It is clear that 2008 marked a very difficult year for the hedge fund industry, particularly for funds of hedge funds. It caused them to lose 30% of their asset base after posting losses of 16%, on average. Despite the stellar recovery in hedge fund performance during 2009, which resulted in a steady stream of assets flowing into single manager funds from the beginning of the third quarter, funds of funds were mainly ignored by investors. Funds of funds now account for about one third of hedge fund assets after topping out at nearly 50% of industry AUM in 2007. Worst hit were some formerly renowned big fund of fund operators which saw assets tumble after they disclosed exposure to Madoff. In some senses, the fund of fund model seemed to be broken as some definitely failed on their due diligence responsibilities. However, since Madoff, all hedge fund investors have increased due diligence efforts dramatically to avoid being ensnared in another fraud.

Another difficult topic in the aftermath of the liquidity crisis in 2008 is the possible liquidity mismatch inherent in some fund of fund structures. Fund of funds that offer their investors monthly redemptions, clearly could face a liquidity problem, as most of them are invested in less liquid hedge funds which are subject to liquidity constraints or even lock-up provisions. It is especially true for multi-strategy funds of funds, which are more exposed to liquidity risk as they normally invest a bigger part of the portfolio in less liquid hedge fund strategies like distressed securities. There are several ways to deal with liquidity mismatches, including having a short term borrowing facility in place, imposing gates or even having a side pocket provision in the prospectus. As the events of 2008 clearly show, some market participants were unaware of the liquidity mismatch since some funds were wound down for that reason.

The lesson investors should have learned is that they need to monitor the underlying fund liquidity more closely and request more transparency on the liquidity structure of the fund of funds they invest in. Going into the second half of 2010, after a strong hedge fund performance in 2009, the performance of funds of funds in the 12 months to April was almost 40% below single hedge funds based on industry-recognized hedge fund index providers. Broadly speaking, multi-strategy fund of funds lagged single managers by around seven percentage points to the end of the first quarter of 2010.

Given the asset/liability mismatch experience of 2008, a simple explanation for the gap might be that most fund of fund managers are still conservatively positioned and, therefore, holding a higher level of cash. The magnitude of the performance gap between funds of funds and single manger hedge fund benchmark indices – by a ratio of 1.0 to 1.5 – would imply that the former held roughly 30% cash since most have yet to regain high water marks. However, the fundamentals of that argument are easily disproved by a glance at the current holdings of various funds of funds, which certainly reveal a higher cash balance than during the years before October 2008 – but nowhere near enough to explain the performance gap. A more realistic explanation is that funds of funds are still entrenched in some illiquid and underperforming hedge fund side-pocket investments, which, due to the numerous hedge fund restructurings, are in most cases no longer reported to the databases.

Sources of Value Added
In the aftermath of the 2008 turbulence and the disappointing performance of 2009 investors are highly critical of the double-fee structure and are revisiting the question of what value is added by fund of fund managers. A look at the typical investment process of a fund of funds suggests that there are several areas where a fund of fund manager can add value. Basically, the manager should have access to top performing and closed hedge funds, or at least to performance data and a network of good performing hedge funds. The next step is to offer thorough due diligence – quantitative and qualitative, as well as an operational due diligence – on interesting hedge funds. The actual investment decision is carried out in three interconnected steps: manager selection, portfolio construction (diversification) and monitoring the portfolio.

In summary, performance can be attributed to two distinct investment decisions made by the fund of fund manager: the asset allocation between different hedge fund strategies and the selection of individual hedge fund managers. Furthermore, the asset allocation decisions can be differentiated between strategic and tactical decisions, where the former is the long-term hedge fund strategy allocation and the latter is more short-term oriented. Those considerations leave us with three distinct sources of value added: manager selection (MS), tactical asset allocation and the strategic asset allocation. By using endogenous benchmarks for the two asset allocation decisions – and an exogenous benchmark in the form of a broad fund of funds index – the fund’s outperformance can be split between the three value added components.

Determinants of performance
For reporting results on our value added approach, we analyze a sample of 757 multi-strategy, USD denominated offshore funds of hedge funds. The sample included 325 “dead funds”, which stopped reporting to Eurekahedge during the sample period from January 1990 until March 2010.

Simply regressing the funds’ return against the return series of the endogenous benchmarks, for the strategic strategy allocation, reveals how much of the variation in fund returns over time is explained by the strategic benchmark. The R² values of these regressions quantify the explanatory power and on average, the strategic strategy allocation explains only 56% of fund of fund return variability. When looking at the absolute average return contributions from the three value added sources, the picture gets much clearer. The biggest value added contributor in absolute terms is the strategic strategy allocation decision at almost 21 basis points on average per month, with almost 12% of the analyzed funds destroying value through their long term strategy calls. The tactical strategy allocating decision contributes just 3 bps on average per month, with 35% of the analyzed funds destroying value through shorter term strategy rebalancing. The most startling finding is that only 15% of the analyzed funds really added value in their core discipline “Manager Selection”.

Little wonder, then, that the average value destroyed by manager selection is almost 28 bps per month over the lifetime of the analyzed funds. Fig.1 displays a cross sectional snapshot of the 12 month average monthly value added from manager selection. Historically just under one third of the cohort of funds of funds have added value by selecting excellent performing hedge funds. Yet over the last year almost all FoHFs drifted into negative territory. In our view this is mainly due to the overstatement of hedge fund performance by single hedge fund indices, which seldom include the underperforming side pockets. Moreover, the dispersion of absolute value added from manager selection has dramatically increased since September 2008, when the liquidity crisis unfolded (as displayed on the chart). Regressing the average monthly returns of the fund of funds against the average of their monthly value added components, illuminates the sources of cross-sectional dispersion between fund of funds performance.

Neither the strategic nor the tactical asset allocation decisions account for the differentials, judging by the low coefficients of determination for the relevant regressions (the R² metric for strategic asset allocation is negligibly below 1% and even the figure for tactical asset allocation is far from statistically significant at 10%). However, the high coefficient of determination obtained from the regression with the value added from manager selection – as high as 65% — clearly suggests that the differences in performance between funds of funds are mainly due to manager selection skills. This result is not surprising in light of Fig.2, which confirms that the range of fund of funds value added through manager selection appears to be significantly higher than from asset allocation (i.e., standard deviation of 0.48% versus 0.10% for the tactical and 0.24% for the strategic value added).

However, despite the fact that most fund of funds appear to destroy value with manager selection, we can conclude that value added through manager selection is a good discriminating factor. Furthermore, given the high volatility of the value added from manager selection and the high cross-sectional dispersion a risk adjustment process seems to be essential. Actually, rankings of funds of funds based on the risk adjusted value added from manager selection are much more stable over time and have more predictive power than rankings based on the absolute value added (see Fig.3). Another fundamental advantage of the value added from manager selection is its low correlation with the Sharpe ratio or more sophisticated risk adjusted measures such as the Sortino ratio or Omega ratio. These two advantages combine to demonstrate that a rating based on the value added from manager selection provides investors a unique tool for selecting promising funds of funds – or for monitoring their current fund of funds investments.