Two sizes fit all

Institutional investors in hedge funds often debate the merits of investing directly versus investing through an intermediary, such as a fund of funds (FOF). Many times the choice is defined as an “either/or” proposition, as if an investor must take a stand. However, instead of being forced to decide, it seems preferable to think of these two options as either end of a spectrum of choice.

Proponents of direct investing generally place an emphasis on the benefit of avoiding an additional layer of fees at the FOF level. They claim that with the ability to easily find large, sophisticated multi-strategy hedge fund managers, it is less costly to just do it yourself.

However, an informed investor also should consider the risk involved. While many investors have done reasonably well by investing with a handful of large managers, often their level of risk has been underestimated due to the impact of a difficult-to-measure concept called agency risk, which simply put is the risk of having too few managers.

In comparison, a well diversified FOF portfolio can sharply reduce agency risk. It can also reduce the expenses associated with direct investing and help keep current staff members focused on the investment areas where they have expertise. And larger FOFs are often able to command fee breaks from their underlying managers because of the size of their investments, further mitigating their costs.

So it seems there are reasonable arguments on both sides, but the institutional investor needs to take a position. Outsource or do it yourself? But perhaps there is a better question: What should be outsourced and what can be done in-house? My answer is this: invest directly where the in-house team has an edge and outsource the rest.

For example, an organisation’s current staff may be adequate for managing equity investments but may not have expertise in hedge funds. Therefore, the organisation should probably outsource all of its hedge fund investments. But maybe its staff is comfortable with a certain strategy such as long/short equity, then it should keep those investments in-house and outsource the rest.

This line of reasoning works well regardless of how an institutional investor divides its investment universe. For example, maybe its research team is strong on assessing investment strategies but is weaker on operational risk; it should focus on large established managers with solid back offices and outsource investments to small emerging ones.

Or maybe a limited budget means the research team can only cover managers in the organisation’s general geographic region but not ones in distant markets, so it should outsource walong geographic lines.

Deciding what to outsource means that an institutional investor should first understand who it is; that is, what kind of culture it has, what its resources are and what its edge is. Secondly, it should know where it wants to go; that is, what kind of organisation it wants to be, how much it is willing to change and how best to manage that change.

If outsourcing in perpetuity makes sense, then an institutional investor should hire a large multi-strategy FOF as a one-stop shop – or maybe a handful of niche FOF managers, but only if it can devote more time to the search and monitoring process.

If the organisation plans to make some direct investments but wants to avoid complex, emerging or geographically distant managers, it should consider a hub-and-spoke approach. This means having a larger allocation to a well diversified FOF manager – the hub – surrounded by a handful of smaller direct investments – the spokes.

Finally, if the goal is to ultimately do it in-house, then an institutional investor should find a large multi-strategy FOF who understands its organisation and where it wants to go and is willing to help get it there. The right FOF can serve as a partner in finding custom solutions as unique as the organisation itself.

Kevin Williams is associate director at the Pacific Alternative Asset Management Company