Maybe it’s a sign of increased investor sophistication. Maybe it’s a sign that funds of funds are not doing a good enough job marketing their value proposition. Either way, the big institutional investors that are driving growth in hedge fund assets these days are shying away from funds of funds, and going the direct route instead.

Pensions & Investments online reports that while institutional investors are continuing to increase their allocations to hedge funds, their buying patterns are changing. Instead of testing the waters with funds of funds, they’re constructing their own hedge fund portfolios, thanks to a better comfort level with the asset class and greater transparency in reporting..

The size of the allocation and the abilities of in-house professionals determine the approach each investor takes. For example, the Employees Retirement System of Texas, Austin, will allocate roughly 5% or $1.158 billion of its total $23.2 billion in assets to hedge funds over the next three years. They intend to pursue direct investments in single hedge funds to create their own multi-strategy approach. However, they are also currently searching for an internal portfolio manager to oversee their hedge fund investments.

Another example is the Kentucky Retirement Systems, Frankfort, which first allocated $100 million to a multistrategy hedge fund managed by Arrowhawk Capital Partners LLC in 2010. However, this year they have decided to split their hedge fund allocation among Blackstone Alternative Asset Management, Pacific Alternative Asset Management Co. LLC and Prisma Capital Partners LP, who will each manage roughly $400 million in a more direct approach. The overall Kentucky Retirement System holds $14.9 billion in assets.

“Many new investors, especially those with large allocations, are comfortable now with their expectations for hedge funds and also recognize that they have the buying power to make direct investments with the assistance of their consultant or with a customized portfolio built by a hedge funds-of-funds manager,” said Susan N. McDermott, chief investment officer of investment consultant Stratford Advisory Group Inc., Chicago, which serves corporate pension plans, endowments and foundations.

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