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Fund of Hedge Funds Jeffrey Glattfelder, John Longo and Stephen Spence

Fund of Hedge Funds Jeffrey Glattfelder, John Longo and Stephen Spence

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J. Glattfelder, J. Longo, and S. Spence



154

3,500



800



3,000



700



Number of Funds



500



2,000



400

1,500



300



1,000



AuM (USD bn)



600



2,500



200



500



100



0



0

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Number of Funds



2007



AuM (USD bn)



Figure 1: Number of Fund of Funds and Assets Under Management

Source: Eurekahedge



2. Objective of Fund of Funds

The primary objective of fund of funds is to deliver attractive risk

adjusted returns, as measured by Sharpe Ratio, Sortino Ratio, or other

metric. Most fund of funds aim to deliver annual returns, net of fees, in

the high single digit to low double-digit range. Risk management is

crucial since many investors choose to invest in fund of funds to avoid

the risk of the large drawdowns that occur more frequently in individual

hedge funds. The “tail risk” of a fund of funds losing all of its capital is

far less than that of an individual fund due to the extra diversification

provided by holding a basket of hedge funds.

Fund of funds provide “instant diversification,” giving investors a

diversified portfolio of hedge funds for a capital commitment typically

on the order of $500,000 to $1 million. Conversely, it would cost an

investor perhaps $20 million for a diversified portfolio of high quality

hedge funds, since top performing funds often have minimum

investments of a million dollars and up. Clearly, a portfolio investment



Fund of Hedge Funds



155



of this magnitude is out of reach of the “mass affluent” hedge fund

investor and falls within the realm of institutional or ultra high net worth

investors.



3. Advantages and Disadvantages of Fund of Funds

As noted above, as an advantage, fund of funds provide investors with

a diversified portfolio of hedge funds for a capital commitment of

$1 million or less. Another advantage is that investors may have partial

access to closed hedge fund managers, since these managers are often

willing to give one of their limited slots to a fund of funds. The

investment commitment of most fund of funds to a top-performing fund

is usually larger than that of the typical individual investor. For example,

a fund of funds managing $500 million, equally spread across 25 funds,

would result in an investment of $20 million to each external manager.

Hedge fund managers running a 3c1 fund are limited to 99 slots, while

those operating a 3c7 fund have a larger, but still limited, 500 slots.

Other things equal, the limit on the number of investors in a fund inclines

hedge funds to have a strong preference for those, such as fund of funds,

which can make large capital commitments.

The organization managing the fund of funds provides services,

which an individual investor would be hard pressed to replicate. The due

diligence process of most fund of funds is quite substantial. Most funds

of funds perform extensive quantitative and qualitative analyses before

selecting a portfolio of funds. After the initial fund of funds portfolio is

created, there is ongoing monitoring, asset allocation, and hiring / firing

decisions. Chapter 13 focuses on due diligence procedures for investing

in single hedge funds and fund of funds.

The main disadvantage of the fund of funds is the additional layer of

fees. The typical fund of funds charges a 1% annual asset management

fee and a 10% incentive fee. However, fees can vary widely, as with

single strategy hedge funds. Other common fee structures include a

higher asset management fee, such as 1.5%, and no incentive fee, or an

incentive fee that is realized after a risk free rate of return is surpassed.



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J. Glattfelder, J. Longo, and S. Spence



Another disadvantage is that fund of funds investors almost always

have to file for a tax extension. Many investors are uncomfortable having

to wait until late summer or early fall to “close the books” on the prior

tax year. Fund of funds cannot complete their K-1 partnership forms until

they receive the tax information from each of their underlying funds.

Typically, the fund of funds will receive K-1s from their underlying

funds in late March or early April of each year, making it virtually

impossible to provide their investors with completed tax forms by the

usual April 15th deadline.

Fund of funds, due to its diversified nature, is unlikely to deliver the

“blowout” returns that are possible with investments in single funds. For

example, Paulson & Co’s Credit Opportunities LP Fund returned a

reported 590% in 2007, using derivatives to take a short position in the

subprime mortgage market. A fund of funds return of 20% in a single

year would be considered “off the charts.”



4. Taxation of Fund of Funds

Fund of funds are generally tax inefficient, since its underlying holdings

often exhibit high turnover. They are taxed on a pass through basis, with

the taxes of the underlying strategy passing through to the holders of the

fund of funds. Accordingly, many fund of funds are held in retirement

vehicles, such as pension funds and qualified retirement accounts and

managed through the offshore counterpart of a domestic fund or through

a master feeder relationship. To use a trivial example, if a fund of funds

held by a high net worth domestic investor provides a gross return of

10% (assume all short-term gains) and an investor is in a 40% marginal

tax bracket, the after-tax return would only amount to 6%. The

inefficient nature of most individual and fund of funds have led to the

development of derivative or structured products on hedge funds, a trend

discussed later in this chapter.



