funds of hedge funds at their peak, a critical view from 2006, before financial crisis

1. 111
Dr Drago Indjic,
Project Manager
for BNP Paribas
Hedge Fund
Centre at London
Business School,
considers the
coming of age of
hedge funds…
Funds of hedge funds:
an academic viewpoint
HedgeFundInvestment
(Diversification)
T
he oldest Funds of Hedge Funds (FoHF) are
approaching their mature 40s. Similarly to
hedge funds, referred to sometimes as ‘courte-
sans of capitalism’, the cozy FoHF sector is changing
fast. For example, today retail investors can choose
between several FoHF listed on the London Stock
Exchange; stock listings and buy-outs of the manage-
ment companies are becoming less rare and staff
retention is becoming more difficult as senior FoHF
portfolio managers are not afraid of jumping ships.
Most industry surveys by investment banks and hedge
fund data vendors (like HFR or Tass Tremont) regularly
indicate that assets managed by the FoHF represent
over one-third of the total assets managed in the
hedge fund industry. Due to existing regulatory con-
straints and perception of ‘safe buy’, FoHF are almost
without exception the first option to create exposure
to hedge funds for most institutional and retail
investors, and hence still receive large capital inflows.
As bulk buyers of hedge fund capacity with very deep
pockets, they carry Solomon’s sword of the initial
investment that determines the destiny of virtually all
emerging hedge fund managers.
There is still an excessive demand for hedge fund expo-
sure, probably overshadowed recently by demand for
commodity exposure. However, market forces are in
play where fundamentally limited ‘quality’ hedge fund
capacity is shared between a small number of ‘rep-
utable’ investors. In fact, quality capacity, ‘good Alpha’,
is becoming less liquid and certainly more expensive.
Given a very large choice of FoHF today and existence
of several dedicated newsletters (like InvestHedge), it is
surprising that there are only a few professional devel-
opment courses and virtually no monographs on
principles of FoHF portfolio design and management:
Nicholas (2004) is an exception to this rule. Hence the
question: In an increasingly competitive market, are all
FoHF still worth their industry standard 1-2% annual
management fee? A few recently launched FoHF have
abandoned charging management fees altogether.
Regrettably, far too many FoHF are still just old-fash-
ioned ‘collectors’ of hedge funds (or capacity in quality
hedge funds). Despite risk system vendor efforts,
notably Riskdata, and academic surveys (for example,
by EDHEC), most FoHF are still not designed and man-
aged as proper investment portfolios. A very small
number of FoHF use new research results designed for
hedge funds like Omega function, and still offer expla-
nations in terms of ‘qualitative’ analysis (sometimes
business and operation risk).
In an unsustainable drive to increase AUM, FoHF
‘product’ differentiation and marketing issues usually
take priority over more subtle quantitative issues. The
portfolio selection biases in FoHF are very serious, in
particular with regard to selection of new investment
candidates or the ‘age’ of FoHF investments and gen-
erated ‘return on capital employed’.
FoHF are not scalable enough and cannot afford to
invest in a very large number of hedge funds due to
organisational and IT limits. Reflecting their perform-
ance fee models, large hedge funds can elect to close
to new investors, but FoHF usually do not wish to and
capacity chasing becomes their ‘raison d’ etre’. In order
to increase their AUM while managing growth, the
largest FoHF can only reasonably accept to invest in
the largest hedge funds and the ‘large (hedge fund)
capitalisation’ FoHF style bias emerges in addition to
many other biases in construction of FoHF portfolios.
It is even possible to question the very definition of
FoHF since the following examples of FoHF composi-
tion and structure have been observed in practice:
● Two hedge funds;
● Eight times levered portfolio of five hedge funds;
● Single strategy, multi-manager (levered);
● Over 100 hedge funds, levered;
● Fund of funds of hedge funds (‘F3’);
● A hedge fund Index, S&P 500-hedged;
● Selection of a dozen hedge funds from the hedge
fund ‘platform’, structured;
● Investing only in closed hedge funds;
● Rebating 50% of management fee to any introducer;
● Mixing long-only and hedge funds.
Therefore, the prospective investor (or trustee) will be
facing numerous questions: Does it need a diversified
FoHF investing across many hedge fund investment
strategies or strategy specific? Should it be levered or
not? Is a rated fund certificate (maybe with ‘guaran-
tee’) safer than direct, undiluted ownership of shares

2. ‘In fact,
comparing one
FoHF to
another, in a
highly
competitive
mandate-
awarding
situation, can
be a rather
confusing, as
well as costly,
process.’
112
HedgeFundInvestment
(Diversification)
in hedge funds? Are managed accounts better than
ownership of shares? What strategies should be best
included or avoided? Or should it be ‘customised’ to fit
a specific portfolio liability or policy benchmark?
