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The Fund-of-One: A Customized
Solution for a Changing World
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The Fund-of-One: A Customized
Solution for a Changing World
It’s no secret that many hedge fund investors were disappointed with their
investments in diversified multi-strategy fund of hedge fund products during
and after the financial crisis. Performance was subpar; The collapse of notable
financial institutions within the industry led to concerns over counterparty risk;
and a series of high-profile blowups led investors to rethink the idea of letting
managers run opaque strategies.
Post-crisis, many institutions reasoned that they
needed to build a better solution for hedge fund
investing. To discuss this, Citi’s Peter Hill, Global
Head of Fund of Hedge Fund Services, sat down to
chat with three firms who believe that a customtailored “fund-of-one” — a hedge fund program
designed specifically for one investor — can be a
key part of the solution.
Thomas Murray
Managing Director, Investment Strategist
Arden Asset Management
Coby McDonald
Global Head of Client Service and Development
Arden Asset Management
Kyle McDaniel
Chief Strategy Officer
Dorchester Capital Advisors, LLC
John Mackin
Global Head of Marketing and Business Development
Protégé Partners
Reaction to Funds of Hedge Funds in Crisis
In a more complicated world where institutions
are aspiring for better results, customization rules
the day. “Funds of hedge funds are at an inflection
point,” declares Protégé’s John Mackin, “there’s
no question, we are facing significant headwinds
and need to reinvent ourselves.” Investors
have been frustrated with poor performance,
inadequate transparency and the fees charged by
off-the-shelf, diversified, multi-strategy funds of
hedge funds.
Arden’s Thomas Murray remarks, “When it comes
to [off-the-shelf] commingled products, very few
are raising institutional capital at the moment.”
His firm has seen a marked increase in demand for
customized solutions over the past several years,
such as the fund-of-one. “From the investor’s
point of view,” he continues, “there are some real
benefits. It’s your account, you can dictate what
the program will look like and you are in control of
your own capital.”
The bespoke nature of the fund-of-one is worth
emphasizing, as it contrasts with the commingled
nature of funds of hedge funds. Many funds
of hedge funds investors became a victim of
their fellow limited partners during the crisis, as
panicked withdrawals led to the imposition of
“gates” in the underlying funds that locked up
investors’ assets.
Post-crisis, some institutions believed that they
could improve their investing experience by
investing directly in hedge funds. At a minimum,
they reasoned, they could improve performance
and remove a layer of fees by avoiding the
management and performance fees charges
often assessed by funds of hedge funds. They
also expected to obtain more transparency
into portfolios.
In practice, however, the experience of “going
direct” has been mixed. Monitoring 30 or
40 managers requires an institution to have
tremendous resources to perform proper initial
and ongoing due diligence, tracking what could
amount to thousands of positions and many
different risk exposures. “There are a lot of setup
and legal costs involved,” notes Kyle McDaniel
of Dorchester Capital. To get a good handle on
risk across these portfolios, an institution might
have to hire a half-dozen analysts or more, which
does not always make sense for a hedge fund
The Fund-of-One: A Customized Solution for a Changing World
allocation that might represent just 5% of the
institution’s assets.
Murray feels that institutions that are simply
building direct hedge fund portfolios composed
of only blue chip managers may find it difficult
to achieve their risk-adjusted performance
objectives, without complementing that core book
with bespoke return-enhancing solutions. “Some
investors are simply creating bottom-up portfolios
of blue chip hedge fund managers without giving
much thought to top-down portfolio construction
or to managers and/or strategies outside of their
list of blue chip managers,” observes Murray.
“Both of these steps add value,” he continues,
“and are necessary to build a hedge fund program
that will meet what I perceive to be fairly lofty
performance objectives.”
Structural Advantages
When it comes to bespoke hedge fund solutions,
the fund-of-one isn’t the only structure
available. In the past several years, some
institutional investors embraced the separately
managed account as a vehicle that would offer
customization while segregating the institution’s
assets from other investors.
In practice, however, the hedge fund managed
account comes with trade-offs. While the
institution is able to choose its own administrator
and have full transparency into the securities held,
many of the esoteric operational responsibilities
(e.g., negotiating their own ISDAs) now fall on the
institution. This incurs costs, as well as some risks,
as plan fiduciaries may one day need to explain
their rationale for the vendors selected.
