(By: Michael Newman, CAIA, AllAboutAlpha.com Editorial Board)
Diversification is often the mantra of hedge fund investors. But a forthcoming academic paper from State University of New York (SUNY) professors Greg Gregoriou and Razvan Pascalau suggests that the optimal number of underlying hedge funds within a fund of hedge fund portfolio may actually be as low as 6-10. Their study is one of the first to utilize actual data culled from a hedge fund database and move beyond theorizing about a magic number.
While that is only one conclusion to be drawn from their data analysis, the primary thrust of the paper is to demonstrate empirically that the number of “HFs included into a FOF has a negative and significant impact on the volatility of returns while having less of an impact on the actual returns.”
Although their findings regarding the volatility of returns has long been an obvious, intuitive conclusion from the application of Modern Portfolio Theory and general rules of diversification, the academic literature had yet to analyze actual FOF data. Moreover, their observations regarding the limited impact on performance will provide plenty of fodder for those on both sides of the debate about just how much alpha a FOF manager provides.
Getting the Lay of the Land
The paper is equally important for investors in FOFs seeking to get the lay of the land. The paper begins with a brief review of the academic literature surrounding FOF diversification, much of which seems to predate the tremendous growth of the FOF industry in recent years. In fact, the bulk of the studies cited were written prior to 2002. This should caution us from jumping to too many conclusions and remind us that we are, in a sense, observing a moving target.
Fortunately, the data the authors use for their analysis, from the Barclay hedge fund database, runs through the end of 2008. It’s especially useful for illuminating the contours of the current FOF marketplace. As an example, of the over 2000 live FOFs in the Barclay hedge fund database, 70% have 30 underlying managers or less. Similarly, the paper cites a MARHedge survey that found two-thirds of FOFs have between 9-11 managers.
With such vivid stats on the current FOF playing field, those investors whose FOF investments have as many as 50 or 100 HFs need to ask themselves why their FOF insists on holding so many underlying HFs. Is it a strategic decision? Is it an integral party of the investment philosophy? Or part of the fund’s structure? How does it relate to their volatility and performance?
Such questions seem all the more relevant when presented alongside the paper’s other findings. The authors noted that FOFs with high water marks averaged six more managers than those without high water marks. One can only wonder whether there may be some risk aversion disguised as diversification in such a finding.
Not surprisingly, the data also show that FOFs tend to add more managers as they increase their investors’ redemption frequency. They find that as FOFs move from offering redemptions annually, quarterly, monthly, etc., the average number of HF managers increases by three for each increase in redemption frequency.
Interestingly, the authors found neither fee structure nor lock-up period to significantly correlate with the number of underlying managers. This suggests that investors may seek a more concentrated FOF portfolio without necessarily sacrificing their overall liquidity or paying substantially higher fees.
So, if the paper is correct and an increase in the number of underlying HFs within a FOF significantly dampens volatility but doesn’t impact performance, what is an investor in FOFs to do? The authors are eager to remind us of the problem of ‘Diworsification’ covered in other academic papers – the decreasing benefits of diversification when underlying managers exceed 40. They actually go one step further – they highlight its counter-productivity:
It can be physically difficult, time-consuming, and costly to monitor 60 or more hedge funds…It is common knowledge that the ability to swiftly change the exposure and rapidly get in and out of position is an advantage only enjoyed by small FOFs.
When the authors looked at the data more closely, analyzing it by tiers designated by the number of underlying managers, they saw that smaller FOFs with 6-10 funds outperformed their peers. This group had an average of only US 200 million in AUM. So, the next question of course is: should investors go seek out smaller concentrated funds?
Applying the ‘Life Cycle’ concept to a Fund of Funds
The concept of a hedge fund life cycle has been widely discussed among both academics and practitioners. In fact, many FOF managers utilize it when evaluating potential HF investments and underlying HF managers – attempting to evaluate where a HF fund is in its life cycle and how the stage may impact the FOF’s investment (i.e., mature vs. decay). The life cycle concept applied to FOFs, should move investors away from looking for a particular number of underlying HFs and instead focus investors’ attention on how and why a particular number/range was chosen. In doing so, the investor will focus on whether there is a grounded investment philosophy and robust process to back up whatever the particular number/range that the FOF manager has identified.
Some FOFs have become infamous for their ‘portfolio drift’ (to put it nicely). As an example, take a successful FOF with several months of strong performance. Sales calls that have been in the works for months finally see a deluge of allocations and commitments. The money pours in and the FOF manager finds himself forced to allocate to new HF managers (all that promised capacity with existing HF managers seems to have disappeared overnight!), increasing the number of underlying funds within the FOF portfolio, and ultimately over-diversifying the portfolio. As it turns out, the growth in the FOF’s assets is often the primary reason the number of underlying HF managers ‘drifts’ significantly upward, often beyond the FOF’s stated investment philosophy.
Following such growth spurts, many FOFs have also needed to undergo a ‘strategic review’ (aka a portfolio restructuring). But, it can take years to move the needle reducing the number of underlying managers within a FOF portfolio, especially because HF investments can be so sticky – involving sensitive business relationships and lengthy time tables. At least when the going was good, many FOF managers were sensitive to their impact on an underlying managers business model, and their ability to potentially make or break a HF. For example, one FOF engaged in a ‘strategic review’ of its portfolio spent over two years moving the dial from 80 funds down to 50 funds. These major shifts in a FOF manager’s AUM and portfolio structure are a major distraction to an investment team and represent a subpar product to what the investor in the FOF has often been marketed.
By focusing on where a FOF is in its life cycle and how the number of underlying HF managers in its portfolio relates to its stated investment philosophy, process, and guidelines, an investor in FOFs can avoid allocating to a manager who is more focused on growing an asset base and identify those FOFs whose discipline process has been prioritized ahead of their growth.
Whether an investor is seeking a highly concentrated FOF hoping for higher returns or a extremely diversified FOFs wanting to minimize volatility, the investor needs to understand the FOFs own life cycle to ensure that the number of underlying HF managers has been consciously chosen, fits the FOFs stated investment process, and is not likely to change due to the FOF management’s growth objectives. In doing so, the investor can be count on having a more focused investment team, committed to managing the FOF portfolio under its stated investment philosophy. Such a team is more likely to produce the lower volatility and higher returns investors desire than any magical number of underlying HF managers will bring about on its own.