By imposing rigid minimum investment thresholds –
for example, minimum investment level of no less
than US$10m, together with risk rule that they cannot
represent more than 10% of AUM in a single hedge
fund – and mandating extortive preferential fees, FoHF
have stopped being a trusted source of hedge fund
‘venture capital’. On the other hand, they have created
a niche for a small number of specialised FoHF invest-
ing in emerging hedge funds.
These are difficult questions that can challenge not only
investors but also the most experienced investment con-
sultants. In fact, comparing one FoHF to another, in a
highly competitive mandate awarding situation, can be
a rather confusing, as well as costly, process. Many insti-
tutions, notably Hermes, have managed to avoid using
FoHF and decided to pursue the ‘Do It Yourself’ approach.
Innovative ideas by the Dutch PGGM fund that follow
in the steps of large US university endowments are
worth mentioning, yet they do not invest directly into
hedge funds.
Pricing ‘alpha’, ‘beta’, capacity and
liquidity
The design of absolute return portfolios and their
performance fee schedules today does not reflect
investors’ appetite for separable alpha and beta
components.
Instead, charged performance fees often reward sim-
ple outperformance of cash, or a certain level of
hedge fund index tracking error – ‘relativisation’ of
‘absolute’ investments. In fact, ‘re-packaged’ com-
moditised beta is sold to investors as precious alpha.
There are many fundamental questions that should be
addressed even before any attempt is made to apply
quantitative methods to FoHF. For example, what is
the size of a ‘live’ and ‘investable’ universe of hedge
funds? What exactly is a hedge fund ‘strategy’ and
how can it be verified from data?
Other important questions are linked to often over-
sold qualitative aspects of FoHF management: What
data (transparency) is demanded from hedge funds
and supplied to investors in FoHF, and for what pur-
pose? What premium should be paid for limited
liquidity or transparency? Or even, what is a FoHF eco-
nomic function and business model, hopefully not just
restless rent-seeking behaviour?
An already complex picture has been made more con-
fusing by the marketing of numerous families of hedge
funds indices offering different levels of investability,
transparency (some do not disclose constituents) and
capacity - in addition to numerous academic studies,
most notably by EDHEC, there is a comparison by
Credit Suisse/Tremont (2005). However, FoHF are in
fact good market proxies for the hedge fund industry,
for example, Fung et al (2005) found the correlation of
monthly returns over the last decade between the
average FoHF and the average of all individually hedge
funds to be as high as 0.90.
In order to carry out comprehensive research of hedge
funds – either in academia or in FoHF – multiple data
sources should be merged and ‘intelligently’ cleaned. For
example, Fung et al’s (2005) data sample comprises 996
FoHF over the period from 1994 to 2002. It should not
be forgotten to characterise the ‘supply’ side of the FoHF
equation: in Agarwal et al’s (2005) study of a sample of
7,269 unique hedge funds, 25% of hedge funds are
‘young’ (less than 3.5 years old) and 50% ‘small’ (less
than $33m of AUM). Academic studies quote many
results, on hedge fund flows, persistence of performance
and risk factors, and more recent research trends include
analysis of hedge fund data not consolidated by strategy
as usual (which is an ill-posed problem as demonstrated
by the failed AIMA initiative to standardise hedge fund
strategy definitions because of lack of research funding)
but by the fund management company that holds very
valuable fund liquidation and (re-)launch ‘options’.
Perhaps not surprisingly, Fung et al (2005) have
analysed hedge fund capital flows and found that
‘sophisticated’ investors are chasing past returns and
herding as retail investors into mutual funds.
Moreover, emerging academic consensus is that aver-
aged hedge fund returns can be replicated, thereby
generating opportunities for ‘smart’ investors to
cheaply outsource alternative beta production to
investment banks while other ‘sticky’ investors may
indulge in an ‘Alpha El Dorado’ quest across and
beyond ‘alternatives to alternatives’.
Regrettably, the majority of FoHF are designed ad hoc,
strongly influenced by their managers’ subjective fac-
tors. For example, a strong selection bias exists in
choice of investable strategies; very often, avoiding
CTA or macro-strategies is a matter of personal taste.
As a result, most FoHF exhibit a large equity risk
component and therefore do not deserve to be con-
sidered a proper risk/reward minimising portfolio.
An even trickier question is, when and why any FoHF is
re-balanced.
The final outcome is that a trend of diminishing alpha
in FoHF returns over time has been observed in Fung
et al (2005).
New future for funds of hedge funds
Given greater competition in ‘absolute return’ product
space, there will be some winners, as well as many
losers, in the FoHF market.

3. ‘Most probably,
new risk-
adjusted FoHF
performance
fee models will
emerge where
management
fee ‘rent’ will
be replaced by
rewarding pure
alpha.’
HedgeFundInvestment
(Diversification)
113
For new ‘principal’ investors, the choice of hedge fund
exposure‘agents’willnotbelimitedtotraditional‘off-the-
shelf’ FoHF but will grow to include multi-strategy single
hedge funds, mutual hedge funds (see Agrawal et al
(2006))andpossiblystructuredindices,tonamebutafew.
