Despite the disappointing hedge funds performance in 2005, the total number of hedge funds reached a record number of approximately 9,000 by year-end with a total of $1.1 trillion assets under management. Representing a stable share of approximately one-third of this amount, funds of hedge funds’ assets under management directly benefited from investors’ search for alpha and diversification and have showed strong growth figures over the last decade. In the last two years, there have been some interesting developments in the financial markets which have had a significant impact on hedge funds’ performance and which have raised questions among investors about the total return attribute of hedge funds. Starting with the General Motors credit crisis in May 2005, many credit arbitrage funds have been hit badly as a result, and some funds have closed after suffering large losses.

In most cases, these funds were using sophisticated models to implement correlation trades on structured finance products. In October 2005 and May 2006, the equity markets suffered losses and many long/short equity funds experienced significant drawdown; but, even more importantly, the benefits of diversification between hedge fund managers – or between hedge funds strategies themselves – did not materialise as promised, since the vast majority of them were producing negative returns.

As such, investors have understandably come to expect more of fund of hedge fund managers, on whom they rely to provide diversified access to absolute returns allocations. The capacity of funds of hedge funds to add value through efficient fund picking and strategy allocation apparently led to some outflows in the second half of 2005 for the first time in a decade. Funds of hedge funds now face increased competition and greater scrutiny from investors; also, they are increasingly constrained by limited capacities and the higher correlation of hedge funds. In this context, it is essential to isolate best practices that can enhance the capacity of funds of hedge funds to select funds and construct portfolios that will offer an attractive risk/return profile and give asset diversification benefits.

This report outlines the reasons why funds of hedge funds have been successful and details four key issues investors should investigate before investing in a fund of hedge funds: team experience, investment process, risk management and transparency.

How Funds of Hedge Funds Have Developed

Funds of hedge funds have developed very rapidly, with assets under management growing from $20bn in 1991 to $395bn by end-2005 according to Hedge Fund Research (“HFR”) (see Fig.1 Estimated Growth of Assets/Net Asset Flow Fund of Funds). The strong growth started at the beginning of 2000 in conjunction with the general success of hedge funds. This recent success is explained by the dramatic downturn in the equities markets after 10 years of exceptional returns and also by a shift from a mainly high net worth clients-oriented product to investment solutions targeting a broader range of clients, including institutional clients such as pension funds. Since 2002, funds of hedge funds’ assets under management have accounted for approximately one-third of direct hedge funds assets.

However, the second half of 2005 funds of funds’ industry figures showed net redemptions for the first time in nine years, mainly the result of investors being disappointed by the negative performance of the funds of hedge funds in May and October 2005. The sector’s continued success depends on its ability to deliver results which justify the additional fees charged for their services. This is all the more crucial as investors in funds of hedge funds tend generally still to be risk adverse and funds are rather liquid, compared with other alternative investments like real estate or private equity investments. Therefore, redemptions are easier and outflows can occur more quickly.

Growth Drivers

The private nature of hedge funds has made direct investment a cumbersome and challenging proposition since it often requires an understanding of sophisticated, often less transparent investment strategies, and gives limited accessibility to hedge fund investment opportunities. As such, many institutional investors have delegated investment in these vehicles to funds of hedge funds with the expectation that these pools of hedge funds are managed by professionals who are able to understand fund strategies, interview managers, fulfil operational due diligence requirements, develop the requisite portfolio risk management tools, and most importantly, achieve diversification objectives, both in terms of strategies and funds within the strategy.

All these functions require input from a number of specialised professionals. In traditional equity and fixed-income investment products, sufficient manager diversification can be achieved by investing with a relatively small number of managers which are well-known to the investor. However, with hedge fund investments, differences in performance from one fund to another can be very large, even within the same strategy, and blow ups (termination of a hedge fund with no cash back for the investor) can occur, which are rather exceptional in traditional mutual funds.

Therefore, to moderate performance volatility among individual funds and strategies, fund of hedge fund managers tout their access to hedge funds as their primary selling point, and their main means of diversifying away idiosyncratic risks. So once the extreme risk is properly mitigated through careful due diligence and monitoring (see below), diversification benefits can be gained in a more pronounced fashion in hedge funds than in more traditional asset classes.