Fund of Hedge Funds



157



5.1 Fund of Funds vs. Direct Investment

As discussed previously, the main advantage of a direct investment in a

portfolio of hedge funds, versus a single investment in a fund of funds, is

to avoid a layer of fees. Table 1 shows the extra loss in returns, or

alternatively the extra alpha that needs to be earned, in order to overcome

the fees charged by the typical fund of funds. For example, if an investor

selected a portfolio of hedge funds that returned 10% after fees, a fund of

funds selecting the same funds would provide a net return to its



Table 1: Returns for Fund of Funds vs. Direct Investment in Hedge Funds

Net Return of Portfolio of

Individual Hedge Funds

-20.0%

-18.0%

-16.0%

-14.0%

-12.0%

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%



Net Return of

Fund of Funds

-21.2%

-19.2%

-17.3%

-15.3%

-13.3%

-11.4%

-9.4%

-7.4%

-5.4%

-3.5%

-1.5%

0.5%

2.2%

4.0%

5.7%

7.5%

9.3%

11.1%

12.8%



Absolute

Difference

-1.2%

-1.2%

-1.3%

-1.3%

-1.3%

-1.4%

-1.4%

-1.4%

-1.4%

-1.5%

-1.5%

-1.5%

-1.8%

-2.0%

-2.3%

-2.5%

-2.7%

-2.9%

-3.2%



Note: The calculation assumes the Fund of Fund (FoF) charges an annual asset

management fee of 1%, has annual operating expenses of 0.5%, and charges a 10%

incentive fee for all positive returns.



158



J. Glattfelder, J. Longo, and S. Spence



investors of 7.5% after the additional layer of expenses. This example

assumes an annual asset based fee for the fund of funds of 1%, annual

operating expenses of 0.5%, and a 10% incentive fee. It may be

unrealistic to assume that the investor creating a “do it yourself ” fund of

funds has no expenses, but they are likely to be less than the 2.5% lost in

fees to the conventional fund of funds discussed in our example. The

higher the returns of the underlying portfolio, the greater the costs due

to the 10% incentive fee kicking in when positive returns are achieved.



5.2 Fund of Funds vs. Multistrategy Funds

Multistrategy funds, as discussed in Chapter 1, deploy capital across a

number of investment strategies. They provide additional diversification,

relative to a single strategy fund, and in some cases, comparable

diversification to a fund of funds. Since the multistrategy fund is housed

in a single partnership structure, it consists of only one layer of fees.

Conversely, fund of funds include a second layer of fees. On the surface,

multistrategy funds seem to dominate the fund of funds approach due to

their lower fee structures. However, multistrategy funds have the same

management, operations and risk management processes, providing a

lack of diversification on these key non-security selection areas. The

blowup of Amaranth Advisors in 2007 has cast fresh doubt about the

superiority of a multistrategy approach vis-a-vis a fund of funds in the

minds of many investors. In Chapter 9 we discuss evolving from a single

strategy fund to a multistrategy fund or series of funds.



5.3 Fund of Funds vs. Portfolio of Managed Accounts

In managed account structures, hedge fund managers replicate their

strategies in separate accounts that are titled in an investor’s name. The

account is run in a largely identical manner to the individual fund, with

the same holdings, weights, trading activity and so forth. In some cases,

managed accounts place restrictions on the holdings and impose

additional risk management mandates. But for all intensive purposes, the



Fund of Hedge Funds



159



managed account is run pari passu to the manager’s hedge fund.3 The

minimum investment to have a manager run a separately managed

account is close to $5 million for startup funds to $50 million or more for

established funds. In short, owning a managed account is like having a

fund manager run a separate hedge fund for you.

From an investor’s perspective, there are several benefits to having a

separately managed account in lieu of an investment in the hedge fund

limited partnership or limited liability company. The most important

is a dramatically reduced risk of fraud. Although quite rare, fraud

occasionally does occur in the hedge fund space. Recent examples

include improprieties related to funds, such as those run by Bernard

Madoff, Bayou Fund, KL Financial, and International Management

Associates. It would be very difficult for an unscrupulous manager to

make off with your money if it were held in an account in your name,

relative to you sending a check or wire transfer to an account controlled

by a hedge fund.