In addition, downward fee pressures will increase;
a second layer of fees will be less acceptable. The
greater, if not complete, fee transparency will be
made possible by the new design of performance fee
equalisation shares.
The restless rent-seeking behaviour will be replaced by
proper investment contracting reflecting the true eco-
nomic function of FoHF as investment intermediaries.
FoHF will be able to achieve savings by outsourcing
their ongoing due diligence, ‘style drift’ monitoring or
even supply of certain alternative strategy beta or
alpha components.
In many cases, investors’ own ‘due diligence’ should
reveal and distinguish business models that represent
pure investment management from those that are
not. For example, in order to secure a capacity that
can be re-sold to final investors, many FoHF will be
conflicted by crossing boundaries of private equity
investment by seeding and incubating hedge funds.
For example, how should cash flows be generated by
hedge fund equity stakes or un-hedged, discounted
incentive fees be accounted for? What is the fair value
of ‘most favoured nation’ investor status?
It is highly possible that quality alpha will be auctioned
in a better way and transparency more equitably dis-
tributed – rather than repeating oxymorons that
‘those people who need transparency will find man-
agers who will provide it’ and ‘those managers who
won’t give transparency will be able to find investors
who don’t need it’.
There will be significant disintermediation opportunities
and a very rich ‘state space’ of incentives beyond the 1%
management fee plus 20% performance fee models.
Most probably, new risk-adjusted FoHF performance
fee models will emerge where management fee ‘rent’
will be replaced by rewarding pure alpha. Obviously,
any beta must be very cheap (if not even free!) as it is
already very cheaply supplied by hundreds of ETFs,
including certain commodities and even real estate.
The novel contracts will be monitoring and pricing
managers’ ‘real’ options to liquidate, or sell, businesses
that are currently given away by investors for free, as
well as managers’ ‘effort’, including risk-taking atti-
tude, moral hazard, ‘lock-in’ behaviour, career concerns
and reputation, as indicated in Boyson et al (2005).
Final remarks
Therefore, 40+ year old FoHF business models and
associated agency problems are ‘squeezed’. The mar-
keting terms, including limited capacity, ongoing due
diligence, style drift and others will get new meaning.
Probably the main question for FoHF will be: can we
index less and seed more managers?
The FoHF survivors should stop suffocating emerging
hedge funds that live in the shadows of their giga-USD
‘radars’ and invest early. Only then, true alpha can be
made free, manufactured by non-consensus thinkers in
micro-enterprises.
In addition to increasing market efficiency and cus-
tomers’ choice even further, the convergence of
‘mutual’ and ‘hedge’ investment fund models will
reduce investment managers’ opportunities for rent-
seeking behaviour and moral hazard.
The new roadmap will require novel theoretical under-
pinning where investment (market), business and
operational risk premiums will be reflected in new forms
of investment contracting. Probably most benefits will
accrue to seeding and early stage investment contracts,
where new optimal security designs can emerge – prob-
ably reflecting disciplined portfolio rebalancing
processes in the venture capital world featuring staged
and contingent financing. Low inventories of quality
alpha (combined with limited supply of any alpha) can
result in better/cheaper contracting for delegated
investment management, but only if investors require it.
A new equilibrium of managers’ incentives and
investors’ preferences is within reach. Crucially, Professor
Fung observed that no natural business ‘exit’ exists for
HF managers.
This would probably represent a better solution than,
for example, FSA’s recent recommendations with
regard to hedge fund practice of issuing ‘side letters’
to their preferred FoHF.
Finally, there will be no hedge fund ‘bubble’ as the
‘invisible hand’ of hedge fund micro-economics will
ultimately price, and therefore adjust, the supply and
demand. However, after fees, returns may disappoint
and hedge funds may once again become ‘dull’ as
they already did in the early 1970s. The winners may
be new ‘absolute return’ cross-asset allocation prod-
ucts (currently popular real estate and commodities).
Bibliography:
Agarwal V et al (2005) ‘Flows, Performance, and Managerial Incentives in
Hedge Funds’.
Agrawal V et al (2006) ‘Poor Man’s Hedge Funds? Performance and
Risk-taking of Hedged Mutual Funds’.
Boyson N (2005) ‘Another Look at Career Concerns: A Study of Hedge
Fund Managers’.
Credit Suisse/Tremont (2005) Investable Hedge Fund Index Analysis,
March 2005.
Fung W et al (2006) ‘Hedge Funds: Performance, Risk and Capital
Formation’.
Nicholas J. G. (2004) ‘Hedge fund of funds investing: An investor’s guide’,
Bloomberg Press, 2004.
London Business School working papers can be downloaded either
from academic repository SSRN (http://ssrn.com/) or directly from
http://www.london.edu/hedgefunds.html.
There is also a summary of working papers: http://www.london.edu/assets/
documents/PDF/Working_Paper_Summaries.doc_pdf.pdf.
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