For funds which market themselves on their ability to spot the sharpest hedge fund minds, it could be their greatest challenge yet. Investors who once trusted them to find the best returns are gaining the expertise and confidence to do it themselves.
US pension funds like the giant $240 billion California Public Employees Retirement System (CalPERS) have picked single hedge fund managers for years. Now smaller players are following suit. Massachusetts' $48 billion state pension fund for instance recently completed a $500 million direct investing program, moving to cut its reliance on funds of funds.
Meanwhile, in Europe, pension funds for companies such as ABB, Nestle and Novartis are following the example set by insurers Swiss Re and Zurich Financial, Zurich University's hedge funds specialist Peter Meier said.
"Even some medium-sized pension funds are investing (in hedge funds) directly, while others have cut hedge fund investing entirely," he said, noting many investors had not returned after access to assets was restricted or blocked during the credit crisis.
The issue is significant because funds of funds, allowing investors to spread their risk, have hitherto helped channel billions of pounds in the direction of hedge fund managers. And if the pool of fund of hedge funds shrinks, many smaller pension funds and less sophisticated investors could find it more difficult to access the returns generated by the $2 trillion hedge fund industry.
Also, a large block of sell orders from pensions invested in the same managers could force those managers to suspend withdrawals - a widespread occurrence during the 2008-2009 financial crisis.
"There is a great deal of pension fund investment overlap which may create issues if a consultant takes a manager off their buy list," said Max Gottschalk, co-founder of $8 billion fund of hedge funds Gottex. Fund of funds charge their investors fees for selecting and then investing in hedge fund managers, and have proved popular with clients making their first move into these so-called alternative investments.
But the sector has also faced criticism for high fees and is yet to recover from redemptions during the financial crisis. Returns have also been questioned. The average fund of funds is up 3.11 percent this year, less than the 4.38 percent gain for the average single manager, Hedge Fund Research shows.
With the trend towards direct pension fund investing gathering pace, smaller fund of funds houses even face the possibility they will not have enough assets to carry on, forcing them to shut down or merge with bigger rivals. One large London-based manager, speaking on condition of anonymity, said its assets under management had stayed stable this year only by pulling clients away from smaller houses.
Fund of funds typically charge their investors an annual 1 percent management fee and 10 percent of performance over a certain benchmark - often the return on cash - on top of the fees underlying hedge fund managers charge.