Transparency is another important benefit derived from owning a

separate account rather than a slot in an individual fund. Owners of a

managed account typically receive monthly statements showing the

account’s holdings and trades. This knowledge often provides investors

with greater insight and comfort related to the hedge fund manager’s

strategy. Of course, many hedge fund managers will refuse to run a

separately managed account for fear of divulging their investment

strategy and holdings, since it can often be “reverse engineered” by an

analysis of the monthly financial statements. In addition, there is an extra

administrative burden on the manager to run separate accounts.

Accordingly, there is often a selection bias, with managed accounts run

by managers without the best performance.

Many high quality managers will run separate accounts if their

strategy is long-term or if they have a strong trust factor, supplemented

by a non-disclosure agreement (NDA) with the client. Long-term

strategies can often be uncovered by reviewing a fund’s 13F holdings,

so there is not much incremental risk to the manager to “show their

hand” in a separately managed account format. The importance of a trust

or strong relationship between the manager and investor allays the

manager’s fears that their strategy will be misappropriated in any way.



160



J. Glattfelder, J. Longo, and S. Spence



For example, the family office of a billionaire is unlikely to start his or

her own hedge fund by copying the strategy utilized in a managed

account.

As noted previously, managed accounts also allow for greater

customization, by placing restrictions on the portfolio, such as avoiding

“hot issues” and limiting leverage and concentration. In addition, tax loss

selling trades can be mandated if necessary. In many cases, liquidity

provisions are often better with the managed account, relative to the 1+

year lockup period required by most hedge funds. In sum, separately

managed accounts are generally in the best interests of investors, but

often not desirable to hedge fund managers, so their use varies widely.



6. Historical Performance of Fund of Funds

To assess the historical performance of fund of funds, we have chosen to

utilize the Hedge Fund Research (HFR) Fund of Funds Composite Index,

an equal-weighted index of the monthly performance of currently over

800 fund of funds. Although it is not an investable index, the historical

returns of new funds added to the index are not utilized, reducing backfill

bias; and survivorship bias has been reduced by maintaining the

historical performance of funds that have closed or stopped reporting to

the HFR database. The monthly returns of the fund of funds that are

included in the index are driven by the performance of their individual

hedge funds and are not subject to database reporting biases.

In Table 2 on the following page, we compare the performance of

the HFRI FoF Composite to the total return of the S&P 500. We

show summary statistics over two consecutive, nearly decade long

periods, one with high equity returns and one with low equity returns,

and the combined period. The returns of the two indices over the

combined period are equal, although the volatilities of the paths traveled

were widely different. The volatility of the FoF Composite was 60% less

as measured by standard deviation (5.5% versus 13.9%) and 70% less as

measured by maximum drawdown (13.1% versus 44.7%).



Fund of Hedge Funds



161



Table 2: Hedge Fund Performance

Strong Equity Markets

Jan 1990 – Feb 1999



“The Lost Decade” 4

Mar 1999 – Jun 2008



HFRI

Fund of

Funds

Composite



S&P 500

Total

Return



HFRI

S&P 500

HFRI

S&P 500

Fund of

Total

Fund of

Total

Funds

Return

Funds

Return

Composite

Composite



Annualized

Return



11.0%



17.7%



8.0%



2.0%



9.5%



9.5%



Ann. Std.

Deviation



5.7%



13.5%



5.3%



14.0%



5.5%



13.9%



Max

Drawdown



(13.1%)



(15.4%)



(5.3%)



(44.7%)



(13.1%)



(44.7%)



Sharpe Index

(5%)



1.01



0.92



0.56



(0.14)



0.79



0.37



% Positive

Monthly

Returns



77%



70%



69%



58%



73%



64%



Performance

Measure



Combined

Jan 1990 – Jun 2008



Correlation



0.40



0.50



0.45



Number of

Months



110



112



222



To highlight the differences in the distributions of the returns,

histograms of the monthly returns of the two indices are shown in Figure

2, on the next page, for the same periods. In each histogram, the light

and dark colored bars represent positive and negative monthly returns,

respectively. The mean return is indicated by the vertical line. The shape

of a smoothed distribution is estimated using a kernel density function

and is indicated by the thin, curved line. The FoF index has had fewer

and much less severe losses. This ability to reduce the downside and

preserve capital has attracted high net worth investors to fund of funds.



