Spotlight on funds of hedge funds: why investors use them

What are funds of hedge funds?

A “fund of hedge funds”, sometimes referred to as a “multi-manager fund”, is a fund that invests in a portfolio of other hedge funds.

Funds of hedge funds can vary enormously, but essentially, they give investors exposure to the hedge fund industry through investments in different hedge funds and different hedge fund strategies. By investing with multiple underlying funds and in multiple strategies, a fund of hedge fund has the potential to diversifying away the risk involved in investing with a single manager, fund or strategy.

In reality, funds of hedge funds vary enormously. Funds can be:

• “fettered” (invest funds run by a single underlying manager) or “unfettered” (unrestricted in the hedge fund manager it invests in)
• Concentrated or diversified – some funds may invest only in a single underlying hedge fund, whereas others have a large portfolio of component funds
• Strategy focused or strategy diversified

The fund of hedge fund manager is responsible for:

• Due diligence – conducting both initial and ongoing due diligence on the underlying funds and their managers, and consequent hiring and firing decisions
• Portfolio management – weighting the funds and strategies in the portfolio to achieve the targeted return within acceptable volatility parameters
• Reporting to the investors in the fund of hedge fund

Problems funds of hedge funds may solve

Direct investing in hedge funds typically has many barriers to entry, which funds of hedge funds may help to overcome:

• Hedge funds and their associated strategies are usually complex and therefore require specialist knowledge.
• Hedge fund performance can be wildly divergent, across both strategies and funds, making fund selection challenging.
• The most sought-after hedge funds often have very high minimum investment amounts, onerous liquidity terms, and may be hard closed to new investment, which can prevent many investors from accessing them directly.
• Access to the most in demand new launches often requires a network of connections and the resources and expertise to perform due diligence on funds.

What are the advantages and disadvantages of including funds of hedge funds in your portfolio?

Advantages

It is widely recognised that hedge funds themselves do not represent a low-cost investment option and of course investing via a fund of hedge funds introduces additional fees. However, another way of looking at these additional fees is that investing via a fund of hedge funds offsets the considerable expense of hiring a hedge fund portfolio management team and provides industry expertise and experience. So, these fees could both represent a cost saving and improve returns for some investors. Below we consider what these fees cover.

• Relationships and networks
• Due diligence – sourcing
• Due diligence – cost
• Due diligence – expertise and experience
• Access
• Diversification
• Economies of scale

Relationships and networks

The hedge fund industry is vast. Aurum’s Hedge Fund Data Engine^[1] tracks the performance of approximately 3,500 active hedge funds worldwide with around $3 trillion in assets at June 2023. In an industry of this size and complexity, it is very difficult for even professional investors with a dedicated hedge fund analyst to monitor and perform due diligence on funds.

Performance varies hugely across the hedge fund industry and identifying the funds with the potential to outperform can be challenging.

High quality fund of hedge funds managers typically have experienced employees and long-standing relationships and networks in the hedge fund industry. They should therefore be better positioned to identify the best emerging funds and to avoid weaker funds.

Performance varies hugely across the hedge fund industry and identifying the funds with the potential to outperform can be challenging. This is illustrated in the chart below which shows the breadth of hedge fund industry performance dispersion over a 12-month period to October 2023.

FIGURE 1: HEDGE FUND INDUSTRY PERFORMANCE DISPERSION BY STRATEGY, 12 MONTHS TO OCTOBER 2023

For more data on hedge fund industry performance and dispersion data, see Aurum’s live hedge fund data here: https://www.aurum.com/hedge-fund-data/industry-performance/hedge-fund-performance-by-strategy-latest-data/

Another benefit of investing through funds of hedge funds is that they may have the contacts and relationships to access new launches that spin out from large funds, which may be closed to new investment.

Due diligence – sourcing

Researching and identifying potential funds for investment requires not only skill and knowledge, but access to information and data.

Initial due diligence expenses typically include hedge fund database subscriptions, independent research reports, and background checks.

Before all this though, a major expense is having suitable staff to perform these functions. Costs associated with this include job-searches for experienced personnel, the ongoing costs of paying staff, of training them, of undertaking professional qualifications and attending industry events to maintain their skills and knowledge.

These components of the investment due diligence process combine to make creating a diversified portfolio of hedge funds both time consuming and expensive.

Due diligence – cost

Researching, investing in, and monitoring a diversified portfolio of hedge funds can be a costly endeavour. Depending on the size of the investment, the complexity of the strategies, and the number of funds to be analysed and monitored.

