Hedge Fund Darwinism With Don Putnam

"In a fund of funds, a manager takes funds from his clients, allocates them across 10 hedge funds, wires the capital to the managers and signs 10 limited partnership agreements with them," says Patrick Hughes, a managing member at Guggenheim Partners, an investment firm whose Alternative Asset Management division was just purchased this week by Bank of Ireland for $184 million. "Every month, he waits for a call from his managers, aggregates the results in a spreadsheet and informs his investors." That does not add much value to the business.

"Banks have already purchased funds of funds or will start them themselves," Putnam says.

To make things worse, investors in funds of funds are often clueless about their positions, as they just get performance numbers. "Investors feel very uncomfortable investing in funds of funds where they lose control of the assets and invest in black boxes," says Kevin Dolan, head of Bank of Ireland's asset management division, who arranged the acquisition of Guggenheim Partners' alternative arm, a business that he finds attractive, as it is not a classic fund of funds.

Funds of funds are also under fire because investors are becoming reluctant to pay fees to their managers on top of the fees paid to the underlying hedge funds.

For diversification purposes, it makes more sense to go with a hedge fund manager that offers several strategies and one layer of fees, says Putnam. Those multi-strategy hedge funds will benefit from the fee pressure and will grow faster than other players, he argues.

Multi-strategy hedge funds will also thrive because single strategy "trader" funds do not work, although the biggest ones started that way, says Putnam. The market won't allow one particular strategy to work forever. The best example is convertible arbitrage: It had a great run for five or six years but has lately been stagnant.