Historicallly, there have been low correlations between hedge funds, and portfolio risk levels – as expressed by volatility, for example – drop significantly when alternative strategies and hedge funds are added to the fund of funds. Liquidity is another great advantage that funds of hedge funds can provide to investors. Many single hedge funds require a lock-up period of several months to be able to pursue a strategy on illiquid assets; however, this is an unacceptable length of time, even for a long-term investor. With a pool of investors and the use of more liquid funds like Commodity Trading Advisors (“CTA”) or managed accounts, funds of hedge funds managers can stagger and mutualise the liquidity needs and then offer weekly or monthlysubscription/redemption schedules. However, the liquidity risk remains and must be managed carefully by the asset manager (see Risk Management).

Another feature of the hedge funds sector is that the best managers tend to close access to their funds quickly, sometimes after less than one year. By pursuing a niche strategy with limited market capacity, these managers prefer to close the funds when they have raised the target capital amounts.Funds of hedge funds managers are used to “negotiating” capacity with the asset managers, thus giving investors access to funds they would not be able to source on their own.

Recent Trends

Allocating assets to diversified funds of hedge funds is typically the first stage for institutional investors. With enhanced knowledge, some of these investors move to more innovative solutions: mono-strategy funds, investable indices and single hedge funds with a multi-strategy approach.

A new type of product has emerged alongside traditional diversified funds of hedge funds: the mono-strategy fund. Mono-strategy funds give investors the opportunity to allocate their own assets and select different providers for different strategies. Another advantage is that investors can select the strategies that fit into their overall allocation. This is not possible with diversified funds of hedge funds where the portfolio manager can invest in a myriad strategies. Mono-strategy funds are also increasingly used by asset managers to create building blocks that can be assembled into tailor-made mandates and that also ease the allocation process.

HFR, Credit Suisse/Tremont and Morgan Stanley, among others, have noticed a growing appetite on the part of investors for their investable index products. Investors consider the lower fee structure and the high liquidity to be major advantages.

However the recent performance figures tend to bedisappointing. Some single hedge fund managers now provide investors with funds that incorporate multiple strategies. Some of these have over 100 investment professionals, cover broad investment strategies and compete directly with funds of hedge funds. They can show lower fees, have good knowledge of market drivers for efficient strategic allocation and have powerful risk management structures owing to the full access they have to their holdings. On the downside, risk concentration can be higher and if stringent risk management is not in place important losses can occur.

Fig.2 Top 10 Funds of Hedge Funds
FUNDS OF HEDGE FUNDS	AUM (USDBN) JUN 06
UBS Global Asset Management A&Q	37.72
Union Bancaire Privée	30.04
Permal Investment Manager	26.00
GAM Multi-Manager	25.76
HSBC Republic	25.21
Credit Suisse	20.00
RMF	19.20
Lyxor Asset Management	17.80
2Credit Agricole Asset Management Alt.	17.57
Inv.Grosvenor Capital Management	17.40

²Includes MSCI investable index assets
Source: InvestHedge

Primary Considerations When Selecting a Fund of Hedge Funds Manager

The benefits of having investment vehicles like funds of hedge funds, have been warmly welcomed by the investment community as evidenced by influx of capital over the last fiveyears. However, as a group, funds of hedge funds are facing increasing pressure to demonstrate their capabilities both pre- and post-investment.

The most notable differentiators among funds of hedge funds will centre on: investment team qualifications and experience, the quality and consistency of their investment process, the depth of their risk management practices and tools, and the level of transparency offered to investors.

Team Qualification/Experience

Staff qualifications, proficiency and experience is a key element when selecting a fund of hedge funds. The potential investment universe for hedge funds is broad and the financial instruments so sophisticated that effective investment in a hedge fund requires varied expertise.

A portfolio manager or an analyst cannot be an expert in US equity event-driven strategies as well as in emerging market debt arbitrage strategies. A long market experience within capital markets trading desks or in the hedge funds business is also beneficial: professionals who have experienced various crisis periods such as the 1994 interest rate shock, the 1997 Asian devaluation, the 1998 Russian debt default and the 2002 corporate credit spread widening are likely to take a more mature view on the potential downsides of a strategy. Also these qualifications will be decisive for the analyst during the limited period allowed for interviewing and challenging the hedge fund portfolio managers; he should certainly not be fooled by well designed marketing documents.

