In the third quarter edition of the S&P Funds of Alternative Investment Funds Rating Directory the agency has again reviewed all the funds of hedge funds it rates. This has enabled better comparison of FOHF performance records. S&P continues to look at FOHFs against their own objectives, but many have been thrown off course since 2008, and therefore it has been necessary to take a closer look at FOHFs’ performance relative to other funds with a similar approach and strategy mix.

Our review covers 2010 and the first quarter of 2011. During these periods the average funds of hedge funds returned about 5% and 1% respectively. Aggregate funds under management have increased during the past 12 months to around $970 billion at end-March 2011, partly due to generating positive returns over the period and to very modest net inflows.

In general, the picture on assets under management is disappointing when viewed against a much more robust recovery in funds under management at the underlying hedge fund level. HFN estimates AUM in hedge funds rose to $2,552 billion at end-March 2011 (up over 3% from end-December 2010).

Over the past 12 months, growth in funds under management aggregate hedge funds has been more than double the growth in FOHFs. Total hedge funds under management are estimated by HFN to be just 15% below their all time peak, whereas aggregate funds under management for FOHFs is around 40% below the peak. The main reason for this divergence is that institutional investors are increasingly favouring direct investment.

Diversification benefits remain
FOHFs remain tarnished by their struggle to meet investor redemptions in the second half of 2008 into 2009, and by the mistake of a minority who were exposed to Madoff. Alpha generation has also been disappointing in recent years, and we have watched the number of rateable FOHFs decline significantly.

This raises the question of whether the FOHF model is flawed. We still think that the FOHF model has a role for investors. At its most basic, the model is all about diversification: diversification by strategy and by manager, as well as by security, sector, geography and so on. That is supported by a huge amount of theory and evidence that having a diverse mix of investments gives a better risk/reward profile.

The problem is the additional layer of fees, which eats up some of the diversification benefit. Larger institutions have sufficient funds under management to create portfolio diversification directly. Therefore, in the absence of meaningful added value beyond the diversification benefit (HFN estimated in December 2010 that FOHFs were trailing the average hedge fund by almost 4% in 2010), institutions have concluded that they can do just as well themselves. Moreover, with relatively stable and secure cashflows they may be better placed than a FOHF manager to deal with the liquidity terms of hedge funds. However, the diversification benefits would seem to be of value to smaller institutions and private individuals. So far though, the relatively high minimum investment thresholds of many FOHFs appear to have discouraged smaller investors.

Encouragingly, some groups have been thinking about the changing needs of the market place. One of the leaders in this has been HDF, which has spent the last six months upgrading its systems to cope with more customised mandates and reducing minimum investment sizes from €100 million down to €30-40 million (to capture additional smaller investors). Permal has also done a lot of work switching its portfolios into separately managed accounts. HDF’s new CEO, Pierre Lenders, believes that information technology will be a key competitive advantage for the group.

The launch of UCITS-compliant funds of funds should also be a way of getting more interest from smaller institutions and private individuals, given typically smaller minimum dealing sizes. UCITS regulation generally limits the portfolios of the underlying funds to liquid instruments, which has more appeal for retail investors. However, the price of excluding less liquid instruments is that some hedge fund strategies are difficult to replicate in UCITS form. This limits the choice of hedge fund strategies outside of basic long/short equity hedge and global macro. So far, the returns achieved by UCITS-compliant funds of funds have been disappointing.

Stock-specific funds will do better
In 2010 the average return of FOHFs was generally held back by disappointing returns on low beta long/short equity hedge funds. In contrast long-biased equity hedge funds performed well. Directional and flexible beta equity hedge funds had a very strong fourth quarter, and for many funds of long/short equity hedge funds September 2010 was the best month in the past five years. This was largely attributable to the unseasonal strength in the underlying equity market. Elsewhere, the returns of most other hedge fund strategies were satisfactory. Many of the managers we interviewed expect a pick-up in stock dispersion to lead to better alpha generation by managers. Somewhat ironically, many of the FOHF managers who said this have been reducing exposure to low beta/market neutral equity hedge fund managers and reinvesting into those that apply a flexible beta policy. For example, GAM, HDF and Olympia, which advises the SAAF I CH Diversified Alpha Fund, have been adding flexible beta equity hedge fund managers to their portfolios. However, Acropolis is looking to add bottom-up long/short equity hedge funds to its portfolios based on Cameron Chartouni’s expectation of greater dispersion between stocks.

Team rationalisation
Against the background of a weak recovery in funds under management we have seen some team rationalisations at groups such as GAM and HDF, which have made savings in their investment teams. In contrast, risk management capabilities have been maintained and in some cases enhanced. For example, Notz Stucki appointed two experienced operational risk managers last year. They work alongside Mirabaud’s operational risk manager, performing due diligence on fund proposals for the portfolio of Haussmann Holdings. Clearview also appointed two new investment professionals to reinforce the operational due diligence and IT systems applied to the Argenta Offshore Fund.

Fund management ratings process

S&P’s Fund Management Ratings are based on an evaluation of quantitative (historic performance, volatility, and portfolio construction) and qualitative (management team, corporate status and investment process) factors that contribute to long-term performance. In S&P’s opinion, long-only funds that adhere to disciplined processes and exhibit strong management are more likely, over the long run, to provide consistent, above-average returns relative to other funds in the same sector. For a fund of hedge funds, the same qualities are more likely to lead to the fund meeting or exceeding its risk/reward objective. The differentiation in the rating categories is based on S&P’s qualitative assessment of the investment process, management and performance record.

The starting point for a rating is an initial quantitative screen based on performance data obtained from Lipper Inc or elsewhere. For long only funds, discrete annual performance comparisons are made, as opposed to cumulative returns over a three-year period. Relative performance of funds within each sector is ranked by decile. This quantitative screen captures approximately the top 20% of funds in each sector, depending on the size of the sector. For funds of hedge funds, the screen is based on the fund’s risk/reward objective.