In contrast, the fund-of-one still allows the
institution to customize the mandate and
segregate its funds from other investors, while
reducing the operational burden. “We’ll ask the
administrator, custodian and other parties all the
tough questions,” Mackin explains, “You’re not
filling out all the subscription documents.” He
also highlights the fact that the fund structure
— with its board of directors and other features —
offers improved governance that resonates with
plan sponsors.
Murray states, “Pension investors like the
fund-of-one structure because it is typically set
up as a limited liability company or a limited
partnership,” he states. Moreover, Mackin notes
that in the event of a loss or dispute, investors in a
limited partnership structure may be able to avail
themselves of the protections offered through the
laws of the fund’s domicile (i.e., Cayman Island
law, Delaware state law, etc.). Similarly, investors
in separate account products using leverage could
be held responsible for losses beyond their initial
investment, whereas this is not the case with a
limited liability fund structure.
Consultative Approach Resonates
The fund-of-one seems to put investors in the
sweet spot between the customization offered
by a direct program and the resources at the
disposal of a fund of hedge funds. “We’re like the
general contractor overseeing a whole bunch of
skilled tradesmen,” Mackin explains, telling clients,
“we can either build you an addition or a new
house; it just depends on your budget and your
goals.” Some of his firm’s clients are asking for
concentrated, “best ideas” portfolios, as opposed
to diluted portfolios, with sub-5% allocations to
the underlying managers.
Beyond the specific advantages of the fund-ofone, clients appear to welcome the consultative
approach. Mackin notes that as a provider brings
customization into the discussion, it allows the
firm to sit on the same side of the table as the
client. “You’re no longer walking in and pitching
a product, and putting a bow around it, while
saying, ‘Here’s my nice box, I hope you like it,’” he
explains. Today, clients are also being proactive,
complementing his firm’s capabilities and value
proposition, but asking for a tailored solution or
something special.
A key factor in being more consultative is to have
a constructive dialogue with the client so as to
understand the goals and objectives of their hedge
fund investments. This is particularly important,
Murray asserts, given a shift in how sponsors view
hedge funds post-crisis. “We’ve seen a changing
mindset at pension funds with respect to their risk
budgeting,” he remarks, with many, “no longer
looking at ‘hedge funds,’ as a separate line item in
their asset allocation.” Instead, Murray observes,
institutions are “embedding equity-focused and
fixed income-focused hedge fund portfolios within
their long equity and fixed income buckets,”
respectively. Mackin agrees: “Hedge funds are
no longer a separate asset class,” he claims,
“Hedge funds with an equity orientation are now
incorporated into the equity bucket, and not the
alternatives bucket.”
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“We’ll ask the
administrator,
custodian and
other parties
all the tough
questions,”
Mackin explains.
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“If you have a
tactical thesis,”
McDaniel argues,
“it makes a lot of
sense to go with
a fund-of-one.”
Coby McDonald of Arden also notes that the
immediate objective isn’t always clear. “You
may start the conversation at the point that the
[hedge fund] portfolio is designed to be an equity
substitute,” he explains, “but at the end of the
conversation, they want an LDI strategy.” By
having this discussion, the provider can not only
recommend the most appropriate solution, but
can also build a stronger relationship with the
client and their advisors.
McDaniel advocates customization in his belief
that the argument for the fund-of-one has
changed to some degree. “People commonly talk
about a fund-of-one from a structural discussion,
but rarely from a strategic perspective.” Mackin
agrees: “Initially, [the fund-of-one discussion] was
a structural idea for transparency, a ‘we gotta
protect ourselves’ decision.” But today, he notes,
every discussion about a fund-of-one starts on
the strategy side, considering a specific objective
and looking at the fund-of-one as a framework for
a solution. “Essentially, we are taking some of the
most complex strategies from capital markets and
putting them together for the benefit of the client,
and this is a challenging proposition,” he explains.
