Author: Eric Uhlfelder

July 2010, Private Wealth

While funds of hedge funds provide diversified exposure to this alternative asset class, the benefits are not that certain, finds Eric Uhlfelder.

With rapidly expanding sovereign credit needs colliding with slow private sector growth, volatile stock markets, and low bond yields, successful investing must involve more than asset allocation.

These concerns led investment panels at a recent Bloomberg investment conference in New York to conclude that despite the challenges confronting the industry, hedge funds will remain a key investment vehicle for institutions and qualified individual investors.

Offering more investment flexibility than any other vehicles can enable hedge funds to thrive, especially in difficult markets, by being short stocks and bonds, gaining exposure to macro trends like interest rates and foreign exchange, and profiting from low-risk merger arbitrage. Such hedge fund strategies generate returns that are often uncorrelated to traditional asset classes, encouraging financial advisors to increase client exposure to hedge funds.

It would then hold that the careful blend of various strategies offered by funds of hedge funds [FoF] should produce even more consistent, less volatile returns. And because of investment minimums that are lower than individual hedge funds, FOFs offer more affordable access to this asset class.

“Many individual hedge funds are not really hedged against risk,” counsels Leo Marzen, partner at New York-based Bridgewater Advisors with $850 million in assets under management, “but one is more likely to gain such protection when one is in a fund of funds, whose pieces have been assembled to produce consistent performance.”

Marzen adds that FoF also take the difficult task of vetting and monitoring hedge funds out of the hands of advisors and places it in the hands of managers who devote their full time doing just that.

But something happens to this argument when you dig down and realize FoF’s diversity has not been delivering either less risk or superior performance over the short, medium, or long run.

Madoff Epiphany

He certainly wasn’t the first hedge fund thief. But it will be difficult to find a more nefarious example that made its way into so many funds of funds. Revelation that this “must have” manager was nothing more than a ponzi scheme shook the hedge fund industry, raising two basic questions. One, how could Madoff have pulled the proverbial wool over the eyes of so many sophisticated investors? And two, what kind of due diligence are investors actually receiving for the additional expense of a fund of fund manager? [FoF managers typically charge a 1 percent annual management fee and a 10 percent performance bonus. This is on top of individual hedge fund manager expenses that usually run 2 and 20 percent.]

Many financial advisors say that the Madoff affair only emphasizes the need to go the FoF route. Funds of funds that get burned by poor fund choices may suffer asset withdrawals. And this could exacerbate losses during a down market, concedes Michael Mattise, chief investment officer of suburban Philadelphia-based Radnor Financial Advisors with $850 million in assets. But he believes most survive, only minimally impacted by exposure to a rotten fund. On the other hand, individual investors who were exclusively in Madoff or Amaranth or Bear Stearns High-Grade Structured Credit Funds will attest to a much worse fate.

Like many advisors, Mattise generally recommends qualified investors have 12-15 percent exposure to hedge funds, which he achieves primarily through funds of funds. And over the 8 years in which he has been providing clients with this alternative investment class, he has generally been pleased with risk-adjusted returns. “Returns have been better than cash and fixed income,” he observes, “and FoF provide us with returns that are uncorrelated to the market, which is very important for the overall portfolio.”

But according to the Chicago-based industry data tracker, Hedge Fund Research, over the past 12 months through April, the average individual hedge fund gained 19.73 percent; the average fund of funds, 12.56 percent or 517 basis points less.

Over the last three years, hedge funds gained an average of 1.95 percent; the average FoF lost 1.92 percent. Annualized underperformance was 387 basis points.

The results are pretty much the same going back five years: individual funds gained an average of 6.62 percent annually, outpacing FoF by 322 basis points a year.

In one measure, fund of funds’ appear less volatile than hedge funds. Over the three trailing time periods, annualized standard deviation [the amount in which performance deviates from its average returns] of FoF is consistently lower than individual funds. [See table below.]

But another measure of risk tells a different story. Maximum drawdown—the largest decline during a downturn before a fund or FOF reclaims a former high—is slightly larger for funds over the trailing and three- and five-year periods. The market collapse that bottomed in early 2009 is the worst such drawdown for both periods: 22.20 percent for fund of funds versus 21.42 percent for funds.

Risk-Returns of Hedge Funds vs. Funds of Funds
Through April 2010
HFRI FWC Index HFRI FOF Composite Index
1-year Returns 19.73 12.56
1-year StD 5.48 3.47
1-year max drawdown 0.76 0.36
3-year Ann. Returns 1.95 (1.92)
3-year Ann. StD 8.68 7.69
3-year max drawdown 21.42 22.20
5-year Ann. Returns 6.62 3.40/td>
5-year Ann. StD 7.31 6.68
5-year max drawdown 21.42 22.20
Source: HFR

Advocates of fund of funds may argue that these conclusions have been skewed by a historic few months. But Sol Waksman, the founder and director of BarclayHedge, another prominent data tracker, says that it would be wrong to eliminate the end of 2008/beginning of 2009 as an outlier. “Occasionally, fund of funds significantly underperform the industry,” says Waksman. Certainly not as bad as they did in 2009 when for the year the average hedge fund returned more than 21.5 percent while the average fund of funds gained only 9.4 percent. “But a five or ten percent deviation in a given year does happen,” cautions Waksman.

