By Alistair Barr, MarketWatch
SAN FRANCISCO (MarketWatch) -- Funds of hedge funds, which allocate billions of dollars to managers in the $1.4 trillion industry, shut down at a record pace during the first quarter as investors called into question the value of the niche in the aftermath of the financial crisis and the Bernard Madoff scandal, according to data compiled by Hedge Fund Research Inc.
Nearly 200 funds of hedge funds liquidated in the first quarter. That represents an attrition rate of more than 8%, nearly double the previous record set in the fourth quarter of 2008, Chicago-based HFR said Tuesday.
Liquidations of funds of hedge funds accounted for more than half of the 376 funds that shut down across the industry in the first quarter, HFR reported. Total industry liquidations were down from a record 778 in the fourth quarter. This represents a quarterly attrition rate of 4.05%, the second highest quarterly attrition rate, exceeded only by the rate of 7.77% from the prior quarter.
"If it's not broken, the fund of hedge fund business model is substantially impaired," said Bill Ferrell, head of hedge fund investment firm Ferrell Capital Management.
The main problem was that some hedge fund managers invested in securities that were less liquid than expected. When the financial crisis hit last year, investors wanted to pull their money out. But some managers couldn't quickly exit positions, so they froze redemptions or limited liquidity in other ways, such as putting hard-to-trade positions in "side pockets" or erecting so-called gates.
Funds of hedge funds were particularly exposed to such liquidity mis-matches because many of them offered quarterly redemptions, while some of the underlying managers they invested in had longer redemption periods.
Ferrell runs funds of hedge funds, but is changing its business to focus on setting up managed accounts with hedge fund managers. Managed accounts keep money separate, which means redemptions by other investors aren't a problem. Liquidity and transparency are better with managed accounts too.
Since the middle of 2008, the hedge fund industry has lost nearly 1,200 funds and now has just over 9,050, HFR noted on Tuesday.
At the end of 2008, most of the funds shutting down were single-manager vehicles felled by losses or large-scale investor withdrawals. However, when the Madoff scandal erupted in December, the focus switched to funds of hedge funds, which are supposed to spread investors' money among a range of different managers.
The scandal showed that some of the largest fund-of-funds operators, such as Fairfield Greenwich, Tremont and Kingate, had the majority of their clients' money with Madoff, providing little diversification. It also added to concerns about liquidity in the hedge fund business.
"Institutional investors were rightly upset about losing money and liquidity in the crash of '08," Ferrell said.
Worth the extra fees?
Hedge funds usually charge annual management fees of 1% to 2%, plus performance fees equaling about 20% of any annual gains.
Funds of hedge funds have traditionally charged another layer of fees on top of that -- about 1% a year for management fees and a 10% performance fee. In return, investors got access to some of the best hedge fund managers, the expertise of firms with experience checking and monitoring managers' performance and backgrounds, and diversification.
However, the performance of funds of hedge funds has often lagged returns generated by single-manager funds, according to data from HFR and Standard & Poor's.
An index of single-manager hedge funds compiled by HFR has outperformed a similar fund-of-funds HFR index almost every year since 1992. Funds of hedge funds only beat single-manager funds in 2002 and 2007, the data show.