Will FoHFs fall prey to The Innovator’s Dilemma?

Thu May 9, 2013

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Few FoHFs coordinate their activities to achieve cooperation as they view each other as competition


By Niki Natarajan

 
   
When Harvard professor Clayton Christensen wrote The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail, Grosvenor Capital Management already had some 25 years' experience in hedge fund investing.

Had the firm, founded by Richard Elden in 1971, shared its performance track record with InvestHedge over the decades, it would have been part of this month's feature on the 'Lessons of the old and wise', alongside its fellow Chicago-based colleague, Aurora Investment Management. Yet despite all the secrecy, with $22.3 billion under management, Grosvenor is still currently the fifth-largest FoHF in the world, and investors still seem to love it.

While Blackstone Alternative Asset Management, Goldman Sachs Asset Management and Morgan Stanley grew their assets in 2012, Grosvenor saw its assets slip down just slightly by 2.19%. It's not a big number and its performance is not bad: for the year ending 31 March 2013, Grosvenor was up 8.4% - compared to InvestHedge's global equity composite index, which was up 6.56% - according to Oklahoma Police Pension and Retirement System's records.

So what is the point of this editorial? Well, the point is about the dilemmas facing FoHF investors as a whole. A closer inspection of Oklahoma's strategy highlights the dilemma facing all FoHFs as they try to adapt to their customers' needs. In the US at least, FoHFs it seems can be bought for a maximum of 85 basis points, while the expertise and knowledge set at FoHFs has not changed, which is evident by Grosvenor's returns.

And this is not the worst part. As investors find the 'best' route to direct investing, those opting for the expertise of their FoHF can probably get their finely honed skills for nothing other than the expenses of carrying out due diligence.

First published in 1997, Christensen's analysis suggests that successful companies can put too much emphasis on customers' current needs, and fail to adopt new technology or business models that will meet customers' unstated or future needs. He argues that such companies will eventually fall behind.

Could FoHFs end up sabotaging their businesses if they continue to give their skills away? It is believed that Grosvenor has similar low-to-no-fee advisory deals in place with Texas Permanent School Fund and Sacramento County Employees Retirement System, but they are not the only ones taking this 'advisory' route.

In terms of reinventing itself, Grosvenor does have the Grosvenor Emerging Managers Fund and various strategy-specific portfolios. It is also thought to be pursuing more liquid RIC offerings.

Neighbouring Aurora has already taken the plunge, along with Arden Asset Management, into the liquid 40 Act market, acknowledging the need for what Christensen calls "disruptive innovation". Will the retail market be the saviour for multi-manager hedge fund investing?

Right now Grosvenor, along with most of the FoHF industry that relies on the institutional investor, is also facing the prisoner's dilemma. This was originally framed by Merrill Flood and Melvin Dresher in 1950, but Albert Tucker formalised a game format in 1992. Two prisoners are set to get one year in jail, but privately each is offered a deal so that if one testifies he would go free and the other gets three years; if both testify against each other both get two years.

Applied to FoHFs - especially smaller ones - each could gain important benefits from cooperating or suffer from the failure to do so. But because it is difficult or expensive, although not necessarily impossible, few coordinate their activities to achieve cooperation as they view each other as competition.

It is the end investor's dilemma, however, that has yet to manifest itself with this move to investing directly. Once the hedge fund manager is selected there are only two variables a pension fund can control: how much money is invested and for how long.

What seems clear from all the pearls of wisdom of the FoHFs with more than 20 years of manager-selection experience is that the key to good long-term performance is compounding returns - which, as Fundana's Dariush Aryeh says, means avoiding big losses. Surely this skill is worth paying for?