While allocation of assets in hedge fund is acceptable for pension plan and other fiduciary trusts, it may result in a breach of trustee fiduciary duty to invest in hedge funds through a fund-of-hedge fund (FoHF).  Specifically, it may compromise the trust fiduciary’s duty of delegation and prudence in selecting and monitoring performance of a service provider, as defined by the Employee Retirement Income Security Act (ERISA, 1974) and the Uniform Prudent Investor Act (UPIA, 1994).

ERISA and the UPIA have adopted the “prudent investor” doctrine and created principles in trust asset management which have led many to conclude that it is imprudent, and not in the best interest of the beneficiaries, to depart from the “traditional manager direct investment process” with the use of a consultant.  In the case of hedge funds, the consultant should have a core competency in hedge fund evaluation, portfolio construction, and manager monitoring.  The hedge fund consultant would conduct its relationship with the trust fiduciary in the same manner a “traditional consultant” would for long only manager investments.  Furthermore, it is the opinion of this author that exercising a trust fiduciary’s obligation to delegate does not mitigate fiduciary liability in several areas.

While trust fiduciaries that use FoHF satisfy the “obligation to delegate” (UPIA, section 9), FoHF fall short and may create potential fiduciary risk in the following areas:

• Ability to establish the scope and terms of the delegation “consistent” with the trust objectives;¹

• Ability to ensure ongoing “compliance” of investments to Plan documents; ¹

• Ability to influence the investment process (asset allocation, manager selection, etc.) when “scope and terms of the delegation” are not being met; ¹

• Ability to perform “prudent,” ongoing monitoring; ²

• Duty to become familiar with hedge funds in order to improve ongoing monitoring; ²

• Duty to “know and inquire” about the nature of their manager’s investments; ²

• “Trustees are obliged to minimize cost;” ³

• Avoidance of unnecessary counter-party risk resulting from an investment in a FoHF (i.e., financial stability of General Partner of FoHF, use of leverage by General Partner, potential increase in valuation risk); ^{1, 2}

• Ability to represent itself and take direct and immediate legal action against a hedge fund manager within the FoHF;

• Ability to participate in class action law suits against stocks held in the portfolio of a hedge fund manager within the FoHF.

Elimination of Restrictions on Investments

All restrictions on investments (including hedge funds) were eliminated by ERISA and UPIA when the “prudent investor” rule was adopted.⁴

The UPIA states, “The trustee can invest in anything that plays an appropriate role in achieving the risk/return objectives of the trust.”⁵

Duty of Delegation

According to UPIA and ERISA, fiduciaries are “obligated to delegate” their investment management duties if they do not possess the requisite knowledge and expertise. In United States v. Mason Tenders (S.D.N.Y, 1988), the court held that “where the trustees lack the requisite knowledge, experience and expertise to make necessary decisions with respect to investments, their fiduciary obligations require them to hire independent outside advisors.”⁶

However, the duty to delegate imposes two key responsibilities that present potential risks to trust fiduciaries when using a FoHF. 

The Duty of Due Diligence

When investment management responsibilities are delegated,  “The trustee shall exercise reasonable care, skill and caution in . . . selecting an agent . . . [and] establishing the scope and terms of the delegation, consistent with the purposes and terms of the trust.”¹ Accordingly, Whitfield v. Cohen found a trust fiduciary liable because the fiduciary “did not know nor inquire as to the nature of the investments” made on behalf of the plan.² When investing directly in hedge funds, the act of knowing and inquiring is a functional part of the trustee’s investment process.  This is not the case when trustees invest in FoHF.

Many FoHF invested in Long-Term Capital Management (LTCM).  As with all who invested in LTCM, the FoHF general partner “did not know nor could it inquire as to the nature of the manager’s (LTCM) investments.”  Consequently, the trust fiduciaries who invested in that FoHF may have breached their duty of due diligence by inadvertently investing in LTCM through the FoHF.  Furthermore, it is extremely unlikely that trust fiduciaries (or their consultants) would have chosen to make a direct investment in LTCM for obvious reasons (i.e., lack of transparency and excessive leverage).  Nonetheless, FoHFs took advantage of an opportunity to invest in LTCM to improve the “performance” profile of their FoHF without the transparency needed to explain how such “performance” was achieved. 

