The Future of Fund of Hedge Funds

Since the credit crisis of 2008 and the Madoff scandal, the percentage of assets being invested in hedge funds through fund of hedge funds (FOHFs) has decreased steadily to 34%.  For FOHFs to survive and thrive, they have to add enough value to justify their fees.  Two researchers at NEPC of Cambridge, MA - Kamal Suppal, CFA, Senior Research Consultant and Antolin Garza, Research Analyst - examine this issue.  The avenues to creating this value are manager selection and portfolio construction.  Portfolio construction may be executed by creating allocations for each investment strategy and finding managers to fill them or the reverse.  Find the best managers and then allocate to each strategy.  Other questions to resolve are the weights of the managers and assigning different portions to be strategic versus tactical allocations.

NEPC views the future of successful FOHFs in three forms:

1. Conservative FOHFs that protect against the downside and participate slightly on the upside.  They have "high-conviction ideas and dynamic portfolio allocations."
2. "Niche" FOHFs with tactical portfolio allocation that is used to complement the other hedge funds in the portfolio
3. Customized portfolios used to complement a portfolio

Portfolio construction rests on the investment philosophy of the FOHF and its business considerations.  For example, a philosophy would be to regard investments as the present value of future cash flows.  Business considerations include whether or not the FOHF is an asset gatherer or seeks to earn the performance  incentive fees.

Asset gatherers use strategic asset allocation as their value add.  An EDHEC study of 200 FOHFs from January 2000 to June 2007 found that 48.4% of managers added an average of 1.54% over the average return.  During the crisis timeframe of June 2007 to July 2009, 77.7% of managers added an average of 3.5%.  FOHFs using tactical asset allocation methods had more muted results.  During the calm period, 60.9% of FOHFs added 1.24% to the returns.  In the crisis period, only 30.9% added 1.86% of returns.  The downside was worse.  69.1% of FOHFs averaged losing 3.13% more than the average return.

FOHFs that use manager selection added the most value during the first period.  92.9% of FOHFs added  an average of 3.89% excess return.  During the crisis, 48.4% added 4.18%.  The remaining managers lost an average of 4.3%.  This high figure leads to the conclusion that strategic asset allocation is the safest bet.

The researchers examined more than 15 years of returns for 1,300 FOHFs in 2011 and discovered that 20% of them added value.  Of those managers selecting hedge fund managers, only 5% added value.  To find these managers, NEPC uses a "6P" process to explain the role of FOHFs in a portfolio and verify its performance.

• People - need to have well-rounded and diverse teams that knit together their knowledge and skill sets to deliver value
• Philosophy - an investment philosophy that provides managers with clarity on how to manage their portfolios in all situations
• Process - Consists of fund research, portfolio building and risk management;  need to have defined research criteria taking into account the size of the fund, specialist versus generalist advantages, different account structures, negotiating lower fees for transparency, more control and better liquidity and monitoring managers;  use diversification to reduce business and headline risk, having access to investments in different investment strategies, sectors and geographies to reduce volatility;  risk management consists of having risk mitigating strategies (global macro, commodities trading adviser, volatility arbitrage and tail risk investing), non-correlation of positions and limits on leverage.
• Performance -  absolute and relative, relative performance for a FOHF is compared against the HFRX (investible index)
• Price - fees charged should not be reduced for FOHF that add value
• Perpetuity - have stable personnel with low turnover and investors such as private clients and family offices

The source for this article can be accessed here.