Funds structure in big trouble

For managed fund investors the news is trickling slowly but inexorably through the financial system: the fund of funds model is in trouble. It had become popular in both the hedge fund sector and among mainstream funds, but the central concept of fund managers taking client money and spending it on other fund managers suddenly looks like a bad idea.

The death knell may be the investigation in New York of what looks like being the world's biggest fraud. The Madoff group for years had enjoyed using money distributed through fund of fund products. It was a structure that clearly perpetuated the world's biggest "Ponzi" scheme because investors could not fully track where there money ended up.

As investigators try to unravel the Madoff scandal, three well-known fund of fund managers - the Man Group, the Tremont Group and Arki Busson's EIM Group - have emerged as big losers.

Separately, in Australia the stockmarket-listed HFA, which employs a fund of funds model, has announced a temporary suspension of redemptions in three funds of funds. These had underlying investments in the Lighthouse Diversified Fund and, because of a change in redemption rules at this fund, the investments in HFA funds of funds now have to be treated as illiquid. The direct effect on Australian investors is that they are unable to redeem money investing in the HFA funds.

It all begs a simple question: Why do fund managers pay other fund managers to do what they could do themselves?

In the Australian market, HFA is the biggest hedge fund group on the ASX. The intertwined nature of its fund of funds mean that problems with Lighthouse have affected the whole HFA business. The reputational difficulties for HFA are now clear: its shares are now trading at 14¢, down from $1.50 last year.

Two years ago I wrote about this in an article entitled Prickly Hedges, which also examined the comments from the Economists Round Table to hedge funds. The article compared the returns from HFA funds to the return from cash investments, and I questioned then whether this was a fair return for the risk that investors took on. Now HFA has suspended redemptions, this question becomes even more relevant.

Flow over into conventional managed funds

At a 2005 meeting of the Economists Round Table, a collection of economists that included Bill Sharpe (Nobel Prize winner), George Kaufman and Kenneth Scott discussed hedge funds. Concerns were raised about investor's understanding of what they were invested in, and the risk/reward characteristics of the hedge funds.

The Round Table pointed out that one of the negatives of such a structure was the fees associated with a fund of funds approach, with fees being charged by both the underlying fund manager and the fund of funds manager.

As the fund of funds structure gained popularity in the hedge fund industry it inevitably became emulated across the wider market. Today there is an official - or sometimes a de facto - fund of funds structure employed by many leading mainstream fund managers. Popular fund managers such as BT and Colonial use fund of funds structures.

The argument for using the structure is to use the best in the business. But it is a seriously flawed argument. There is a lack of transparency, there is a raft of fees demanded across the system, there is liquidity risk and there is the enduring concern of an "old boys" network whereby friends in the market simply keep business to themselves and fund mangers that don't make the "lists" never get a chance to prove themselves.

To take a typical example from the market, the BT Multi Manager High Growth Fund offers retail investors exposure to Australian shares (40%), international shares (48%) and hedge funds (12%) in a single fund structure. Close examination reveals at least six different fee layers inside this single product. The September fund update lists 19 underlying fund managers that make up the overall fund.

There are a couple of interesting aspects to this. The first is that BT is itself a fund manager. Does this mean it considers its fund management skills inferior to those of the external fund managers it uses? If it doesn't, why doesn't it manage a multi-asset class fund itself (perhaps outsourcing the hedge fund exposure if it doesn't manage that asset class itself)?

A BT Multi Manager Funds Update from May 2007 provides an insight into another problem with these funds. The update discusses some variation in BT's approach to international share managers, which it did through both its BT specialist Investment Solutions team and independent investment consultants. Suddenly another layer of costs is introduced, those of the independent investment consultants (asset consultants are often used for multi-asset class funds).
It is worth considering the layer of fees and investor is exposed to while investing in such a fund:

1. The brokerage fees when underlying shares are bought or sold (paid to the stockbroker).
2. The fees of the actual fund managers.
3. The fees charged by BT to act as the "multi manager".
4. The fees of the independent investment consultant.
5. The fees to the custodians who hold the actual assets for investors.
6. The commission to the financial adviser (the Product Disclosure Statement says it is an ongoing commission of up to 0.6%).

The management fee for the $33 million fund is listed as being 2.15%, according to the September 2008 update. This is a reasonably high fee by industry standards. If future returns from growth assets are about 10% a year (7% above an inflation rate of 3%), then a fee of 2.15% is a fee equal to 21.5% of future returns.

Conclusion

We definitely live in exciting times - and some of the happenings in the world of hedge funds reflect this; we can't say we weren't warned. When some of the best economic minds sat down to discuss this issue in 2005 they warned about the lack of understanding that some people had of the underlying investments of hedge funds, and voiced concerns around liquidity.

The fund of funds structure favoured by some managers is flawed - as shown by the way that the lack of liquidity in one underlying investment of the HFA fund of funds has led to a suspension of withdrawals from three funds.

The fund of funds structure is also used in more conventional funds, such as the BT Multi Manager High Growth Fund. The layers of fees in this structure act against investors - and it raises an important question: why should a fund manager have to use other fund managers in an investment product. Over the next year it's likely more investors will answer this question by putting their money elsewhere.