Furthermore, a FoHF investment in LTCM was often used by the FoHF to attract new investor capital since many investors could only get exposure to LTCM through a FoHF.  Realizing the high investor demand for LTCM, those FoHF who had LTCM exposure marketed their product with an emphasis on the inaccessibility of LTCM to outside investors.  This resulted in one of several conflicts between the objectives of a trust fiduciary and that of the FoHF.  The objective of a trust fiduciary has nothing to do with FoHF product marketing, yet fiduciaries become bystanders to the capital gathering mission of FoHF.  Consequently, the FoHF investment can cause a trust to be invested in hedge fund managers that are “not compatible with the terms of their trust” (i.e. LTCM, transparency, leverage, etc.). ¹

Direct investing in hedge funds by the trust greatly improves the ability of the trustee to verify  compliance to their trust plan.  Direct investing also reduces risk to trust fiduciaries and avoids the potential for conflicts of interest between the trust plan investment policies and the FoHF investments in hedge funds that may not be in compliance.

The Duty to Monitor

Once the duty of due diligence has been completed, the trust fiduciary has an ongoing duty to monitor the performance of the selected investment manager and periodically review the agent’s actions in order “to ensure compliance with the terms and scope of the delegation.”¹ This can be extremely difficult for a fiduciary invested in a FoHF.  In many cases it can be impossible due to insufficient transparency of most FoHF.

“The duty to monitor carries with it, of course, the duty to take action upon discovery that the appointed [managers] are not performing properly.”⁷ Whitfield v. Cohen (S.D.N.Y. 1988) emphasizes this ongoing responsibility of fiduciaries by finding that “the fiduciary had a duty…to withdraw the investment if it became clear or should have become clear that the investment was no longer proper for the Plan.”² 

A FoHF investment in LTCM (or any other manager with similar issues in transparency and leverage) may present a risk to the fiduciary’s duty to monitor, which is substantially mitigated, but not entirely eliminated, by direct investing in hedge funds.  One could make the argument that monitoring the performance of a FoHF, but not being able to ensure “compliance with the terms and scope of the delegation”¹ at the hedge fund manager level, is insufficient given the spirit of trustee responsibility and accountability.

Conclusion

It is clear to many that direct investing and direct involvement in the investment process at the hedge fund manager level (not the FoHF General Partner level) is more in line with established and proven practices currently in place for the “traditional long only” manager investments made by trust fiduciaries.  Hedge fund investment consultants can be retained to make direct investments in hedge funds using a process similar to that of “traditional investment consultants” who are retained to make direct investments in long only bond and equity managers.

Essential to the issue is the belief that direct investing in hedge funds better reflects what the beneficiaries of the trust expect from their trust fiduciaries. Beneficiaries may consider indirect investment in hedge funds through FoHF as imprudent and the least cost-effective option for trust fiduciaries.  A case can be made that investments in a FoHF (although in compliance with UPIA’s “obligation to delegate”) is not sufficiently transparent to trust fiduciaries and is ultimately delegation with abdication of fiduciary duty.  Recent case history has put to question whether fiduciaries can delegate both responsibility and accountability and remove themselves from regulatory scrutiny and personal liability.

[1] UPIA, Section 9 (a)(1), (2)

2  Whitfield v. Cohen, 682 F.Supp 188 (S.D.N.Y., 1988) 

3  UPIA, Section 7

4 The Restatement (3^rd) of Trusts, Prudent Investor Rule

5 UPIA, Section 2 (e) 

⁶ United States v. Mason Tenders (S.D.N.Y., 1988)

⁷ Liss v. Smith, 991 F.Supp 278 (S.D.N.Y., 1998)

Other Sources:

Langbein, John and Bruce Wolk, Pension and Employee Benefit Law, Foundation Press, Third Edition, 2000 

Trapani v. Consolidated Edison Employees’ Mutual Aid Society, 693 f. Supp. 1509, 1516 (S.D.N.Y. 1988) 

Report Released by American Federation of State, County and Municipal Employees (AFSCME) Florida Council 79 regarding fiduciary responsibilities of Florida State Board of Administration in oversight of Alliance Capital Management (August 2002)

Charles J. Gradante is managing principal of Hennessee Group LLC, New York, a consultant to hedge-fund investors. Parsa Kiai, a Hennessee associate, contributed to this article.