Download The Case for Funds of Hedge Funds

December 2015 | January 2016
The Case for Funds of Hedge Funds
Why institutional investors should still consider them
PATRICK GHALI, MANAGING PARTNER AND CO-FOUNDER, SUSSEX PARTNERS
A superficial analysis of the topic may well lead
investors to such a conclusion. However, we
strongly feel that funds of funds can still be an
extremely valuable tool for investors, and that
the right ones still very much deserve a place in
investors’ portfolios. Therefore, in order to arrive
at a meaningful conclusion, we need to examine
not just the different potential benefits that a
FoFs approach may yield, but to also to take a
very close look at the cost side of the equation,
one of the main criticisms levelled against FoFs.1
To build or buy?
Let’s start with the fee criticism and the perceived
double layer of fees. The argument here is that
by levying additional management and/or
performance fees on top of the fees already charged
by underlying hedge funds, the final product ends
up with a very high total expense ratio, which
may mean that little could be left over in terms
of net performance or added value for investors.
Though this may be the case for some funds of
funds, especially those investing in managers
that are already well known to many hedge fund
investors, with arguably little added value coming
from their research process, it isn’t necessarily true
for all. Many funds of funds actively apply their
own macro view, employ a thematic approach, a
geographic focus or actively trade the managers
in their underlying portfolios, thus offering
additional benefits and expertise beyond simply
picking easily accessed and well-known hedge
funds. Therefore, investors need to look at different
aspects of this cost argument, each of which we
feel it is important to discuss in more detail.
One obvious consideration, though often
underappreciated, and in our experience rarely
1
Source: Sussex Partners. *Benchmark: HFRI FoF Index annualised returns since index inception in January 1990.
In-House Team
1,400,000
1,200,000
1,000,000
Perceived FoF
Costs: 1%/10%
based on
Benchmark
Returns*
800,000
600,000
FoF Fees: 0.15%
Mgt Fee only
Net of
Underlying
Discount
400,000
700
670
640
610
580
550
520
460
490
430
400
370
340
310
280
250
220
190
160
130
70
100
40
200,000
10
In the aftermath of 2008, many investors have
decided that they would directly invest into singlemanager hedge funds instead, and that the services
offered by funds of funds were no longer of use to
them. The mere mention of funds of funds with
investors these days can lead to raised eyebrows
and questioning looks. After all, why would
anybody suggest employing an investment strategy
that charges an extra layer of fees, and that by and
large has underperformed over the past few years?
Fig.1 In-house costs versus perceived FoFs cost and achievable net FoFs costs
ANNUAL COST OF PORTFOLIO ($)
F
unds of hedge funds (FoFs) were once a
significant way for investors to gain access to
hedge funds, but since 2008 their reputation
has suffered, their total assets and market share
have shrunk (there were 30% fewer FoFs in
2014 than in 2007, representing approximately
14% of overall hedge fund assets as of Q3 2015
versus approximately 36% in 2007), and many
of the better known ones have disappeared
or have had to merge in order to survive.
PORTFOLIO AUM ($m)
properly simulated and budgeted for by investors,
is the cost of setting up an equivalent team inhouse. This analysis must inevitably also include
all the human resources and management-related
ramifications this may have on an organisation.
Setting up an in-house team not only entails
significant legal and compliance costs and the need
to create customised risk and reporting systems,
but of course also the cost of the portfolio manager,
the supporting analysts, and the challenge of
attracting, and retaining, the best talent for each
of these positions (something which will be rather
difficult for smaller or lesser known investors to
achieve). This in and of itself may be a task of
Herculean proportions. In addition, there are also
ongoing travel and due diligence expenses incurred
by continuously meeting with existing managers in
the portfolio, as well as new potential additions,
a process which is never finished. These recurring
costs rapidly add up to significant levels which
means that, for those investors looking to allocate
across multiple asset classes and geographies, this
can quickly become a logistical and intellectual
challenge, further multiplying the complexity
and cost of managing portfolios cost-efficiently.
Depending on the location of the investor, and
taking into account associated as well as direct
costs, a properly resourced in-house team can easily
cost $1 million a year, but will likely exceed that
amount significantly, without any guarantee of
performance – let alone outperformance – versus
a benchmark or peers. This alone means that for
any investor unwilling or unable to allocate at
least $100 million to a hedge fund portfolio, the
economics of setting up an in-house team will likely
be significantly worse than employing a fund of
funds. Having a team in-house also means that in
the event things don’t work out as initially planned,
the decision to terminate an underperforming
manager not only has HR ramifications, which may
be expensive and cumbersome, but it is also most
certainly going to take significantly longer than the
one to three months’ notice period for redemptions
offered by funds of funds to their investors.
Moreover, it also requires the investor to
consider what to do with its portfolio posttermination, as the liquidity of that portfolio
may be even more protracted than any notice
period employees may have, and the liquidity of
that portfolio will ultimately be the liquidity of
the least liquid component contained therein.
