The Case for Funds of Hedge Funds

Why institutional investors should still consider them

PATRICK GHALI, MANAGING PARTNER AND CO-FOUNDER, SUSSEX PARTNERS

Funds of hedge funds (FoFs) were once a significant way for investors to gain access to hedge funds, but since 2008 their reputation has suffered, their total assets and market share have shrunk (there were 30% fewer FoFs in 2014 than in 2007, representing approximately 14% of overall hedge fund assets as of Q3 2015 versus approximately 36% in 2007), and many of the better known ones have disappeared or have had to merge in order to survive.

In the aftermath of 2008, many investors have decided that they would directly invest into single-manager hedge funds instead, and that the services offered by funds of funds were no longer of use to them. The mere mention of funds of funds with investors these days can lead to raised eyebrows and questioning looks. After all, why would anybody suggest employing an investment strategy that charges an extra layer of fees, and that by and large has underperformed over the past few years?

A superficial analysis of the topic may well lead investors to such a conclusion. However, we strongly feel that funds of funds can still be an extremely valuable tool for investors, and that the right ones still very much deserve a place in investors’ portfolios. Therefore, in order to arrive at a meaningful conclusion, we need to examine not just the different potential benefits that a FoFs approach may yield, but to also to take a very close look at the cost side of the equation, one of the main criticisms levelled against FoFs.1

To build or buy?  
Let’s start with the fee criticism and the perceived double layer of fees. The argument here is that by levying additional management and/or performance fees on top of the fees already charged by underlying hedge funds, the final product ends up with a very high total expense ratio, which may mean that little could be left over in terms of net performance or added value for investors. Though this may be the case for some funds of funds, especially those investing in managers that are already well known to many hedge fund investors, with arguably little added value coming from their research process, it isn’t necessarily true for all. Many funds of funds actively apply their own macro view, employ a thematic approach, a geographic focus or actively trade the managers in their underlying portfolios, thus offering additional benefits and expertise beyond simply picking easily accessed and well-known hedge funds. Therefore, investors need to look at different aspects of this cost argument, each of which we feel it is important to discuss in more detail.

One obvious consideration, though often underappreciated, and in our experience rarely properly simulated and budgeted for by investors, is the cost of setting up an equivalent team in-house. This analysis must inevitably also include all the human resources and management-related ramifications this may have on an organisation.

Setting up an in-house team not only entails significant legal and compliance costs and the need to create customised risk and reporting systems, but of course also the cost of the portfolio manager, the supporting analysts, and the challenge of attracting, and retaining, the best talent for each of these positions (something which will be rather difficult for smaller or lesser known investors to achieve). This in and of itself may be a task of Herculean proportions. In addition, there are also ongoing travel and due diligence expenses incurred by continuously meeting with existing managers in the portfolio, as well as new potential additions, a process which is never finished. These recurring costs rapidly add up to significant levels which means that, for those investors looking to allocate across multiple asset classes and geographies, this can quickly become a logistical and intellectual challenge, further multiplying the complexity and cost of managing portfolios cost-efficiently.

Depending on the location of the investor, and taking into account associated as well as direct costs, a properly resourced in-house team can easily cost $1 million a year, but will likely exceed that amount significantly, without any guarantee of performance – let alone outperformance – versus a benchmark or peers. This alone means that for any investor unwilling or unable to allocate at least $100 million to a hedge fund portfolio, the economics of setting up an in-house team will likely be significantly worse than employing a fund of funds. Having a team in-house also means that in the event things don’t work out as initially planned, the decision to terminate an underperforming manager not only has HR ramifications, which may be expensive and cumbersome, but it is also most certainly going to take significantly longer than the one to three months’ notice period for redemptions offered by funds of funds to their investors.

Moreover, it also requires the investor to consider what to do with its portfolio post-termination, as the liquidity of that portfolio may be even more protracted than any notice period employees may have, and the liquidity of that portfolio will ultimately be the liquidity of the least liquid component contained therein.

In contrast, an investment in a fund of funds provides investors with access to dedicated portfolio managers who split their fixed costs across a wider pool of investors. This allows funds of funds to build out more robust teams, and investors can therefore avoid all the fixed costs, and associated considerations, that come with building an in-house team. Liquidity for investors is more clearly defined, and it is generally also more likely that fund of funds managers are significantly invested in their own products than may be the case for in-house portfolio managers where, for a variety of reasons, this may not be possible or appropriate.

It is also not unusual to find managers that earn more from the returns generated on their own invested capital than from the fees they charge to other investors. The advantage this gives is that managers are tied personally to the success or failure of a fund’s performance, thereby further aligning interests between all parties.

Investors also shouldn’t underestimate the bargaining power that funds of funds managing significant assets have with underlying hedge fund managers. The benefits they can derive can include significant fee concessions, the ability to switch mid-month between multiple products a fund provider may be offering, preferential liquidity terms, both for investments and redemptions, improved transparency and reporting of underlying positions, and even customised portfolios which other investors may not be able to access.

All of these elements can provide significant additional value to investors. With regard to fee discounts, we have seen several large funds of funds being able to reduce the underlying fees to such a degree – given the size of their investments – that their total expense ratios are only insignificantly higher than if an investor had invested directly in a portfolio of single managers, sometimes as low as only 15 bps extra. It is not unheard of for the “2 and 20” approach of 2% management fees and 20% performance fees to more realistically be represented by fees of 0.5-1.5% (management fees) and 10-20% (performance fees).

This means that the due diligence, portfolio management, asset allocation and any other services provided by these funds of funds are virtually free of charge to their investors. Once again, contrasting this with the aforementioned running costs of an in-house team quickly shows that the AUM hurdle for internalising this function is very high, and likely only makes sense for portfolios multiple times larger than the $100 million we suggested earlier.