J. Glattfelder, J. Longo, and S. Spence

“The Lost Decade”4

Mar 1999 – Jun 2008



0.20

0.15



0.20



0.10



0.15



0.05



0.10



0.00



0.05

0.00

-10



0



5



10



-10



-5



0



-10



-5



0



5



10



0.25

5



-15



-10



-5



0



5



10



0.20

0.15



0.20



0.10



0.15



0.05



0.10



0.00



0.05

0.00

0



-10



0.25



0.25

0.20

0.15

0.10

0.05



-5



-15



0.30



-15



-5



0.30



-10



Combined

Jan 1990 – Jun 2008



0.25



0.30

0.25



0.25

0.20

0.15

0.10

0.05

0.00

-15



0.00



S&P 500 Total Return



HFRI Fund of Funds

Composite



Strong Equity Markets

Jan 1990 – Feb 1999



0.30



162



10



5



10



-5



0



5



10



Figure 2: Distribution of FoF Returns



The correlation between the two indices is 0.40 in the first period and

0.50 in the second period and is 0.60 over the last three years ending in

June 2008, indicating a potential increase in correlation over time.



7. Investment Process

7.1 Strategy Allocation

As discussed above, the diversification provided by a fund of funds is

one of its primary benefits to investors. One of the most important

drivers of this diversification is how a fund of funds portfolio is allocated

among the various hedge fund strategies available. Figure 3 outlines

assets under management by investment strategy.



Fund of Hedge Funds



Others, 14%

Arbitrage, 10%



163



Relative Value, 9%

Multistrat, 4%

Macro, 8%



CTAs, 2%

Distressed, 4%

Event Driven, 11%



Long / Short Equities, 30%

Fixed Inc, 8%



Figure 3: Proportion of Hedge Fund Assets By Strategy

Source: Eurekahedge



While the chart above is illustrative of the general investment

strategies used by fund of funds managers, there are many sub-strategies

within these broad categories that need to be evaluated when

constructing portfolios. For instance, in the largest category, Long / Short

Equities, there may exist sub-strategies focusing on directional equity

exposure, emerging markets, market neutral, statistical arbitrage, and

sector specific or short biased strategies. Ongoing developments in the

capital markets also present managers with an ever-changing menu of

strategies to choose from. Strategies will typically go in and out of favor

with investors as the opportunity set for that strategy changes over time.

Fund of funds managers also have the ability to work with underlying

hedge fund managers to “create” exposures that may be unavailable

elsewhere, or not available on a consistent basis. Dedicated short equity

portfolios are a good example of one of these types of strategies. In the

process of evaluating and monitoring an underlying hedge fund manager,

a fund of funds manager may uncover that the hedge fund manager has a

robust short selling strategy that is a component of their long / short

portfolio. The fund of funds manager may ask the hedge fund manager to

carve out this short portfolio to provide a defensive strategy for the fund

of funds to allocate to.



164



J. Glattfelder, J. Longo, and S. Spence



There are numerous processes used by managers to decide on which

strategies to allocate to. Qualitative inputs, such as experience in

investing in a particular strategy, can be just as important as quantitative

inputs, such as expected risk and return. A firm may include or exclude

various strategies depending on a firm’s overall guiding investment

principles, such as avoiding strategies that rely on leverage. Strategy

allocations may also be dictated by the design of a particular product.

Firms often design a product to appeal to different investor needs, such

as lower volatility. A lower volatility fund would normally not include

exposure to directional equity strategies.



7.2 Fund Sourcing

Manager sourcing is another area of significant focus by fund of funds

managers. Before any allocation decisions can be made among strategies,

hedge fund managers must be sourced and evaluated. Finding unique

and talented managers is extremely challenging, but can often be a

differentiating factor among firms. There are three primary methods for

sourcing hedge fund managers: databases, capital introduction meetings,

and referrals.

There are a number of organizations that offer databases of hedge

funds that a fund of funds manager could use to identify potential

investments. Firms such as Lipper Tass, Eurekahedge, and Hedge Fund

Research all offer products, which allow for the scanning of their

database for hedge fund managers that meet various criteria. A great deal

of academic and practitioner research has been written on the potential

limitations of hedge fund databases when examining historical returns.

Like many quantitative investment tools, hedge fund databases should be

used in conjunction with the other quantitative and qualitative tools at the

managers’ disposal.

Many firms also maintain their own database of hedge fund managers

that they have been introduced to. As the number of hedge fund

managers that ultimately receive an investment allocation is a small

percentage of the managers that a firm may review or follow, these

private databases can be quite robust. In addition, the data collection



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