In contrast, an investment in a fund of funds
provides investors with access to dedicated
portfolio managers who split their fixed costs
across a wider pool of investors. This allows
funds of funds to build out more robust teams,
and investors can therefore avoid all the fixed
costs, and associated considerations, that
come with building an in-house team. Liquidity
for investors is more clearly defined, and it is
generally also more likely that fund of funds
managers are significantly invested in their
own products than may be the case for in-house
portfolio managers where, for a variety of reasons,
this may not be possible or appropriate.
It is also not unusual to find managers that earn
more from the returns generated on their own
invested capital than from the fees they charge
to other investors. The advantage this gives is
December 2015 | January 2016
Making use of strategy-specific managers
Fig.2 The importance of diversification and manager selection in a hedge fund portfolio
Source: Sussex Partners. Data for hedge funds reporting to HFR between Jan-07 to Oct-15. Outlier results omitted (0.3% of sample)
HF Risk/Return Dispersion Jan-07 to Oct-15
35.00%
ANNUALISED RETURNS
25.00%
15.00%
5.00%
-5.00%
-15.00%
-25.00%
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
ANNUALISED VOLATILITY
that managers are tied personally to the success
or failure of a fund’s performance, thereby
further aligning interests between all parties.
this function is very high, and likely only makes
sense for portfolios multiple times larger than
the $100 million we suggested earlier.
Investors also shouldn’t underestimate the
bargaining power that funds of funds managing
significant assets have with underlying hedge
fund managers. The benefits they can derive can
include significant fee concessions, the ability to
switch mid-month between multiple products a
fund provider may be offering, preferential liquidity
terms, both for investments and redemptions,
improved transparency and reporting of underlying
positions, and even customised portfolios which
other investors may not be able to access.
When considering investing in markets other
than an investor’s home market, cultural aspects
should also be taken into consideration. This may
further weigh in favour of successful local fund
of funds managers, who may be able to access
better information on the underlying investments,
make calls on country/regional economic cycles,
and conduct proper and detailed due diligence
on their counterparties and investments. These
cultural aspects are not only important for
quantitative reasons – the decision of what
funds to allocate to and how to extract the best
performance – but also for qualitative reasons
of understanding how a region or country truly
works, how government policy may be set and how
all of this may affect the underlying portfolio.
All of these elements can provide significant
additional value to investors. With regard to
fee discounts, we have seen several large funds
of funds being able to reduce the underlying
fees to such a degree – given the size of their
investments – that their total expense ratios are
only insignificantly higher than if an investor had
invested directly in a portfolio of single managers,
sometimes as low as only 15 bps extra. It is not
unheard of for the “2 and 20” approach of 2%
management fees and 20% performance fees to
more realistically be represented by fees of 0.5-1.5%
(management fees) and 10-20% (performance fees).
This means that the due diligence, portfolio
management, asset allocation and any other
services provided by these funds of funds are
virtually free of charge to their investors. Once
again, contrasting this with the aforementioned
running costs of an in-house team quickly
shows that the AUM hurdle for internalising
2
Having explored the issues around the build
or buy decision investors should also consider
taking advantage of strategy-specific managers.
Geographically, the case for funds of funds is
both appealing and strong, where a detailed
understanding of local markets is crucial to
extracting better returns. To take a recent
example, the last year’s volatility in China, both
in terms of market performance and regulatory
changes, has been a clear reminder that things
are more complex and multi-faceted than is often
appreciated. Funds of funds can offer investors the
opportunity to hold a more diversified regional
exposure in their portfolio, thereby hedging against
idiosyncratic manager and market risks, as well as
allowing them to take advantage of more diverse
opportunity sets than provided by allocations to
a small number of single-manager hedge funds.
Additionally, they also remove the due diligence
burden an investor would otherwise have and
help investors to navigate foreign markets more
efficiently and with less risk. The most skilled
local managers are able to dynamically and
quickly move around different opportunities and
replace underperforming, or less attractive risk/
return propositions with more suitable ideas.
Investors can also make use of sector specialists
in areas such as healthcare or technology, or
strategy specialists focused on commodities or
alternative credit, where in some instances greater
diversification and real specialised knowledge
is needed, and where most investors wouldn’t
typically feel comfortable allocating all their
risk to just one or two single managers. In these
instances, funds of funds can act as trusted
guides and are often able to allocate risk more
efficiently among sub-strategies depending on
changes in underlying risk/return drivers.