The costs associated with pursuing a diversified hedge fund portfolio could range from hundreds of thousands to millions of dollars.

Investing in hedge funds is a truly global business. The chart below illustrates the regions where hedge fund investment managers are based (focusing on the largest regions by assets managed, which span the globe).

FIGURE 2: GLOBAL HEDGE FUND INDUSTRY BY REGION

Certain regions appear to favour particular investment strategies. For example, the UK is a hub for macro funds, with over 40% of macro assets managed from the UK, while New York and Chicago have historically been centres for multi-strategy funds.

Constructing a high-quality portfolio of hedge funds that is diversified by underlying strategy is a global endeavour, requiring regular international travel, which can be expensive. Investing through a fund of hedge funds can reduce these costs by making use of economies of scale.

Due diligence – expertise and experience

Due diligence is not only essential at the outset of an investment – it is an ongoing responsibility during the lifetime of an investment. Investment due diligence requires the monitoring a fund’s performance, the execution of the strategy, and the quality of management.

Hedge funds are operationally complex. Assessing the operational risk in a hedge fund investment requires analysis of multiple counterparties, service providers, IT infrastructure, back office, and accounting systems, and whether the fund’s terms, legal structure, and transparency levels are appropriate for its strategy.

Both investment and operational due diligence are highly specialised tasks that take expertise and time. Good funds of hedge funds bring expertise and experience to hedge fund analysis, supported by an organisational structure that has robust risk control systems and operational due diligence experts.

Access

Many of the most sought-after hedge funds are closed to new investors. Funds of hedge funds often have long-standing relationships with hedge fund managers. An investment in a fund of hedge funds can provide exposure to hard closed funds. Funds of hedge funds may also be able to secure capacity for new investments in otherwise closed funds. This may be because underlying funds may prefer to offer additional capacity to existing investors who have already undertaken due diligence rather than entering into a new relationship and starting the due diligence process from scratch. Underlying funds may also have contractual agreements in place which give certain existing investors, such as fund of hedge funds, access to a specified amount of capacity.

Diversification

Hedge funds vary enormously, not only by strategy, but also by how the strategy is executed by different managers. A diversified portfolio of hedge funds can generate a truly uncorrelated return stream. However, a diversified portfolio of hedge funds, typically requires a very large capital outlay, due to the high minimum investment amounts of many hedge funds. Good quality, diversified funds of hedge funds offer the benefits of a portfolio of hedge fund investments, with a significantly lower minimum investment amount.

Economies of scale

By pooling the investments of multiple underlying investors, funds of hedge funds may give smaller investors access to cheaper share classes which have minimum investment amounts that are targeted at larger, institutional investors.

Disadvantages

• Fees
• Performance dispersion
• Strategy selection limitations

Fees

Funds of hedge funds typically charge an additional layer of fees. In addition to the fees charged by the underlying hedge funds, funds of hedge funds add an extra layer of management and/or performance fees, which can reduce returns compared to investing directly in the same underlying hedge funds. However, the additional fees may be mitigated if the fund of hedge funds has secured preferential terms or otherwise invests in share classes with lower fees than what may be available to some other investors.

Performance dispersion

As with any direct investment in hedge funds, when investing in a fund of hedge funds, manager selection can be challenging, though is critical for a successful outcome.

The chart below looks at the dispersion in fund of hedge fund performance over the past five years based on data provided by HFM/With Intelligence. Jefferies estimates the size of the fund of hedge fund industry in 2021 at around $800 bn^[2]. At June 2023, the HFM/With Intelligence database tracked the performance of just over $113 bn fund of hedge fund assets. Although only approximately 14% of fund of hedge funds industry assets are represented in the HFM/With Intelligence data, there are enough constituents within the index to facilitate illustrative observations.

2022 was notable for the particularly broad net performance dispersion, with an over 26% spread between the 90^th percentile return (-18.1%) and the 10^th percentile return (8.3%).

FIGURE 3: FUND OF HEDGE FUNDS- PERFORMANCE DISPERSION

This can be demonstrated over the longer-term in the chart below, which shows the difference between the HFR FOF Conservative Index^[2] and the HFR FOF Composite Index^[2], the latter of which has exhibited a higher correlation to equities. The HFR FOF Conservative Index (the more conservative index which typically has lower exposure to higher beta hedge fund strategies) has, over the period, experienced less severe drawdowns and faster recoveries during periods of equity market volatility.

FIGURE 5: UNDERWATER DRAWDOWN