One of the central value propositions of a fund of hedge funds is its ability to diversify among the notoriously idiosyncratic risks of single manager hedge funds. So you’d think a portfolio of funds of funds would ultimately perform akin to a portfolio of all hedge funds. But as we noted in February, 2009 saw a major divergence between funds of funds indices and single manager indices. We wondered what would have caused this. There were several theories.
Most theories rested on the assumption that the kinds of funds in which FoF’s invest are fundamentally different than the average hedge fund. A paper originally written prior to 2009 offers some tantalizing clues about the kinds of funds that FoF managers seek out. “A Random Walk by Funds of Funds Manager?” was originally written in late 2008 by Frans De Roon, Jenke ter Horst and Jingqiang Guo of Tilburg University in the Netherlands. But the paper hit our radar screens when it was updated a few months ago, containing data up to May 2009.
Like the recent paper we covered that compared quant managers to “qual(itative)” managers, this one compares funds that count FoFs as clients to funds with no FoF’s as clients. Here’s a quick snap-shot of the notable differences in our view (all tables below were re-created from data in the paper):
As you can see, funds with FoF investors tend to be larger and older, they are more likely to be closed, they have higher minimums and apparently, they also perform better.
This seems to match expectation. Funds of funds, after all, are tasked with finding the best managers – and they rarely like to be a large part of a tiny fund.
But there were some interesting, counter-intuitive findings too. Funds with fund of funds investors also tended to be less likely to be SEC registered. In addition, their portfolio turnover was lower (we’re not sure what to make of that).
Funds with FoF investors also tended to use less ubiquitous strategies (below). This made sense to use since funds of funds are often on the lookout for unique sources of alpha. “Unique” is often not a word used to describe long/short equity. In addition, long/short equity managers tend to have a variable bias, making net exposure management tougher at the fund of funds level.
Things get a little weird when you compare the liquidity terms of funds with FoF investors to those without FoF investors. Despite all the griping from funds of funds about the liquidity terms of their underlying managers, funds with FoF investors actually seem to have slightly worse liquidity (below). (Although both groups seem to have pretty similar advance notice periods and initial lock-ups.)
Finally, again despite the supposed negotiating power of FoFs, funds with FoF investors had roughly the same fees as those with no FoF investors (although they did tend to have more high water marks).
With so much of the hedge fund industry’s asset flowing in (still) through funds of funds, this paper is worth checking out – especially if you are a single-manager fund looking to get your share of FoF assets.
But curiously, the conclusion that funds of funds have skill in finding higher-information-ratio managers seems to conflict with the reality of their under-performance in 2009. It would be interesting to see how 2009 data might have changed the outcome of this analysis…