Murray also highlights the need to adapt as the
client’s circumstances change. “Client’s objectives
will change throughout the tenure of the client/
provider relationship.” he advises, “You have to be
proactive and come to the table with suggested
changes to the customized mandate you are
managing as your client’s objectives change, not
wait for them to tell you.” Some might suggest
that the industry should have anticipated this
before. McDaniel agrees, and notes that it is the
provider, not the vehicle itself, that is part of the
solution. “Lots of funds-of-one I’ve seen are very
stale and not proactive,” he observes.
Tactical, Nimble Solution
The advantages of the fund-of-one from a
strategic perspective are particularly relevant in
the current market environment. Given the volatile
swings in equities, credit and other instruments,
some have questioned whether or not the “buyand-hold” approach is dead. Arguably, the “riskon/risk-off” nature of the market, driven perhaps
by geopolitical developments, has muted the
underlying fundamentals of individual securities.
In some cases, this volatility creates tremendous
opportunities in securities or asset classes, but
those opportunities are very short-lived. The
fleeting nature of these opportunities may be
at odds with plan governance — new allocations
typically require at least internal committee
approval, and sometimes external board members
must also sign off. “Most pension plans have a
governance structure where managers must
be approved,” McDaniel notes. “Even a 25bps
allocation to a new manager may need to be
approved.” That process may take as long as six
months, he notes.
The fund-of-one can overcome this challenge.
“If you have a tactical thesis,” McDaniel argues,
“it makes a lot of sense to go with a fund-ofone.” Instead of having different redemptions
and investments for each such opportunity, the
pension plan has one line item on its books, greatly
simplifying things. “If you have a good working
partnership, and embed your guidelines into the
investment management agreement,” he states,
the investor experience can be “far superior
to direct hedge fund investments, and far, far
superior to a separately managed account.”
Equally important, as the plan’s own
circumstances change, it becomes easier to
reposition its hedge fund investments through the
fund-of-one. “As required return, funded status or
asset allocation guidelines change, you can now
change the mandate,” adds Mackin, “whereas with
an off-the-shelf product, you have no such ability.”
Key Success Factors
For all of the positive features of the fund-of-one,
the structure itself is no panacea. Providers need
to execute on a number of levels to ensure a
positive client experience.
One such area to focus on is the management of
liquidity. While no longer commingled with other
investors, and in control of their own liquidity,
investors going through a fund-of-one are still
beholden to the underlying managers’ terms.
“Typically, institutions want to access a portion of
their assets quarterly.” To deliver on that demand
requires some advance planning on the part of
the fund-of-one provider. Underlying managers
often require 60 days’ notice, plus another 30
days to process the redemption request, for a
total of 90 days. Like a chess master, the fund-ofone provider has to be able to think several moves
ahead. “Managing liquidity is a constant exercise,”
The Fund-of-One: A Customized Solution for a Changing World
Hedge Fund Industry Investment Structures
Structures Used by Direct Allocators
Traditional Fund of
Funds
Commingled
“Fund of One”
SMA Third-Party
Platform
SMA Internal
or
Risk Profile
Contagion risk with
market events
Adjacency risk w/
other investors
Isolation of investor’s
pool—no adjacency risk
Full control of assets/
No adjacency risk
Full control of assets/
No adjacency risk
Transparency
No transparency to
asset level exposure
Dependent on terms
offered by LP and
reporting available
Dependent on terms
negotiated as part of
the fund
100% transparency to
underlying assets
100% transparency to
underlying assets
Ticket Size
Sub-allocation managed
by FoF
Up to 25% of total AUM
Custom allocation
No limit
No limit
Fees & Returns
Additional management
& performance fees;
diversification concern
No additional fees; full
realization of return
Additional management
& performance fees in
FoF version
Concern about tracking
error & platform fees
Concern about
tracking error
Operational Scale
No operational
overhead
Minimal requirements
No operational
overhead
Outsourced to thirdparty
Internal team to
oversee risk and asset
levels
Infrastructure Cost
No infrastructure
overhead
Some investment in risk
management
Substantial legal fees
required for setup
Fees paid to third-party
for systems and
infrastructure
Internal systems
connected to PB
and Custodians
Pro Con Neutral
Murray details. Arden’s Investment Committee
meets at least once a week to discuss liquidity,
considering whether or not they have the proper
flexibility to execute the investment theses of
each portfolio they are managing.
