Research Says Funds of Funds More Than 'Multi-Manager Funds with Extra Fees'

In a classic episode of Seinfeld, Jerry tries to buy a car from Elaine’s boyfriend “Puddy.” Puddy begins the negotiation by offering his friend Jerry a sweetheart deal. However, during the course of the half-hour episode, Elaine breaks up with Puddy and as a result Puddy’s goodwill all but dries up. As he revisits his original price quote, Puddy adds on a litany of dubious extra fees and charges that are probably familiar to many car buyers out there: ”undercoating,“ “rust proofing” and the ultimate: the “optional overcharge.“

There are some in the hedge fund industry that look at the fees charged by funds of hedge funds as the equivalent to Puddy’s “optional overcharge.“ However, a new study by one fund of funds supplier aims to dispel this notion once and for all. (Says Puddy: “Yeah. That’s right.”)

As hedge funds began to ride a wave of interest around the turn of the century, there seemed to emerge a general consensus among those new to the asset class that funds of funds were the most appropriate way to invest. The argument made a lot of intuitive sense as the idiosyncratic risk posed by hedge funds could be ameliorated through diversification. And so the fund of funds became a dominant species in Hedgistan.

But as we reported last week, there now seems to be a subtle shift back to single-strategy hedge funds. In fact, discussion about the potential weaknesses of funds of funds (fees, illiquidity of underlying funds and a lack of transparency into the underlying funds etc.) began a few years ago with the rise of the multi-strategy fund.

Multi-strategy funds argued that, like funds of funds, they too were diversified. But, they said, they had lower aggregate fees and could dynamically allocate between strategies at the drop of a hat. In addition, they argued that since they were familiar with the underlying holdings in each strategy, they could manage risk in a more holistic manner. And so it was that multi-strategy funds seemed to be gaining the upper hand. Until a few months ago…

The Winter 2007 Journal of Alternative Investments included a paper by Giresh Reddy, Peter Brady and Kartik Patel - all of New Jersey-based Prisma Capital - called “Are Funds of Funds Really Multi-manager Funds with Extra Fees?” The paper (available here at Prisma’s website) makes a cogent argument in favour of the much maligned funds of funds. In other words the answer, according to the authors, is “No, funds of funds are more than just multi-manager funds with extra fees.”

They point to the fact that the performance divergence between hedge fund managers is larger than the performance divergence between different hedge fund strategies (in contrast to what is encountered in traditional long-only investment classes). They observe:

While multi-strategy managers have an advantage with respect to strategy allocation, manager selection is an area of potential advantage for funds of funds. A fund of funds can select managers from a large, global universe of hedge funds, whereas a multi-strategy manager is limited by its ability to hire outstanding teams within each strategy in which it participates. Theoretically, a fund of funds can select best-of-breed managers across a wide range of strategies.

They go on to compare the effects of re-allocating each month from a) the worst manager to best manager (a process at which funds of funds excel) and b) worst strategy to best strategy (a process at which multi-strategy funds excel). According to their model, shifting strategies each month yields very little additional return - as illustrated in the following chart from the paper:

But when money is re-allocated between the worst and best managers in the universe (something the authors posit a fund of funds is more qualified to do), then the picture changes…

The trio makes a number of other arguments in favour of funds of funds, including:

• Operational risk is a leading cause of blow ups, but by definition, multi-strategy funds have very little operational diversification.
• The additional (and independent) level of monitoring by the fund of funds is a better risk management strategy.
• It can be a challenge for multi-strategy funds to retain key employees - particularly if the fund is below its high water mark.

On the sticky issue of fees, the authors contend that multi-strategy funds do charge more than single manager funds - albeit not a ”second layer” like a fund of funds.

But what about the fact that some managers in a fund of funds could earn a performance fee even though the overall fund may be down on the year? (See related posting on this phenomenon.) After all, isn’t it far better to calculate performance fees once, not across many funds?

The authors run some numbers to show the total affect of this phenomenon amounts to only 16 bps per annum in additional costs (or only around 10bps when you factor in high water marks).

While some may consider funds of funds to be like expensive training wheels for hedge fund newbies, there may be method the madness after all according to this paper. And so it seems that the death of funds of funds may have been overstated. Perhaps there is still hope for this modest, trillion-dollar industry.

As Puddy would say, “High five!”