Fund of hedge funds, once the darling of the alternatives space, fell dramatically from grace in 2008. Performance was disappointing and many got caught up in the most notorious hedge fund blow-ups in recent history. The result has been a greater interest in direct allocations to hedge funds, much of which is fl owing into multi-strategy single manager funds, arguably the closest alternative to fund of funds given the diversification benefits of spreading assets across a range of underlying strategies in an uncertain market.
“Operational risk accounts for more than 75% of hedge fund failures.”
Lionel Erdely
However, in a market that continues to see hedge funds struggle, close and blow-up, operational risk has come sharply into focus. On this score, funds of funds have a significant advantage in terms of resources and by diversifying operational risk across a range of managers.
Is it time to take another look at funds of hedge funds? Are investors potentially putting themselves at undue risk as they change their hedge fund investment approach?
A fall from grace
Without doubt 2008 was an appalling year for most fund of hedge funds. Despite selling themselves on their ability to diversify exposures and therefore off er downside protection, the average fund of funds lost 21.37% based on the HFRI Fund of Funds Composite Index, a 2.34% underperformance versus the HFRI Fund Weighted Composite Index (-19.03%). BarclayHedge indexes support this relative underperformance, albeit by only 0.55%.
As a result, funds of funds have seen net outflows every year since 2008, totalling nearly $200bn. After peaking in 2007 with assets of nearly $800bn across 2462 funds of funds, total assets and the number of funds fell 22% each by the end of the second quarter of 2012 to $627bn in 1932 funds, according to Hedge Fund Research data.
“Funds of funds are in a position of having to adapt or face a tough future,” says Chris Jones, head of alternatives at consultancy bfinance, and former chief investment officer at Key Asset Management, one of Europe’s oldest funds of hedge funds. “Investors don’t care too much if hedge funds make money if everything else does well, but they really do care that hedge funds do well in the tough times.”
Figures from eVestment HFN show the trend towards direct investment rather than funds of funds has picked up markedly since the financial crisis. Having already lost 4.6% between 2002 and the end of 2007, the proportion of assets invested through funds of funds fell a further 12% by the end of last year to 36.2% of the industry’s total AUM.
During that period, the hedge fund industry has ‘institutionalised’. Citi’s Institutional Investment in Hedge Funds June 2012 report shows the proportion of industry AUM coming from institutional investors rising from around 25% in 2002 to around 60% by the end of 2011.
As institutions become more sophisticated, many are deciding the funds of funds model does not suit them,” bfinance’s Jones says.
The trend towards direct investment has proven particularly beneficial for large, multi-strategy funds, which diversify their exposures across a range of underlying strategies, thereby offering an alternative to a funds of funds approach without the second layer of fees.
On the surface, the case for doing so appears compelling. Since 2008, multi-strategy funds have consistently outperformed funds of funds, providing better returns in up years and smaller losses in down years, based on analysis of the Barclay Fund of Funds Index versus the Barclay Multi Strategy Index (see chart).
Underestimating operational risk?
However, in a world where hedge funds are struggling to outperform traditional asset classes and examples of large-scale blow-ups continue to mount, there is a danger investors are underestimating the operational risk involved in direct investment. Is it time for investors to take another look at where funds of funds can still add significant value?
John Caulfield, chief investment officer funds of hedge funds at Momentum Global Investment Management (MGIM) says: “The easiest way to make money is to not lose it and the easiest way to lose it is through taking operational risk.”
Operational risk accounts for more than 75% of hedge fund failures according to Lionel Erdely, chief investment officer of alternatives at Lyxor Asset Management.
Hedge funds increasingly have to be good investors and good business managers. Yet, the job of conducting operational due diligence on hedge funds is increasingly resource-intensive and, with little quantitative method for measuring operational risk, experience lies at the heart of avoiding operational failings.
“The ingredients of the hedge fund universe are unique to that universe,” says Morten Spenner, chief executive of fund of funds International Asset Management. “An investor’s level of insight into how the industry works makes an enormous difference. If you want to be in this space, you have to jump in with both feet and maintain a focus on it.”
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