Source: Citi Prime Finance analysis based on primary research
managing liquidity all the time for a semi-liquid
portfolio seven days a week,” he cautions. “That
would diminish the alpha,” he continues.
Murray concurs that such portfolios are
challenging. “In fund-of-one structures, you
have to manage liquidity assuming no additional
investor inflows,” he advises. He notes that
having access to a credit facility helps hedge fund
advisors to “bridge the gap” between the effective
date of underlying manager redemptions and the
payment of redemptions.
Catalyst for Change
Our panelists share the concern that the direct
model may come under further pressure, possibly
a victim of its own success. “Pension funds’ hedge
fund allocations will, in general, continue to grow,”
Murray asserts, “from on average 5% today to
15% or more.” While the re-categorization of some
types of hedge fund risk from alternatives to
equities or fixed income may seem like a bonanza
for the industry, it may have some repercussions
for plan sponsors going direct. “If you start
with 20 manager relationships, you’ll run out of
capacity at some point,” Murray predicts, “and
if you have to increase the number of managers
significantly to fund the increased allocation, the
workload of proper manager due diligence and
monitoring will be too great for a small team.”
While liquidity management is important,
McDaniel cautions against not seeing the forest
for the trees. “You don’t want a portfolio manager
McDaniel believes that a static portfolio of blue
chip hedge funds may not generate an optimal
portfolio. “The point that it’s not a buy-and-hold
McDaniel stresses the particular challenge of
managing liquidity for shrinking investment
pools. “Portfolios with flat or declining assets
can be challenging to manage,” he laments. As
new investments can’t simply be funded by new
inflows in these cases, another investment has to
be sold every time there’s a reallocation.
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strategy just can’t be overstated,” he notes.
Not enough investors consider the notion that a
manager or the strategy on which the manager
focuses might be en vogue today, but faces
valuation, liquidity, strategic or even structural
issues going forward.
$10 billion multi-strategy fund is cheaper from a
cost perspective at the firm level as opposed to
running 50 custom portfolios.” Mackin also thinks
the fund-of-one is a more expensive business
model for providers, but says that the demand is
there, and the solutions are scalable.
Whether going direct or through a fund of hedge
funds, transparency is key. “If you’re going direct,”
Murray advises, “you have to have the resources,
the experience and the leverage with managers to
glean the information you need to dictate proper
ongoing portfolio changes.” Going with a hedge
fund solution provider, he argues, makes it a lot
easier, as they have the resources needed to
execute this strategy.
The bigger challenge in Murray’s eyes is the
shift in approach. “You could have 50 different
portfolios, and 50 different sets of decisions to
make each month as all customized portfolios
have specific goals, objectives and guidelines,”
he explains. While his firm has been delivering
custom solutions for 13 years, building bespoke
portfolios will prove challenging for hedge fund
advisors accustomed to managing one multistrategy fund of funds product for many years.
Murray likens the shift to the distinction between
wirehouse model portfolios and the personalized
portfolios typically put together by independent
registered investment advisors. There aren’t many
firms that have the experience and expertise to
manage many different customized portfolios that
all reach their objectives.
Clients will differ in terms of how much
transparency they want. Some may be hands-off,
while others will want a conversation every week.
Nevertheless, providers have to be prepared.
“As a provider of customized solutions you
don’t have a choice and the more interactive the
relationship the better,” Murray comments, “if
you’re not willing to provide the client’s required
level of transparency, at some point you’re going
to be obsolete.”
Mackin notes that transparency is also a mindset.
“I’d reiterate that it’s by being consultative that
you really deliver transparency,” he states. “It has
to be provided in value-added format, through
real discussion,” he continues. To some degree,
he concedes, funds of hedge funds are prisoner
to the whims of the underlying managers. “What
we get, we give,” he explains, “but if an A-player
is only providing some ratios and exposures, do
you want to take a pass on them because they are
providing less than full transparency?”
Surprisingly, Murray observes, not all funds of
hedge funds are so forthcoming. “There are still
a few holdouts, who think they have the ‘golden
manager list’ that no one else has access to.”
