Hedge fund stats and the role of fund of funds

This weekend's Barron's has an article (paid subscription required) by Lawrence Strauss discussing the findings of the Hennessee Group's annual survey of hedge fund managers. Here are the key stats and a two quick comments:

Key stats: (all changes are 2004 over 2003):

Assets, industry size and sources of capital

  • Assets up 27%, versus 34% in the prior year.
  • There were 8,050 funds, up from 7,000.
  • 44% of capital was from individuals and family offices
  • 28% of capital was from funds of funds up from 20%.

Portfolio turnover

  • 25% of respondents said they turned over their portfolios more than 5 timess, up from 20%.
  • 33% said they turned over their portfolios 2 to 5 times, same as prior year.


  • 43% of respondents charge a management fee of 1%, down from 58%.
  • 35% charge a management fee of 1.5%, up from 25%.
  • 15% charge a management fee of 2%, same as prior year.
  • Most funds still charge a 20% performance fee.


  • Average leverage was 148%, up from 141% in 2003 and 121% in 2002, but down from 159% in 1999.


  • 31% of managers allow investors to view their entire portfolios.
  • 60% disclose their largest positions.

Quick comments:

1. In aggregate, these numbers are lousy for investors:

  • Rising hedge fund assets mean that it's harder to generate alpha (too many managers chasing the same opportunities).
  • Hedge fund fees are rising, and greater involvement by fund of funds means that many investors are now paying an additional layer of fees.
  • Higher portfolio turnover means that hedge funds are becoming even less tax efficient for individual investors who are subject to income and capital gains taxes. This is surprising, because the reduction in long-term capital gains taxes should have incentivized the entire fund management industry to maximize long term capital gains and minimize short term capital gains (which are taxable at current income tax rates). Note that the opposite is happening in the mutual fund industry, where ultra-tax efficient ETFs are gaining share of inflows.
  • Will the rise in leverage continue? It shouldn't, because short term interest rates are rising, and that raises borrowing costs and lowers the risk-reward ratio for using leverage.

2. There's clearly correlation between these statistics. Increased involvement of funds of funds (28% of assets, up from 20%) leads to higher portfolio turnover, since funds of funds focus on monthly returns and demand regular access to portfolio holdings.

I must admit, I'm baffled by the behaviour of funds of funds. They use their influence to push managers towards lower monthly volatility and therefore higher portfolio turnover. That increases trading costs, makes it harder to generate alpha, and lowers tax efficiency. Instead, they should use portfolio diversification to allow individual fund managers higher short term volatility in return for higher long-run returns.