The top fund of funds investment firms typically employ sizeable teams of investment professionals and analysts to meet the manager’s due diligence/selection, portfolio management/monitoring, and investor communication/relations requirements as expected by institutional investors. Given these requirements, they closely watch the number of funds assigned to individual team members, to maximise their analysts’ understanding of individual funds and to maintain a close relationship with their stable of hedge fund managers.

An organisation that is dedicated to funds of hedge funds, as opposed to a company that just has a funds of hedge funds department, often invests in specialised staff and technology. As a company’s survival is dependent on the quality of its funds’ results, this ensures that management will focus strongly on delivering robust performance. Also, talented investment professionals are attracted by the possibility of an equity holding in the asset manager.

However, with increasing interest being shown by large institutional investors in funds of hedge funds, and with investors’ natural preference for well established asset managers, Fitch has observed that more and more traditional asset managers are developing their own alternative multi-management departments to meet demand. As this development is helping to drive better transparency in the hedge funds sector, the more successful firms will be those which give sufficient support to their multi-management teams and develop infrastructure.

In their rush to develop fund of hedge fund product offerings, some asset management companies have resorted to the use of less experienced staff members – even school leavers – with the result that the bulk of the investment decision-making falls on too small a number of senior team members. As market mechanisms and extreme market movements are not always quantifiable or rational, inexperienced staff are not as able as experienced members of staff to react quickly and anticipate strategies that may be at risk.

For example, convertible arbitrage was the strategy for overweighting for several years (1995-2002) until equity market volatility started to decrease and hedged convertible bonds positions began to lose value. Many multi-managers reacted slowly to this structural change, and only after performance had deteriorated significantly If a company’s track record is often a good way to assess the efficiency of its team, one should nevertheless be awareof the numerous hidden traps such as when the worst performing funds of a firm close and their track records disappear leaving only information about the better performing funds, or when an investment team leaves the company but its track record is perpetuated in databases.

It is therefore advisable to monitor turnover of the company’s investment professionals over the previous five-year period. A strong track recordcombined with low staff turnover is the best combination for an investor: it shows that management has been able to attract talented people and, more importantly, to keep them. It also indicates that the company is offering a competitive financial package and a working environment, which helps to retain qualified staff. Hedge funds investing is still a “people business”; as the degree of transparency is low, the manager’s experience and the quality of its relationship with investment banks, prime brokers and individual hedge funds are key to avoid the selection of inappropriate funds.

INVESTMENT PROCESS

Managing funds of hedge funds requires a rigorous and disciplined investment process. Hedge funds exhibit non-normal return distribution (they have fat tails distribution characteristics: i.e., a higher probability of large losses or gains) with significant potential to experience rapid losses, amplified bylimited liquidity. A disciplined investment process is therefore essential to avoid the numerous potential pitfalls. The primary indicator of the quality of the fund of fund manager’s investment process is its ability to clearly articulate its investment process, notwithstanding the use of proprietary models.

A manager should be able to clearly describe its investment process to investors. Without such a clear description the risk that a disciplined process may not exist becomes a very real possibility. Generally, the investment process in funds of hedge funds management can be broken up into threecomponent parts: strategic allocation, fund/manager selection and monitoring.

Strategic Allocation, Portfolio Construction

Market movements have different impacts on different strategies, even though many strategies were positively correlated during the last equity market downturn in May 2006 (with the exception of short-selling and CTA strategies). Diversification in strategies is thus key to improving the risk/returnprofile of funds of hedge funds; however, there are large differences between managers in terms of the weighting of various strategies and their management of strategy allocation. Some asset managers do not claim to be able to enhance returns through tactical allocation. By contrast, others believe they can add value by overweighting/underweighting strategies that are likely to perform/under-perform in the future. To achieve performing active asset allocation, the asset manager must first have a clear understanding of the various market factors that can impact each strategy.

Investors, who for the most part delegate such analysis/decisions to the manager, will want to know that allocation decisions will be based on defined objectives and detailed market analysis. Alongside qualitative considerations, some of the stronger managers have developed thorough quantitative techniques. For example, a well recognised fund of hedge funds manager has identified eight market drivers for convertible arbitrage performance. A score is then attributed to each of them to predict the strategy’s performance.

