Markets & views

Fund of hedge funds investing – a disciplined approach

Fund of hedge funds (FoHFs) have increased in prominence since the 1990s, with those FoHFs each managing $1 billion or more having aggregate assets of $955 million 1. The growth in FoHFs has outpaced the growth in hedge funds and this looks to be a trend that will continue.

According to Hedgefund.net, the net inflows into FoHFs during the first quarter of 2008 were 35% greater than the net inflows directly into hedge funds 2. What is driving this rapid growth relative to direct hedge fund investing and will it continue? The introduction of new institutional investors has played a key role. Institutions have accounted for much of the growth to date, and are projected to represent 65% of all net inflows into hedge funds through 2010 3. Generally speaking, new institutional investors tend to utilise FoHFs for their initial hedge fund exposure. Once they have gained more knowledge and experience, they may move towards making direct hedge fund investments. Pension funds, which have been instrumental in the growth of institutional investment in FoHFs, are generally looking for modest and relatively stable returns with little or no correlation to other investments. Diversified FoHFs fit this profile.

We will investigate the merits of investing in FoHFs and the considerations that need to be given when constructing and managing a portfolio of FoHFs.

 

The benefits of FoHFs

When analysing FoHFs, it is important to note that they are not an asset class, but rather an active management style that utilises asset classes. An investment in a FoHFs is, therefore, an investment in people. It is the skill of the FoHFs managers, both in identifying talented hedge fund managers and constructing diversified portfolios, that is a key factor driving the continued growth of the industry. This skill manifests itself in a number of ways, including:

 

Performance

Broadly diversified FoHFs have produced both good absolute and relative performance, as shown in Chart 1. Here, the HFRI Fund of Funds Diversified Index (HFRI Index) – an index comprising FoHFs that follow diversified strategies – has outperformed fixed income and delivered returns close to those of equities. In addition, these FoHFs really shine when risk-adjusted performance is considered. Many of them are market neutral, which smoothes out volatility over time. For example, over the last ten years the standard deviation of returns for the HFRI Index has only been around 40% of the standard deviation of returns for the S&P 500 Index 4.

Diversification

The allocation of capital across many underlying managers and strategies is what leads most FoHFs to be largely market neutral. This provides for meaningful portfolio diversification benefits when FoHFs are included in a portfolio containing equities and/or fixed income investments. The correlation of the HFRI Index with various broad market indices is shown in Chart 2. While the HFRI Index correlation with these indices has varied over time, it has nevertheless remained at a level that provides for overall portfolio diversification benefits.

Infrastructure

Investing in a portfolio of FoHFs rather than a single FoHFs provides risk reduction benefits which we will touch upon later. Most investors do not have the infrastructure and experience to manage a portfolio of FoHFs, let alone a broadly diversified portfolio of hedge funds. Selecting and managing a portfolio of hedge funds requires significant resources, given that there are nearly 10,000 hedge funds in existence. Additionally, in today’s world the time frame an investor has in which to make a decision about top new talent entering the hedge fund arena has been greatly reduced.

Access to closed managers

Many of the top hedge fund managers are closed to new investors. FoHFs have exposure to some of these managers, and may have negotiated for additional capacity as well.

 

The components of a disciplined approach

When an investor makes the decision to invest in a portfolio of FoHFs, the first step is to establish clear objectives and guidelines. These should be determined for the portfolio as well as for each FoHFs within the portfolio. While this seems like commonsense, there has probably been more chasing of past returns in the hedge fund space than in any other. Adherence to pre-established objectives and guidelines mitigates this risk.

One objective that needs to be established is the level of risk, in terms of the volatility of returns and the probability of loss, with which the investor is comfortable. In order to adequately assess and monitor this risk, the investor needs to be provided with a certain degree of transparency from each FoHFs within the portfolio. At a minimum, the investor should receive a list and the allocation percentages of the hedge funds held by the FoHFs. This ability to “look-though” the FoHFs to the individual hedge funds enables the investor to ensure that they truly have a diversified portfolio and that each FoHFs is not reliant on the same group of individual hedge funds. For the same reasons, each FoHFs should provide information regarding their allocation to the various hedge fund strategies.

Sourcing is a critical component of good portfolio construction. While there are a number of databases available, many of the top FoHFs do not report to them. Therefore, relying only on databases when selecting FoHFs may lead to an inferior portfolio. Sources should be expanded to include, among other avenues, existing FoHFs. In our experience as managers of portfolios of FoHFs, some of the best recommendations have actually come from FoHFs managers with whom we have developed a long-standing arms-length relationship.