Business Implications for Hedge Fund Advisors
If plan sponsors increase their adoption of
fund-of-one structures as a means of accessing
underlying hedge funds, there could be
implications for providers. “It’s a more expensive
business model,” Murray admits, “Having one
Another imperative for hedge fund advisors
looking to be more consultative is to foster
better communication and collaboration across
their own organizations. “Historically,” Mackin
observes, “the functions of operations, marketing,
risk management, portfolio management and
client service were siloed.” In the past, when
underlying managers were bought or sold based
on the goals of the off-the-shelf fund itself, the
investment team may have never met the firm’s
clients. Now, with the fund-of-one arrangement,
as such decisions are based on needs of a specific
client, various pockets of expertise need to be tied
together. “Today, integration is critical,” Mackin
states. Speaking to his own role, he notes that,
“The job has changed from selling a product to
building a solution.”
Panelists agree that there are some limitations
on a fund-of-one, and circumstances where a
commingled product would be required. A fundof-one requires a minimum amount of capital
to properly diversify the portfolio. This amount
depends on the nature of the mandate. By going
direct vs. a fund-of-one, McDaniel states that
the investor may be “literally saving 50–70 basis
points, which makes sense particularly for a valuepreservation strategy,” where fees will have a
greater impact given the lower expected returns.
The Fund-of-One: A Customized Solution for a Changing World
However, if the fund-of-one is conceived as a
completion strategy, it might be possible to invest
$25 million using only ten to 20 managers. Mackin
sees similar opportunities with his clients. “We’re
seeing growing interest in market-independent
solutions where performance is generated
independent of traditional equity and credit factor
risks,” he relates.
The fund-of-one itself isn’t necessarily a silver
bullet. McDonald says, “We ourselves are agnostic
regarding the type of solution our clients desire,
but we feel that from the client’s perspective,
it entails much more work to go direct.” The
fund-of-one also allows hedge fund advisors and
their clients to forge deeper relationships. “As
we all face the headwinds of lower rates,” Mackin
remarks, “we need to add value beyond the
numbers.” Institutions know that they can hire a
multi-strategy manager and not only avoid the
added layer of funds of hedge funds fees, but also
easily get board approval for that approach. “We
present a product that’s complementary, with
value added that’s effectively fee-neutral vs. a
multi-strategy fund,” Mackin explains, “If you can’t
offer that, you don’t get a seat at the table.”
McDonald is frank about the increased level of
complexity facing the industry. “Just as managers
have to do more for clients today, advisors and
funds of hedge funds do as well,” he observes.
Advisors need to understand not just the objective
of the specific mandate, but also the client’s entire
asset allocation, and where and how their hedge
fund exposure fits in. “Today, providers need to
have much greater knowledge,” he concludes, “in
order to meet exponentially greater deliverables.”
Find the Right Provider
Customization may sound like a simple extension
of a hedge fund advisor’s off-the-shelf funds of
funds, yet there is significant variation in the
marketplace. “Very few funds of hedge funds
have been customizing for a long time and are
good at it,” Murray asserts. He believes that the
allocator needs years of experience working with
hundreds of relationships. “There may be dozens
of possible options, but only one solution that is
best for the client. It takes years of experience
to arrive at the most appropriate conclusion
consistently,” he adds.
McDaniel seconds the notion of experience
as a critical success factor. “I could not agree
more regarding the experience with portfolio
construction,” he states. “It’s not just putting
together a diversified set of betas with the
potential for outperformance.” Mackin also
stresses the importance of portfolio construction.
“A specialist consultant may know individual
managers inside and out,” he grants, “but they
may not have the legacy perspective to construct
portfolios, and put the relevant information to
good use.”
Mackin believes that the best providers have
the ability to step in and proactively engage
the underlying manager. While clients may see
transparency as a goal in itself, he sees it more as
a means to an end. “You need a risk management
team who can interpret the data and identify
whether the manager has gone off track,” he
asserts. For any caution flags that arise in the
course of monitoring process, “you must have
someone who can make a phone call to ask the
principals, ‘is this a new view or a complete change
in strategy?’”