This means that, as a prerequisite, strategies must be clearly and unambiguously defined and hedge funds allocated to the correct strategy. Most funds of funds have defined categories, sometimes with up to three levels, and their statistical database is populated with a proprietary nomenclature. The predicted market factors are then used to help define the weighting for each strategy. As noted earlier, some asset managers have chosen to create building blocks, in the form of mono-strategy funds, to ease the portfolio’s construction and moreactively change the weighting of the various strategies in the client portfolio. Funds of hedge funds should not be considered as an asset class by itself as strategic allocation can be very different between the various players, thus creating very different risk/return profiles.

Fund/Manager Selection

Fund/Manager SelectionFund research is at the heart of hedge funds’ multimanagement process. Before analysing a hedge fund it is important to 1) have knowledge of its existence, 2) to have access to it, and 3) to have sufficient capacity to invest in it. Operating experience within the industry is essential for hedge funds managers to be considered a trusted partner. A long history helps to build relationships and leads to good “deal sourcing” which smoothes access to most promising new hedge funds.

Established networks and a local presence are important requirements for a hedge fund manager to be able to gain access to the better hedge fund opportunities. As proximity to hedge funds managers is of paramount importance to funds of hedge funds, some managers have decided to invest only in hedge funds with a particular focus(type of strategy, location, regulatory status). Previous traders or managers from banks’ proprietary desks or well established hedge fundsoften create their own hedge funds. Funds of hedge funds managers who know these professionals very well can then invest in their new funds without having to wait two or three years for the hedge fund to appear on everyone’s radar screen as one of the better-performing funds.

Once a potential hedge fund manager is identified, a thorough analysis of the fund is necessary if it is to be included. Some asset managers perform two different investigations by two different portfolio managers or analysts in order to compare and challenge results and opinions. In any case, due diligence reports must be comprehensive and call reports (i.e., reports conducted by phone or direct contact with the hedge fund portfolio manager) should be systematically recorded and include information beyond what is usually available in the hedge fund’s monthly report. A scoring process is an efficient method of formalising hedge funds analysis and keeping track of the strengths and weaknesses of each; it also provides a common framework for analysts to express their views on the managers they cover. In any event, the strategy and performance drivers must be understood to guard against surprises occurring when net asset values (“NAV”) are communicated.

Often the investment process includes an investment committee made up of senior management and analysts to decide on the addition of a fund and the size of the investment. This committee stage is important as it forces the people in charge of the due diligence to express and formalise their views in a structured manner with quantitative and qualitative arguments. Generally, it is preferable that a collegial decision-making framework is employed. This draws on the expertise and knowledge of available multiple resources, as analysts may, on their own, develop some bias after working for a long time on a particular fund.

Quantitative techniques can also be useful to scrutinise the hedge funds universe and help identify interesting candidates for the portfolio. However, it is not easy to distinguish between the alpha and the beta, especially as statistical models are difficult to run with weekly NAVs and almost impossible with monthly NAVs, which is often the case. Also, the lack of any track record often prevents analysts from carrying out any analysis.

This leads to the development of proprietary databases filled with self-reported data. Despite this limitation, prudent use of such information can be useful in better understanding a fund’s characteristics. However, significant investment in technology and human resources is required if a manager is to be able to conduct effective independent performance tracking and monitoring of hedge funds. For example, Fitch has noted that some of the stronger managers are using techniques such as multiple factor regressions analysis as a means of detecting the level of sensitivity to various factors including commodities, and yield curve slope or foreign exchange rate volatility to support the fund selection process and as an ongoing risk management tool (see below).

Monitoring and Reaction

Along with the deteriorating performance (lower alpha) of underlying hedge funds, one of the major risks when managing a portfolio of hedge funds is a fund’s “style drift”. This is the effect on the fund of a change of strategy, the use of more leverage (higher beta) or a change in the investment universe (without notice). This can have a considerable impact on the fund of hedge funds. It can alter the fund’s performance but also create an imbalance in the asset allocation strategy chosen by the asset manager, thus distorting the risk profile the manager has tried to establish. To prevent this, a robust fund monitoring procedure must be in place.

This would include quantitative tools and regular contact with the various hedge fund managers. Quantitative techniques can be broken down into two categories.