Some of the most successful funds of funds that
we have researched reallocate risk among their
Table 1 Risk/Return statistics since 2008
Long
Only
Equity
FoFs
Indexes
Source: Sussex Partners
Annualised
Return
Annualised
Standard
Deviation
Max DD
Sharpe
Ratio (0%
risk free)
Calmar
Ratio
MSCI World
10.62%
15.80%
-19.64%
0.67
0.54
MSCI APAC
7.34%
16.56%
-19.27%
0.44
0.38
HFRI FoF Composite
3.82%
4.03%
-7.67%
0.95
0.50
Eurekahedge Asia Pacific FoFs
5.60%
6.34%
-9.33%
0.88
0.60
Eurekahedge L/S Equity FoFs
4.98%
5.66%
-9.56%
0.88
0.52
Eurekahedge Fixed Income FoFs
4.83%
3.67%
-4.32%
1.31
1.12
December 2015 | January 2016
underlying funds very actively, as if those were
individual securities and not funds, and the
managers in which they invest could be classified
as off-site proprietary traders rather than hedge
funds. This approach, and the risk aggregation
these funds often employ at a portfolio level,
can lead to significantly better risk-adjusted
returns than investors may be able to generate
themselves, but also adds a level of complexity
few organisations could manage in-house.
funds returns, then they should find a liquid index
in which to invest, save the fees and not suffer
any sort of illiquidity, not even monthly liquidity.
However, we have seen a plethora of funds of
funds that have been able to significantly and
consistently, both on a risk-adjusted and absolute
basis, outperform hedge fund as well as long-only
indexes. To us, a lot of this has to do with the
ability of good funds of funds to limit downside
volatility, and to positively compound noncorrelated returns over significant periods of time.
Positive compounding, diversification
Investors seem to keep forgetting some of the
most basic rules of finance. Amongst these are
the value of diversification and the power of
positively compounding returns over long periods
of time. Diversification in the case of a hedge fund
portfolio comes at a cost: cost in terms of actual
assets needed to invest due to the high minimum
investments, cost in terms of infrastructure, and
cost in terms of managing the resulting complexity
at a portfolio level. All of these can, to some extent,
be addressed through the use of funds of funds.
Even more important though, and by far the
most powerful ally any long-term investor can
have, is the value of positively compounding
returns. This of course also means keeping
investment losses to a minimum, as recovering
from significant losses is very hard, especially
without taking undue risks. The most important
aspects to look for in any investment are
therefore to limit the potential downside and to
generate consistently superior, net of fee, riskadjusted returns. These are also the metrics that
any fund of funds investor should consider.
3
Where does this leave us?
Though a couple of pages are never enough to
exhaustively discuss a topic as polarising as funds
of funds, for the preceding reasons, not least (but
perhaps for some people most surprisingly) the
cost consideration of going it alone, we strongly
feel that funds of funds still have a legitimate
place in investors’ portfolios. We would even go
as far as to suggest that for most investors, other
than some of the largest and most sophisticated
multi-national groups, selecting single managers
may be challenging and that they may be better
served in the long run to select a group of trusted
funds of funds that have a demonstrable long-term
track record of outperformance – especially when it
comes to strategy or geography-specific investment
ideas. It is in these areas that we see funds of
funds adding the most value to investors both in
terms of quantitative and qualitative measures.
On the other hand, any fund of funds purporting
to merely provide access to well-known managers,
or that mimics an index, clearly adds little to no
value to investors and understandably will struggle
to survive in a highly competitive environment.
Ultimately, the only thing that should matter to
any investor is whether they receive better net of
fee risk-adjusted returns from their fund of funds
investments than they could otherwise. Especially
in the current low interest rate environment,
there is ample research to suggest that a fund of
funds approach may even be a good substitute
for a fixed income portfolio, as funds of funds can
mimic the risk/return profile of such a portfolio
without the significant downside risk of traditional
fixed income investments at these valuation
levels (Michael Cembalest, JP Morgan Asset
Management, “Eye on the Market”, May 2nd 2013).
As with any other investment, it is hard to generalise,
and a more thoughtful approach is required when
determining whether or not a fund of funds may
make sense for specific investors. Ultimately though,
a fund of funds is nothing other than a portfolio
manager, and what should count is whether or not
this portfolio manager, compared to other similar
investment options, can consistently generate
superior risk-adjusted net of fee returns. THFJ
What is generally true though, including in 2008,
and even for the most mediocre performing funds
of funds, is that FoFs as a group had on average
significantly lower losses than long-only portfolios.
In a portfolio context this would have added some
stability to most investors' portfolios. Of course,
an allocator shouldn’t aim to pick a mediocre
fund of funds, and we always advocate that if all
an investor wants is exposure to average fund of
1. To us, a fund of funds advisory mandate, bespoke
fund or managed account are essentially all the
same in terms of the most basic considerations of
whether or not to invest. Of course, they all have
their own unique aspects but we will leave these
out of the discussion and focus instead on the highlevel aspects we feel are important and common to
all of them.
FO OTNOTES
“A properly
resourced inhouse team can
easily cost $1
million a year, but
will likely exceed
that amount
significantly,
without any
guarantee of
performance.”