Despite this discouraging fact, Waksman thinks the risk of an individual fund blowup—due to fraud, a rogue trader, misjudged risk, or significant strategy drift—is reason enough to find safe haven in the company of funds. “Most investors don’t have sufficient capital to diversify across a series of individual hedge funds to protect themselves from a meltdown,” says Waksman. “So I think investors would be wiser to give up some performance in exchange for the security of multi-fund exposure.”

A Remarkably Lousy Year

Why did funds of funds underperform so badly in 2009? Should the reasons still concern?

First, some found themselves locked into underlying funds that either restricted redemptions or kept substantial portions of illiquid investments locked up in so-called sidepockets that couldn’t be sold to meet redemptions. Not having access to all their capital prevented fund of fund managers from rotating into strategies that were rebounding in 2009.

Second, there may have been some reluctance by managers to jump back aggressively into the market after having failed to protect assets in 2008, observes Kristoffer Houlihan, Director of Risk Management at Pacific Alternative Asset Management Company, a fund of funds manager with $9 billion in assets. [The average fund of fund lost 22.18 percent in 2008, having underperform the average hedge fund by 55 basis points.]

Third, funds of funds experienced the worst net asset flow in their 20-year history, with more than $118 billion having left the industry in 2009, according to HFR. This made it more difficult for fund of funds managers to invest and exploit the rally.

Fourth, but as important as any other factor, there was a significant reduction in leverage. FoF managers typically employ leverage to boost returns and cover their additional expenses. In the arena of Asset-Backed Loans [ABL], a traditionally profitable, low-risk strategy, the sudden elimination of leverage froze nearly all FoF focused on this strategy.

According to Jonathan Kanterman, managing director at Stillwater Capital Partners, ABL funds of funds were forced to return billions of dollars to banks who pulled their leverage during the credit crisis by redeeming shares in underlying funds. This suddenly transformed a patient medium-term strategy into something it was not—a short-term trade. Without sufficient liquidity to meet rising investor redemptions, more than 150 of these funds were forced to gate, temporarily suspend, or wind down their operations.

Citing data from, Kanterman believes FoF leverage has dropped from a 2008 peak of around 80 percent of net assets to now under 40 percent.

Another credit crisis and sudden outflow of assets could trigger many of these risks. But investors are addressing these hazards by avoiding short-term and overly-leveraged funds. They are also looking to segregate their assets in managed accounts–where investor money is not comingled in a fund, where every position is accounted for, and where ultimate ownership and control of investments are retained by the investor.


Many issues affecting funds of funds’ performance were compounded by insufficient transparency. This prevented many managers from truly knowing their composite risk by sector, asset class, currency, leverage, and duration, and how the addition and deletion of individual funds are affecting these risks.

Ron Papanek, head of business strategy at RiskMetrics, a leading hedge fund aggregator of portfolio-level data, says there is a clear need for improved understanding of investment concentration and risks associated with FoF portfolios. At the same time, hedge fund managers are increasingly aware of the need of making their individual portfolios transparent to investors.”

According Dr. Nicholas Verwilghen, the partner overseeing risk management at the Swiss-based fund of funds EIM—a $8.5 billion global manager that customizes multi-fund programs for over 100 institutional investors—the percent of underlying funds having agreed to provide this information has jumped over the past year from 50 percent to 100 percent. They do so through an independent third-party that verifies and aggregates the data.

On the operational side, the 2008 meltdown also emphasized the need of independent and full-service third-party administrators to ensure accurate pricing and trade information, and use of independent custody to ensure legitimacy of assets.

“These improvements,” says Verwilghen “are significantly improving the assessment of portfolio exposure and concentration, counterparty, liquidity, credit, and manager balance sheet risks.”

Ken Heinz, president of HFR, thinks increasing industry transparency will be a boon for FoF. “Fund of funds should be seeking to more effectively consolidate and interpret data of underlying funds,” says Heinz, “enabling them to deliver essential value-adding analysis to investors.”

But Kenneth Phillips, founder and CEO of Santa Monica-based HedgeMark, which analyzes and integrates hedge fund portfolios and risk management systems, is less sanguine about industry prospects. He believes FoF have been systemically compromised, and managers often get hurt because they over rely on modern portfolio.

Two problems in doing this: MPT requires reference to a reliable and relevant benchmark, which Phillips believes does not exist because hedge funds are a mix of various strategies and leverage that cannot be meaningfully averaged together; and two, funds of funds seek greater diversity across individual funds and investment platforms that don’t always provide sufficient transparency, preventing thorough portfolio analysis.

Phillips’ solution: use of managed accounts on the underlying fund level to ensure full transparency, asset control, and manager accountability. This enables a FoF manager to apply a comprehensive risk management overlay to protect the entire portfolio. “But this approach is still far from the norm,” says Phillips, “but it should be to ensure investment mandates are met and fiduciary standards sustained.”


Leave a Reply