The first one is a return-based method that allows the “profiling” of hedge funds based on previous NAVs. It tries to identify market factors that statistically impact the fund’s performance. The second is based on the holdings analysis or sensitivities analysis provided in the hedge fund reports. This allows the fund of funds manager to estimate the hedge fund’s performance once the identified market factors’ performance is known.

Models vary from a very simple model using a single simple factor like an equity index to a more sophisticated multi-factor model, with factors such as the performance difference between growth and value stocks or a foreign exchange options-implied volatility rate of change.

However, even the most sophisticated model will not replace human supervision. Continuous monitoring of the hedge fund behaviour using reporting and contact with the portfolio manager cannot be avoided. The ideal situation would be to have access to the hedge fund positions. This can be done through managed accounts but is complex and costly, and generally only the larger fund of fund complexes offer separately managed accounts.

A compromise solution is to have access to the position through the funds manager’s or the administrator’s reports. This has to be negotiated before the investment as hedge fund managers are often not keen on disclosing their current trades. Some managers may agree to send a report delayed by one or two months to avoid the publication of their funds’ latest strategies. Even though it may not be based on the most up-to-date data, having access to the position allows the fund of funds managers to monitor what the hedge fund portfolio manager is doing and to compute relevant risk indicators (see Risk Management).

Managed Accounts

Various types of managed accounts exist but the principle is the same for all. The hedge fund manager operates a dedicated account held in an independent custodian bank chosen by the fund of funds manager. It provides full transparency on transactions and positions to the manager, thus allowing advanced risk monitoring, better liquidity and a secure environment, as the fund’s holdings can be ascertained very quickly. It is also a very efficient solution to mitigate operational risks such as misrepresentation and misappropriation. However, not all managers offer managed accounts solutions and below a certain amount in assets under management, it may prove too costly.

RISK MANAGEMENT

Risk management in the context of funds of funds requires focus on investment risk and operational risk, both at the fund level and at the fund of fund level, and continuous assessment of portfolio level risk measurement and monitoring.

Operational Due Diligence

This is part of the investment process but is often separated from the investment review and performed by dedicated analysts. It consists of an assessment of the risks associated with supporting the operating environment of the fund (i.e., trade processing, administration, valuation, personal trading compliance rules and reporting). This phase of the investment process is often allocated the least resources, time and attention. As hedge funds managers typically are small unregulated firms the need to get comfortable with the organization’s operational infrastructure is magnified.

As recent history has shown, the calibre of other investors in the fund cannot serve as a substitute for independent assessment. Sometimes, due to time constraints, multi-managers are tempted to skimp or even skip this necessary step before investing. The operational risk of hedge funds for fund of hedge fund management is conceptually similar to the default risk on credit portfolio management. A fund of hedge fund track record with low volatility objectives can be severely affected in one day by a “blow up” in the portfolio.

Fund Level Risk Management

As mentioned previously, detecting the fund manager’s style drift is of paramount importance as the targeted allocation equilibrium can quickly change. Some major players have implemented a managed-accounts structure. This enables them to follow daily transactions and positions but more interestingly to consolidate positions between funds and compute daily basis risk indicators like value at risk (“VaR”) on the global portfolio. Without managed accounts, evaluating the market risks of the various funds and computing a consolidated risk statement can become very challenging. Some asset managers decided to ask for standardised monthly risk reports which include information on the main positions, greeks indicators (delta, vega and gamma options-based related-instruments indicators) and other sensitivity indicators like DV01 (exposure to interest rate market movement) or CD01 (exposure to spread market movement), for example. This is valuable information but aggregating this information for the whole portfolio is often generally challenging. Most indicators, like VaR or volatility, for example, are not additive.

Fund of Funds Level Risk Management

Diversification is a major benefit that funds of hedge funds managers can provide to investors. However, this needs to be measured by appropriate tools as hedge funds returns exhibit non-normal distribution. Techniques like VaR using Monte Carlo simulation can help the manager to select the most appropriate funds to improve the risk/return profile of its fund.

Also it is very useful to monitor how the fund of funds will react in a crisis situation. This can include simulated scenarios such as a 20% equity markets drawdown or an historical crisis applied to the current portfolio like October 1987’s Black Monday, the Asian crisis of 1997 or the Russian crisis of 1998.IT systems in hedge funds risk management are of paramount importance and require technical and human resources. Data is also crucial as well, as unlike traditional asset classes there is no Bloomberg or equivalent system to download reliable historical information.

