A growth industry

Hedge funds represent a lot more nowadays than the exotic investment of the past. Hedge funds offer a respectable investment area that must be considered by the prudent investor.

The trend among investors seeking hedge funds is to move towards a fund of fund structure. The movement by larger schemes towards single funds reflects, given their greater resources, an increased knowledge enabling them to invest directly without the help of funds of hedge funds.

For the mid-sized scheme though, funds of hedge funds offer the most realistic route into hedge funds on an opportunity cost basis, especially when considering the due diligence responsibility in selecting single managers. The movement of this segment of the market is just beginning to gather pace.

Performance Fees

The investor's dislike of performance fees has also waned in recent years. An acceptance that performance fees reward managers who consistently deliver an absolute return, often against a given risk target regardless of the equity and bond markets' performance, means the institutional investor is now more focused on managers who consistently deliver that absolute return to justify the fees from managers who do not. Performance fees are accepted as aligning the manager's interest to the investor's. The manager only earns performance fees if the investor makes money.

Furthermore, there has been no downward pressure on fees resulting from the investor's increased presence. Managers whohave demonstrated consistent alpha-generating ability have maintained fee levels and with no noticeable change. This also applies to fund of hedge fund fees. The bottom line is net return, and the fund of hedge funds that have met their medium-term risk and return targets have no pressure on fees.

There has also been the development of hedge fund platforms following the lead of firms such as Lyxor and the huge growth of investable indices. All offer different ways of altering the fee structure and packaging of alternatives for investors to invest, essentially providing a different form of fund of hedge funds.

Regulatory landscape

Recently, the regulatory landscape changed significantly across Europe. Changes from regulators reflect a growing comfort with the industry's own standards in dealing with risk, investor communications and also recognition of greater investor understanding and desire to gain access to such alternative investments.

Spain has recently seen new regulations, opening up its market for onshore investors to invest in hedge funds. The spirit of the regulations allow investors to access hedge funds and the domestic hedge fund industry to thrive. In this situation, a fund of hedge fund must have an EU passport and be run by a locally registered manager, but is allowed to have a non-Spanish adviser. A non-EU offshore fund cannot be bought locally in Spain due to prohibitive tax implications.

In France, it has been some time since the regulator amended the rules for approved investments. Previously a fund had to be listed; now the regulator has a series of principles a fund must satisfy for approval, principles that enable a certain level of protection for investors but allow well run offshore investment companies to be accessed by local investors through fund of hedge funds. In France, funds of hedge funds are limited to 10% in unapproved investments, and under the old rules many funds were in the 10% bracket.

This restricted the ability of French fund of hedge fund managers to gain exposure to some good managers. Under the new rules many well-managed offshore funds moved into the approved 90% eligibility, and this has been a big change in the regulatory environment for fund of funds.

All these changes in the European regulatory environment culminated recently in the UK where the Financial Services Authorityhas announced (in principle) its intention, after industry consultation, to amend its rules to allow retail fund of hedge fund investment products in the future. This announcement is the first step in the retail access to hedge funds across Europe.

In the United States the SEC recently amended its rules to protect investors. Managers could register with the SEC to maintain liquidity and attract onshore US investors or, in not registering, a manager had to amend the terms of their funds to lock up new investors for two years. In the event of the new legislation there have been great managers both registering with the SEC and deciding not to register.

Transparency

Much has changed regarding the topic of transparency. Many hedge fund managers and fund of hedge fund managers have understood the importance of communicating the position level/sector level or aggregate portfolio risk to investors. Equally it is common place for institutional investors to recognise the importance of protecting a manager's edge or illiquid position level names, and so they are willing to work with independent risk aggregators rather than demand position level transparency.

Capacity

In a growing industry where a manager's alpha-generating ability is limited to a given capacity, the best managers with long-term records are closed to new investors. Funds of funds seek to differentiate themselves by clearly identifying their edge in finding and accessing the best managers.

For the few with long enough experience in the industry it is their ability to access capacity in 'closed' funds based on the longevity of their business and deep manager relationships. For others, often as a result of their size, it is a 'process' to try to identify the best new managers among a huge wave of new fund launches ongoing within the industry.

In conclusion, the changes noted above highlight the speed and breadth of change across the fund of hedge fund landscape as well as the broader hedge fund industry. For investors, it is important to select a manager who can embrace these changes and maintain net returns as they grow. The speed of change purely reflects the growth of the industry during its acceptance as a mainstream institutional investment. We can expect more change on the way as the industry continues to grow.key points

Fund of hedge funds, and hedge funds in general have gained industry acceptance in Europe and US

Funds of hedge funds offer the mid-level investor a cost effective route into hedge funds

Performance fees are becoming more acceptable

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