For increasing numbers of institutional investors, funds of hedge funds offer a first taste of alternative, absolute return investing. Newcomers to the asset class gain exposure to a diverse range of carefully-chosen and closely-monitored strategies, designed to deliver a dose of sought-after alpha.
Well, that is what the marketing literature claims. Unfortunately, the performance of many funds of hedge funds over the last 12 to 18 months has not matched the promise, leaving investors with little to shout about for the extra layer of fees they have shelled out.
FT Mandate’s research team examined the 15 biggest fund of hedge fund managers, ranked them by assets under management and solicited submissions for a fictitious Request for Proposal by a continental European country’s €15bn fund to meet future liabilities of pensioners.
The supposed fund is tendering several fund of hedge fund mandates, so we wanted to compare investment processes, portfolio breakdowns, investment teams and performance. Six submissions were received before the deadline from Coronation Fund Managers, Dexia Asset Management, Gottex Fund Management, HSBC Republic Investments, Lombard Odier Darier Hentsch and Union Bancaire Privee.
Our survey was carried out in conjunction with the French-based Edhec Risk and Asset Management Research Centre, which conducted an investment style and risk-return analysis for four of the six submissions received.
In addition to individual fund of hedge fund analyses, Edhec also examined how funds of hedge funds can be best used by institutional investors to generate alpha and improve portfolio diversification.
It would be remiss not to remark on the disappointing response to the survey. It is regrettably ironic that the high level of transparency demanded by fund of hedge fund managers of underlying hedge strategies is not afforded to financial journalists endeavouring to inform readers, many of whom are prospective hedge fund clients. One can only wonder whether the existing clients of these silent fund of hedge fund managers are also subject to such limited disclosure of trading information.
The survey reveals similar methods among funds of hedge funds. Respondents generally combine a top-down and bottom-up approach to selecting underlying hedge strategies.
The top-down analysis tends to focus on the relative attractiveness of the chosen strategies depending on the supply of opportunities, demand, capacity, skill sets, sentiment and current key risks. The choice of the selected underlying strategies is the result of this analysis.
Bottom-up research is used to select individual hedge fund managers. Usually both qualitative and quantitative approaches will focus on people, process and risk management.
Looking forward
The survey finds much consensus among respondents on future trends affecting the industry. They point to continued asset growth in the fund of funds arena, driven by increased allocations from institutional investors.
Dexia Asset Management says the fund of hedge fund industry has grown by more than 20 per cent over the last five years, with assets under management standing at $850bn (e634bn). This influx of capital, allied with the high level of margins offered at the single strategy level, has led to a proliferation of hedge fund managers. The less talented are expected to fall victim to poor performance, leading to further consolidation.
Union Bancaire Privée says the manager selection process “will continue to be crucial in separating the men from the boys”.
Dexia notes that diminishing volatility levels have hit fund of hedge fund performance over the last 18 months, leading to a reduction globally in the opportunities that hedge fund managers can exploit. For instance, the firm says it is underweight relative value/arbitrage strategies since current levels of volatility are not sufficient to create performance. The challenge is finding strategies that can provide consistent returns.
Gottex predicts growth in the number of strategies used by managers to generate alpha, due to increasing liquidity in existing products as well as the emergence of new products resulting from financial innovation.
The firm says that hedge fund strategies, such as convertible arbitrage, fixed income arbitrage and equity long-short, may continue to see their alpha erode over time, and new strategies with greater alpha will replace them.
Coronation Fund Managers predicts that hedge funds will continue to outperform and advises investors to make significant allocations. But in order to generate returns, it says that fund managers must be able to forecast which hedge fund strategies are in danger of being oversubscribed and where hedge fund managers might be taking excessive risk.
Arne Hassel, Coronation’s chief investment officer, says that as competition for alpha increases, fund of hedge funds will become increasingly complex, requiring greater levels of skill and understanding.
Another challenge facing the industry is the likely increase in regulatory scrutiny. Gottex, which says it voluntarily sought registration with the Securities and Exchange Commission in the US and Financial Services Authority in the UK, maintains that regulation of all hedge funds and fund of hedge fund managers “would reduce the risk of fraud by some of the marginal, fringe fund managers, where current barriers to entry are very low”.
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