When considering investing in markets other than an investor’s home market, cultural aspects should also be taken into consideration. This may further weigh in favour of successful local fund of funds managers, who may be able to access better information on the underlying investments, make calls on country/regional economic cycles, and conduct proper and detailed due diligence on their counterparties and investments. These cultural aspects are not onlyimportant for quantitative reasons – the decision of what funds to allocate to and how to extract the best performance – but also for qualitative reasons of understanding how a region or country truly works, how government policy may be set and how all of this may affect the underlying portfolio.

Making use of strategy-specific managers
Having explored the issues around the build or buy decision investors should also consider taking advantage of strategy-specific managers.Geographically, the case for funds of funds is both appealing and strong, where a detailed understanding of local markets is crucial to extracting better returns. To take a recent example, the last year’s volatility in China, both in terms of market performance and regulatory changes, has been a clear reminder that things are more complex and multi-faceted than is often appreciated. Funds of funds can offer investors the opportunity to hold a more diversified regional exposure in their portfolio, thereby hedging against idiosyncratic manager and market risks, as well as allowing them to take advantage of more diverse opportunity sets than provided by allocations to a small number of single-manager hedge funds. Additionally, they also remove the due diligence burden an investor would otherwise have and help investors to navigate foreign markets more efficiently and with less risk. The most skilled local managers are able to dynamically and quickly move around different opportunities and replace underperforming, or less attractive risk/return propositions with more suitable ideas.

Investors can also make use of sector specialists in areas such as healthcare or technology, or strategy specialists focused on commodities or alternative credit, where in some instances greater diversification and real specialised knowledge is needed, and where most investors wouldn’t typically feel comfortable allocating all their risk to just one or two single managers. In these instances, funds of funds can act as trusted guides and are often able to allocate risk more efficiently among sub-strategies depending on changes in underlying risk/return drivers.

Some of the most successful funds of funds that we have researched reallocate risk among their underlying funds very actively, as if those were individual securities and not funds, and the managers in which they invest could be classified as off-site proprietary traders rather than hedge funds. This approach, and the risk aggregation these funds often employ at a portfolio level, can lead to significantly better risk-adjusted returns than investors may be able to generate themselves, but also adds a level of complexity few organisations could manage in-house.

Positive compounding, diversification
Investors seem to keep forgetting some of the most basic rules of finance. Amongst these are the value of diversification and the power of positively compounding returns over long periods of time. Diversification in the case of a hedge fund portfolio comes at a cost: cost in terms of actual assets needed to invest due to the high minimum investments, cost in terms of infrastructure, and cost in terms of managing the resulting complexity at a portfolio level. All of these can, to some extent, be addressed through the use of funds of funds.

Even more important though, and by far the most powerful ally any long-term investor can have, is the value of positively compounding returns. This of course also means keeping investment losses to a minimum, as recovering from significant losses is very hard, especially without taking undue risks. The most important aspects to look for in any investment are therefore to limit the potential downside and to generate consistently superior, net offee, risk-adjusted returns. These are also the metrics that any fund of funds investor should consider.

Ultimately, the only thing that should matter to any investor is whether they receive better net of fee risk-adjusted returns from their fund of funds investments than they could otherwise. Especially in the current low interest rate environment, there is ample research to suggest that a fund of funds approach may even be a good substitute for a fixed income portfolio, as funds of funds can mimic the risk/return profile of such a portfolio without the significant downside risk of traditional fixed income investments at these valuation levels (Michael Cembalest, JP Morgan Asset Management, “Eye on the Market”, May 2nd 2013).

What is generally true though, including in 2008, and even for the most mediocre performing funds of funds, is that FoFs as a group had on average significantly lower losses than long-only portfolios. In a portfolio context this would have added some stability to most investors' portfolios. Of course, an allocator shouldn’t aim to pick a mediocre fund of funds, and we always advocate that if all an investor wants is exposure to average fund of funds returns, then they should find a liquid index in which to invest, save the fees and not suffer any sort of illiquidity, not even monthly liquidity. However, we have seen a plethora of funds of funds that have been able to significantly and consistently, both on a risk-adjusted and absolute basis, outperform hedge fund as well as long-only indexes. To us, a lot of this has to do with the ability of good funds of funds to limit downside volatility, and to positively compound non-correlated returns over significant periods of time.

Where does this leave us?
Though a couple of pages are never enough to exhaustively discuss a topic as polarising as funds of funds, for the preceding reasons, not least (but perhaps for some people most surprisingly) the cost consideration of going it alone, we strongly feel that funds of funds still have a legitimate place in investors’ portfolios. We would even go as far as to suggest that for most investors, other than some of the largest and most sophisticated multi-national groups, selecting single managers may be challenging and that they may be better served in the long run to select a group of trusted funds of funds that have a demonstrable long-term track record of outperformance – especially when it comes to strategy or geography-specific investment ideas. It is in these areas that we see funds of funds adding the most value to investors both in terms of quantitative and qualitative measures. On the other hand, any fund of funds purporting to merely provide access to well-known managers, or that mimics an index, clearly adds little to no value to investors and understandably will struggle to survive in a highly competitive environment.

As with any other investment, it is hard to generalise, and a more thoughtful approach is required when determining whether or not a fund of funds may make sense for specific investors. Ultimately though, a fund of funds is nothing other than a portfolio manager, and what should count is whether or not this portfolio manager, compared to other similar investment options, can consistently generate superior risk-adjusted net of fee returns.

Footnote

1. To us, a fund of funds advisory mandate, bespoke fund or managed account are essentially all the same in terms of the most basic considerations of whether or not to invest. Of course, they all have their own unique aspects but we will leave these out of the discussion and focus instead on the high-level aspects we feelare important and common to all of them.