Liquidity

Single hedge funds are often invested in non-liquid financial assets like over-the-counter products or emerging markets’ small cap stocks to take advantage of inefficiencies in recently developed markets and arbitrage securities that do not trade actively, thus such hedge funds are highly vulnerable to price volatility. The underlying assets’ liquidity coupled with the need to preserve a stable (or growing) asset base justify the setting up of a lockup period and notice period.

However, for funds of hedge funds managers, this creates an asset/liability mismatch between the subscription/redemption notice period available to their investors and the usually longer period for which they are invested in theunderlying funds.

Managers need to closely monitor this liquidity issue to avoid sustained imbalances. Robust and automated tools need to be implemented to provide the asset manager with information on stress scenario situations that can occur if investors redeem their cash en masse.

Also, they need to pay particular attention to the liquidity of the underlying funds itself, ensure the percentage of the fund they hold is not too large so they can redeem their shares without pricing impact or limitation, and also check that no investor owns too large a percentage of the fund. Transparency on a hedge fund’s position (i.e., where there is access to the hedge fund portfolio holdings information) will prove to be very useful to compute, for example, the average number of days required to sell shares of the portfolio (10%, 20%, 50%) based on the average daily volume of each security in the portfolio. It is then possible to check if the hedge fund is able to handle the notice period it offers to investors. A hedge fund offering a one-week notice period is at risk if as little as 5% of the fund can be liquidated in a single week.

REPORTING AND TRANSPARENCY

Public information about hedge funds is scarce; even for fund of funds investors. Although the quality of information available is improving, gaining access to relevant and timely information is still a continuing challenge for investors.

Standard information is usually available in monthly reports: for example, on performance, broad asset allocation and the performance of each asset class. In addition, more institutional investors now have access to information regarding leverage, the performance of each underlying fund, the fee structure of the underlying funds, new transactions, VaR, sensitivity analysis and stress test scenario analysis. These trends certainly help to build confidence among investors, especially when accompanied with qualitative information and basic allocation figures. Also, performance fee calculations are not always easy to follow. High watermark, hurdle rate and equalisation fees can be confusing. Examples should be provided to illustrate how performance fees are calculated under different scenarios.

Sometimes, the asset manager can even start to charge performance fees based on the absolute return rather than on its excess return above cash rate. Regardless of the fee structure, investors should insist on unambiguous disclosure.

Indices

Another reporting issue is the difficulty experienced in finding a reliable and representative reference index to evaluate the performance delivered. Hedge fund indices are often criticised by funds of hedge funds managers as they have found them to be unrepresentative of the real world. The main argument against indices is that they contain closed hedge funds managers that cannot be accessed (part of the definition of an index is that it should be investable). Another valid argument is that index performances differ widely from one provider to another (see the Hedge Funds Indices Performance2003-2006 chart). Between CREDIT SUISSE/TREMONT, MSCI and HFR, to name three major ones.

Another problem in evaluating funds of funds’ historical performance using indices is in the index construction process itself: it overstates returns because of survivorship (remaining funds in the index are the best performing ones) and backfilling biases (some indices include past performances of newly included hedge funds and adjust back index performance history).

Several studies have tried to estimate the bias in performance: Brown, Goetzmann and Ibbotson (1999) found an annual 3% bias only due to survivorship bias; Fung and Hsieh (2000) detected a 1.4% bias due to backfilling. The results of the recently launched investable indices showed dramatically lower performances than the main index of the same provider which tend to give credits to the academic research (see the Hedge Funds Indices Performance 2003-2006 chart). Funds of hedge funds can be tempted to compare their performances with these investable indexes.

However this would not be sufficient as funds of hedge funds should compare their performances to a representative index including major players and not to a restricted universe benchmark. Despite improvements in funds index transparency, some funds of hedge funds managers have decided to create their own indices. This could be a viable solution but it requires rigorous construction (by an independent committee and external experts) and also further transparency if it is to satisfy investors.

Another alternative solution to compare performances is to provide, in addition to the hedge funds indices, a composite index such as 50% equityindex + 50% bond index for a diversified fund of funds or an equity index for a long/short equity mono-strategy fund of funds, for example. THFJ