Academics and researchers who study the hedge fund industry sometimes say that the best way to gauge the average performance of hedge funds is to look at an index of funds of funds (FoFs), not an index of hedge funds themselves. The funds of funds, the argument goes, contain many funds that do not report to any databases – and would therefore be missed by indexes of single hedge funds. In addition, an index of funds of funds is more diversified and is therefore a better representation of so-called “hedge fund beta.”
The HFRI Composite routinely shellacked the FoF Index in the 1990s. But since the turn of the century, the FoF index has generally exhibited performance that resembled the broader indexes – with lower volatility…
While it may not look like it due to the absolute performance disparity between the two indexes, the FoF Index actually has a high correlation to the Composite Index…
So in a sense, the HFRI FoF is a deleveraged version of the Composite Index. Or, put another way: a portfolio containing roughly 66% Composite Index and 33% cash.
This tight relationship held up until last year when the HFRI FoF underperformed the HFRI Composite Index by a whopping 8.5%, even higher than 2003’s 7.9% under-performance (note that 2003, like 2009, was another barn-burner for the Composite Index.)
So what happened? Theories abound. Author and industry commentator Cathleen Rittereiser recently told Dow Jones:
“Arguably, funds of funds, could and should have reinvested their cash in hedge funds a lot earlier, especially if anecdotes are true that every fund in creation was open.”
Rittereiser is reflecting a common view of last year’s FoF under-performance – that funds of funds were sitting on mattresses full of cash they hoarded in case of massive withdrawals. This cash cushion apparently came back to haunt them.
A new study from Fitch Ratings backs up this hypothesis. The following chart from the firm’s recent Q1, 2010 Quarterly Hedge Fund Report shows that funds of funds actually performed in line with single hedge funds on a risk-adjusted basis. (If you draw a Capital Market Line between the HFRI Composite (green triangle) and, say, a 2% risk free rate, the FoF index isn’t really that far below it). (Click to enlarge chart)
Some say it wasn’t the mattresses full of cash that were the problems for FoFs, it was their return-chasing (or “safety-chasing”) behaviour. After watching global macro stay afloat in a stormy 2008, funds may have sought refuge in the strategy. Kristoffer Houlihan, Director of Risk Management at PAAMCO told the FT as much recently. According to the FT:
“…some managers sought refuge in global macro, a generally conservative, steady strategy. In 2008, global macro funds were off only fractionally, beating the industry average by more than 20 percentage points. This year, as of November, global macro has registered gains just north of 8 per cent, trailing the industry by 13.5 percentage points. The strategy delivered absolute returns, but in the context of the 2009 bull market its performance looked sluggish.”
Whatever the reason for last year’s anomaly, it will be very interesting to see if fund of funds indexes come back in line in 2010. Things are off to a good start. The difference between the HFRI Composite and the HFRI FoF Index in January: 1 bp.