Our panelists believe that convincing pension
plans of the benefits of a completion portfolio is a
matter of sitting down, reviewing and discussing
their current hedge fund program and its future
goals. “There seems to have been a shift where
allocators are equal-risking,” says McDaniel,
referring to a systematic allocation process of
investing in hedge funds, which seems to be at
odds with the very reason hedge funds exist, i.e.,
to capture a particular investment thesis. “It also
seems there has been a seismic shift in providers
investing in money management organizations
that call themselves hedge funds,” he continues,
“rather than trying to address specific client
needs to find funds that represent the original
hedge fund value proposition.” McDaniel questions
whether or not systematic rebalancing is the best
way to create sustainable performance in the form
of alpha and differentiated returns.
Mackin sees the “a-ha!” moment unfolding when a
provider sits down with the investment committee
to provide diagnostics on their exposures. If the
provider can show significant position overlap in
popular trading themes, they will realize that they
are not as diversified as they had assumed. “That’s
when the CIO says, ‘I’ve got a nice lineup of blue
chip managers, but I don’t get it done on a trailing
1-, 3-, and 5-year basis, and I’m overly exposed to
these trades.’”
7
“There may
be dozens of
possible options,
but only one
solution that
is best for the
client,” Murray
asserts.
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Citi Transaction Services
About Arden Asset Management
Arden Asset Management (“Arden”) was founded
in 1993 and specializes in providing alternative
investment solutions, including creating and
managing portfolios of hedge funds using a
disciplined, research-driven investment process.
In addition, Arden also offers risk aggregation and
advisory services and has been establishing and
managing customized portfolios for investors,
with specific guidelines determined by the client’s
individual needs, since 2000. Arden is equipped
with a highly sophisticated infrastructure,
including a robust investment process and
institutional quality business functions. It is
Arden’s goal to continuously seek enhancements
to our core investment processes of research, risk
and operational due diligence. Arden provides
world-class fund of hedge fund solutions, offering
transparency, position level based analytics and
enhanced reporting capabilities for our clients.
length investments, along with thematic and
tactical opportunities, Protégé works with some
of the most sophisticated institutional investors in
the world to complement and complete a robust
hedge fund program.
About Dorchester Capital
Founded in 2002, Dorchester Capital Advisors,
LLC is a Los Angeles, California based, SEC–
registered investment advisory firm with offices
in Los Angeles and Austin. Together with its sister
investment advisory firm, Dorchester Capital
Private Equity Management, LLC, Dorchester’s
core business is building and managing portfolios
of hedge funds, customized solutions and
opportunistic capital call structured funds in
credit and secondary assets.
Headquartered in New York with an office in
Singapore, Protégé currently employs over 40
professionals.
About Protégé Partners
Protégé Partners, LLC (“Protégé”) is a specialized
asset management firm that was founded in
2002 by Jeffrey Tarrant and Ted Seides to focus
exclusively on investing in established smaller
hedge funds and select emerging managers.
Differentiated from the broader universe of
hedge fund investors that principally focuses on
large, widely held funds, Protégé is recognized
as an industry expert in what it believes is
the highly attractive, less efficient and under
allocated universe of smaller hedge funds. By
deploying its expertise through a unique model
of investing, one that blends seeding and arms-
In addition to Protégé’s commingled investment
strategies, we are able to construct customized
portfolios that focus on our core capabilities in
order to address a broad range of challenges
faced by our investors. Customization can range
from very concentrated portfolios to strategic
portfolios that have a specific strategy and
regional focus.
Protégé is 100% employee owned, maintains a
substantial co-investment alongside clients and
is a culture that thrives on innovation and idea
generation, transparency and risk management,
technology and alignment of interest with
investors.
About Citi OpenInvestorSM
Citi OpenInvestor is the investment services
solution for today’s diversified investor that
combines specialized expertise, comprehensive
capabilities and the power of Citi’s global network
to help clients meet performance objectives
across asset classes, strategies and geographies.
Citi OpenInvestor provides institutional,
alternative and wealth managers with middleoffice, fund services, custody, investing and
financing solutions that are focused on their
specific challenges and customized to their
individual needs.
For more information, please contact:
Peter Hill
617-824-1431
peter.hill@citi.com
Citi Transaction Services
transactionservices.citi.com
© 2013 Citibank, N.A. All rights reserved. Citi and Arc Design is a registered service mark of Citigroup Inc.
OpenInvestor is a service mark of Citigroup Inc.
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