Funds of Hedge Funds

The best option in today's challenging environment

Originally published in the September 2008 issue

It is not the knowing that is difficult, but the doing.
– Chinese Proverb

Once in a while commentators turn on the funds of hedge funds industry by criticising performance and fees. And lately, the industry has also been competing with replication strategies offered by investment banks and market indices. Warren Buffet has bet US$1 million that the S&P 500 will outperform a given fund of funds over a decade. The winner will donate the stake to a charitable organisation. Buffet has attributed a 60% probability to his winning the bet. It is a wise but also a brave bet, given that the bet is placed in times of above average price/earnings ratios (even more so if adjusted for cyclicality of earnings). However, a decade is a fairly long time and a probability not too far from 50% is a reasonable bet.

We have witnessed, since the mid-80s, an incredible cycle of PE expansion, lately brought down by an exponential increase in earnings under strong emerging market growth. This cycle is about to take a long break. How long this state of slower growth will last will depend on many different dynamics in place (depth of the credit crunch, monetary and fiscal smoothing policies, emerging market demand, new equilibrium of energy prices). All the adjustments that have taken place, since the summer of 2007, are certainly here to stay and will give rise to a very different investment environment a few years from now. Investors have been used to ever-increasing equity prices in buy and hold mode. One should look at history and recall that prolonged periods of range-trading or bear markets are more the rule than the exception. A recent example has materialised in the Japanese equities and real estate markets, on a bearish/range-trading mode for the past two decades.

Energy prices have been the safe haven in 2008, until July. It is now clear that dollar depreciation and speculative money had more influence on oil prices than most people thought. Fundamentally, now that a litre of crude is again cheaper than a litre of Coca Cola, the pressure remains on the upside because of the long term constraint on supply, but in the short term it is more difficult to see what the price of energy will do. And what happens if we find a sustainable alternative in the meantime?

Funds of hedge funds: the long term decision
The credit crisis has already seen much of investors' equity wiped out and many hedge funds have shut up shop. In this current market environment now is the time to invest with a fund of hedge funds. By investing one's capital with a variety of managers, active in different strategies, having different opinions and different trading style, one is making a long term allocation decision which should bring absolute return in accordance with one's target.

Were we to compare industry performance with the market index, the investable HFRX Global Hedge Fund Index (July included) lost -3.8% YTD, while MSCI World lost -14.0% YTD. If we take a longer term view, since Jan 2000, the HFRX Index has returned a cumulative performance of +69.1%, while MSCI World has returned -1.3%. To be fair, if one had been able to time the market perfectly and invested in September 2002, the MSCI would have returned +64.5%, while the HFRX Index would have returned +32.9%. We don't pretend to be able to time the market and we always invest our portfolios so that we can protect our investors for the worst case scenario and profit from a positive environment, reaching our target in the long term. Whether we are out/under-performing a given index over a given period is fairly irrelevant to our investment process.

Are the fees justified?
In order to answer the question, let's see what alternatives investors have. First, investors could invest directly with hedge funds. Well, the question is one of a trade off. If an investor estimates the cost of conducting their own strategy and operational due diligence, monitoring their underlying investments, risk manage their portfolio and take care of the legal and operational aspects of investing and redeeming hedge funds to be lower than investing with a fund of funds, then they should invest directly.

On average, we believe that there are sufficient barriers to entry that justify the cost of investing with a fund of hedge funds rather than building one's own hedge fund team. Besides avoiding the associated direct cost, the investor gets access to a team of experienced professionals with extensive business contacts and industry knowledge, as well as risk management and operational capabilities and legal experience built over the years. We are confident that funds of funds will continue to attract investors for these reasons. But we are aware that the industry is witnessing a very difficult environment in 2008 and, given the operational cost of the business model, some consolidation is very likely, with the top 50 funds better positioned to attract institutional investors.

Avoid the road to replication
Second, investors could put their money with 'replication products' (offered since 2007 by various investment banks). Those replication models are more or less sophisticated, but are essentially linear factor models aiming to replicate the returns of an index by investing in a few investable factors that fit best to recent historical data. It is generally argued that their lower cost will give better performance over the long term and that they reduce single manager risk. There are different flaws in this theory.

First, alpha is simply the excess return over betagenerated return. Hence, a one-to-one relationship is not necessarily an indicator of skill. For example, looking back, cash has generated significant alpha over technology stock indices for 7 years and over Japanese stocks for 17 years, but cash is not skilled. Breaking down hedge fund investment to beta and alphaignores the reality of investing with hedge funds. But let us assume that there is a way to provide cheap hedge fund beta and beat funds of hedge funds indices. We are fortunate enough that the track record of those products goes back a few years for some and allows us to compare it to indices.

Generally speaking, over this period of a few years, based on gross performance publicly available and adding the average 1.5% pa. management fee for those products, net performance of replication products underperforms most of the global fund of funds on a net basis. The underperformance is even more pronounced in the difficult environment we have experienced this year.
So, clearly the second alternative does not seem to add value over the long term, after fees. And we did not take into account the bid/ask spread that an investor would have to pay on those products. So why have we seen such a push for these products from the investment banks? Because 1.5% management fee for a product which requires a monthly run of a linear regression model is a goldmine with a huge margin and a zero marginal cost.

Furthermore, investors could be lured into the idea that they will avoid single manager risk by investing with a replication product. That is wishful thinking. What happens in practice is that investors trade their exposure to a diversified portfolio of managers for one single manager, running a regression model based investment strategy. Hence, they are increasing their exposure to one single bank and its model.

In conclusion, we are aware that 2008 has been a very challenging period for asset managers in the hedge fund space and are satisfied that in such stress scenario we have been able to protect investors' capital. We expect to see further consolidation in the fund of funds industry with larger institutional players taking the lead.

However, given the complexity and uncertainty of the investment space we should see fund of funds vehicles as an excellent long term alternative for global asset allocators such as pension funds and institutional asset managers.

Simeon Stoitzev is Portfolio Manager, Harcourt Investment Consulting