutions such as these making assertive investment decisions, BHA analysts believe other Asian SWFs will be encouraged to do the same.

Investor interest in funds of hedge funds has seen a resurgence in recent weeks as the shake out in the hedge fund industry continues, and managers are offering more transparency and more favorable liquidity terms. Investors have shown particular interest in specialized funds of funds that are performing well, such as commodities, global macro, and long/short equity.

For example, a family office based in Eastern Europe is seeking opportunities in single-strategy funds of funds, and is currently researching CTA/managed futures funds. Additional interests include global macro and other short-term trading-oriented strategies. Another example is a wealth advisor based in Belgium. The firm is currently looking for a fund of hedge funds focused on commodities.

After a year of poor performance, investors were wary of investing in funds of hedge funds. Managers have begun adjusting to investor demands, however, which was the impetus many investors needed to allocate once again to funds of hedge funds.

Diversification is an investment strategy designed to reduce risk, specifically unsystematic risk, by selecting a variety of investments that are unlikely to respond to market fluctuations in the same way. There are many different types of risk endemic to private equity funds, with two being long time horizons and access to liquidity. These risks can be exacerbated by the long lock-ups required, typically seven to twelve years and in some cases longer. As a result, it is paramount that institutional investors select funds that will be negatively correlated to each other over that period of time.

In addition to being able to provide a well-diversified private equity portfolio, funds of private equity funds can leverage their expertise and strong, extensive relationships in the field to design portfolios that have broad exposures to various strategies and geographic regions.

Experienced funds of private equity funds typically have access to a deep pool of managers and can create customized portfolios based on particular investors’ needs. These funds typically have an extensive due diligence process in place and have identified institutional quality private equity funds for their portfolios. Therefore, it is easier and much more cost effective to work with a fund of private equity funds to construct a portfolio and select managers rather than go direct.

During the past week, a family office based in New York mentioned that it had looked for private equity funds, but it did not have success finding qualified managers. Instead, it is considering hiring a fund of private equity funds to add exposure in its portfolio. Similarly, a European-based healthcare organization is looking for a fund of private equity funds to provide it with broad exposure to distressed, buyout, turnaround, and emerging markets opportunities.

With the recent credit crisis not too far removed, many fund of private equity funds have access to fund managers that they otherwise would not have had access to even twelve months ago which makes for plenty of opportunities to construct well diversified private equity portfolios. The only issue is whether there will be enough inflows of capital from institutional investors to fuel these opportunities, but according to Dow Jones despitebeing down from record inflows of $32.4 billion raised in 2007, funds of private equity funds raised $21.6 billion in 2008, the fourth highest total on record. Given those numbers and the influx of distressed, buyout, and emerging market opportunities we feel the asset flow into funds of private equity funds looks strong for the rest of 2009.

The debate over the viability of funds of hedge funds, while always in existence, seems to have picked up fervor in the wake of the Bernie Madoff scandal. The due diligence by funds of funds’ managers was at the very least negligible and, in some cases, nonexistent. While some have argued that funds of funds are going to evaporate like the morning dew, in our one-on-one interviews with alternative investors, BHA analysts find sustained interest in funds of funds among certain pockets of the investor community, namely consultants and wealth advisors.

For these investor types, the right funds of funds can provide diversification as well as a wealth of experience in hedge fund analysis. Most of the interest in funds of funds has been focused on diverse multi-strategy products as opposed to single-strategy or narrowly focused funds of funds. In the first quarter, 77.42 percent of investors interested in funds of hedge funds have been looking for multi-strategy funds, and 49 percent of interested investors are looking for globally diverse funds. What this data indicate is that investors actively looking for new funds of hedge funds want to diversify their alternative fund exposure in terms of fund types and geographic regions.

An investor whose search epitomizes this trend is a Midwestern wealth advisory firm that is looking for diverse funds of hedge funds with exposure to at least 30 underlying fund mangers. It is also looking for funds with at least $800 million in assets under management. It is targeting

well-established, extremely diversified funds in the current market. A Southern U.S. consulting firm is targeting funds of hedge funds with attractive fee structures for a potential allocation. It is looking for funds with diverse geographic exposure and is targeting funds with at least $500 million in assets.

Both of these searches are fairly representative of the interest that BHA analysts have heard from investors during the past few weeks. For established funds with diversified exposure, now is the time to take advantage and target wealth advisors and consultants.

An opportunistic wealth advisory firm is currently looking for managers of qualified funds of private equity funds. Managers do not necessarily have to have long track records to be qualified; however, funds need to have a minimum of $200 million in assets under management. The wealth advisor invests in onshore and offshore vehicles. The firm will invest with funds that have a lock-up if the length of lock-up is acceptable for its strategy. Its clients require that a manager offer high transparency.

Funds of hedge funds are at an important crossroads in the current market. In 2009, more than 70 percent of investors interested in funds of hedge funds mentioned an interest in multi-strategy-focused funds. While some investors remain interested in single-strategy-focused funds, with long/short equity, distressed credit, and CTA/managed futures all being strategies mentioned by investors, demand has focused on funds that can provide investors with access to a group of managers that diversify using many different strategies. With investor interest focusing on multi-strategy offerings, funds and investors alike are looking to further qualify and quantify the value that specific funds offer in the current market environment. While some funds of funds can easily determine their value due to a focus on a specific type of underlying manager, or expertise in a specific geographical region, other funds of funds need to be creative when branding themselves. One domestic wealth advisory firm specifically wanted funds of funds that had outperformed those in their peer group; it thought that funds of funds that outperformed their peers during the second half of 2008 were likely to outpace their peers going forward. This specific investor search serves as a reminder that relative performance remains key for funds.

Liquidity also remains a key issue among interested investors. In 2009, out of the 80 or so investors with an interest in funds of funds that BHA analysts have interviewed, 56 have had specific requirements with regards to the liquidity offerings of potential funds of funds. Approximately 53 of the 56, or 95 percent, have been interested only in funds offering quarterly liquidity or better. Investors across the spectrum require favorable liquidity terms in response to the lack of liquidity they faced in years past. One Swiss wealth advisor in particular that was only now resuming the process of evaluating potential funds of funds, required that it be offered monthly or better liquidity. Funds of funds managers need to be cognizant of what potential investors are currently seeking; according to BHA data, investors are overwhelmingly telling our analysts that favorable liquidity terms are crucial in the current market environment.

While investor interest remains steady for diverse, liquid, multi-strategy offerings, the job of differentiating a fund of funds from its peers lies in the hands of marketers. Funds need to spend these crucial months building their pipelines, identifying interested investors, and pitching prospects on the uniqueness and superiority of their products. The capability of a fund of funds to effectively brand itself as a unique product with a specific niche may be the key to securing new allocations.