Given the large number of FoHFs in existence (the HFRI FoHFs Database alone contains more than 2,500 FoHFs), quantitative screening of returns is a valuable tool that enables one to efficiently eliminate FoHFs that fail to meet the investor’s risk and return objectives. An investment in a FoHFs should never be made based upon quantitative screening alone, for quantitative screening only highlights whether or not the FoHFs track record meets the requirements of the program. In other words, it is backward-looking. Qualitative due diligence is where the investment decision should be focused, as it is here where the investor determines if the track record was based upon skill, and therefore, whether it is repeatable. While all of the elements of good qualitative due diligence are too numerous to mention here, we highlight a few:

On-site visits

Making one or more visits to the offices of the FoHFs managers is the only way to get a true feel for the organisation. These visits should include meeting as many people as possible and not just focusing on the principals of the firm.

Background checks on principals

Depending on the number of principals of the FoHFs firm, background checks can become expensive. However, investing with a manager that has a less than stellar background can prove to be more expensive.

Growth projections and capacity constraints

Understanding management’s plans for the FoHFs organisation over the next several years can be an indicator of future performance. Does the firm have the infrastructure to handle any planned growth? Is the firm more concerned with growing assets than producing superior returns?

Reference checks

Each FoHFs manager should provide a list of references and these should be checked. As it is expected that these references will prove to be positive for the manager, otherwise they would not be on the list, the investor should also check with their own industry contacts to attain a more unbiased view.

Ultimately, the focus is on determining the adequacy and integrity of the people, processes and systems.

Once the FoHFs portfolio has been constructed, monitoring of the portfolio is a vital component, as it is with any portfolio of investments. It takes on increasing importance with FoHFs though, given the limited liquidity of the investments. Whereas equities and bonds can usually be liquidated within a day, most FoHFs may only be liquidated on a quarterly or less frequent basis. As a result, early identification of changes at a FoHFs that might inhibit the ability to continue to meet the investor’s objectives is crucial.

 

Portfolio performance

At the end of the day, the ultimate determinant of successful portfolio management is performance relative to objectives. Selection, a key driver of performance for most portfolios, takes on more importance in a FoHFs portfolio than it does in most equity and fixed income portfolios, again due to reduced liquidity. If a poor selection decision is made in an equity portfolio, such a decision can usually be reversed in short order. This is not the case with FoHFs. However, just like equities, FoHFs tend to produce a wide and negatively skewed dispersion of returns. Chart 3 shows the median, 25th percentile and 75th percentile of annual returns for the constituents of the HFRI Index for each year since the year 2000. The chart highlights the impact of selection, as during this decade the bottom quartile of managers have on average produced annual returns of nearly 4% less than the median return, whereas the top quartile of managers on average have produced annual returns more than 3% above the median. In other words, the range of returns between the bottom quartile and the top quartile has on average been about 7%.

Portfolio diversification also plays an important role. Four or five FoHFs managers should provide for adequate diversification, but only to the extent there is not significant overlap in the underlying hedge funds utilised by the FoHFs managers. Modern portfolio theory would argue that the diversification benefits of adding an additional investment are minimal once the total number of investments – albeit randomly selected – reaches 20. While this may be the case with liquid investments, FoHFs, as indicated, have reduced liquidity. When looking through the FoHFs, the exposure to underlying hedge funds needs to be much higher. A portfolio of four or five broadly diversified FoHFs is likely to contain exposure to more than 100 different hedge funds. We view this as adequate diversification. A FoHFs manager could make the correct decision to liquidate one of its hedge funds, but have that hedge fund significantly under-perform before the manager can execute upon its decision due to the reduced liquidity. Having a high degree of diversification insulates the overall portfolio from this risk.

So a disciplined approach to FoHFs investing enhances the prospects of selecting top-tier managers, while at the same time provides for downside protection.

 

Key points

• Diversified FoHFs portfolios have produced returns that have approached those of equities, but with significantly reduced volatility.
• Assessing the quality of the FoHFs organisation is the most critical component of selection, as it determines the reliability and sustainability of the track record.
• The ability to manage risk within a FoHFs portfolio is severely limited without an adequate level of transparency to each of the FoHFs.
• The range of returns produced by individual FoHFs is widely dispersed, placing a premium on the selection process.
• Diversification requirements for a FoHFs portfolio are significantly greater than that suggested by modern portfolio theory, given the reduced liquidity of the underlying positions.

 

TIMOTHY M. REIMER

Senior Vice President of Alternative Strategies

Joined Investment Industry in 1988

MAIN RESPONSIBILITIES

Tim is responsible for alternative strategies for Aviva Investors North America Inc.

EXPERIENCE & QUALIFICATIONS

Tim joined the portfolio management team at Aviva Investors North America Inc.in 1998. Tim holds a MBA with an emphasis in finance from the London Business School and a BA in philosophy from Valparaiso University .

 

STEVE S. STOTTS

Vice President / Senior Portfolio Manager, Alternative Strategies

Joined Investment Industry in 1992

MAIN RESPONSIBILITIES

Steve manages the fund of funds and private equity investments for Aviva Investors North America Inc.

EXPERIENCE & QUALIFICATIONS

Steve joined the portfolio management team at Aviva Investors North America in 1992. Steve holds a MBA from Indiana University , a BSc in economics from South Dakota State University and the Chartered Financial Analyst designation.