Fund Of Hedge Funds Becoming Obsolete

We've written before about some of the issues with Hedge Funds that are less than desirable for prospective investors, especially the fee structure which creates an element of moral hazard.  Even more egregious are the "Funds of Hedge Funds" (FOFs), which charge an additional layer of fees for the "value-added" of selecting individual funds and combining them into a basket.

FOFs were designed to accomplish several objectives that an individual investor might not have the resources to achieve on his or her own.  They pride themselves as "experts" on each individual fund by performing extensive due diligence and detailed statistical analysis of their return profiles.  In addition, they create better diversification by placing 10 or more funds in a pool.  Investors are also given access to funds that have closed to new investment, except through the fund baskets.

Great concept in theory, but like so many others, often fails miserably in practice.

FOFs, for their services, usually charge both an additional management fee and often take a modest performance fee.  The hedge fund norm is a 2% management fee combined with a 20% performance fee.  The FOF often adds another 1% and 10%, respectively, brining the total to a very steep 3% and 30% of profits.  This fee structure, in a world of single digit returns, makes the entire FOF concept ensure that investors will achieve sub-standard returns.

In addition, despite the claims of great due diligence, so many FOFs have been caught in manager wipe-outs.  Industry fixtures Tremont and Ivy Asset Management, two firms that were former clients, both got trapped by Bernie Madoff.  In fact, every hedge fund manager meltdown, beginning with Askin Management in 1994, Long-Term Capital Management in 1998 and then the slaughter in 2008-09 has exposed the weaknesses of the FOF industry.

The bloom is off the rose.  In year-end 2007, FOFs represented a massive 43% of assets.  Currently, it is down to 34% and shrinking.  FOFs have a growing list of detractors.

David Swensen, the long-time manager of Yale University’s endowment, recently slammed FOFs, claiming among other things, they “are a cancer on the institutional investor world”.

Although Mr Swensen has a well-renowned track record, his group isn't the only one to have added value over the past couple of decades.  In fact, as a substitute for equity investments over the past 10 years, the Hedge Fund Research (HFR) FOF Index has performed remarkably well, returning 5.4% a year versus a return of minus 1.4% for the S&P 500, with a volatility of 6.2% versus 15.1% for large cap equities.

Nevertheless, the very public failures have stuck a knife in FOFs.  According to a recent report by HFR, FOFs are liquidating much faster than they're being created.

Hedge fund liquidations rose in the first quarter of 2010 with 240 funds closing during the period, according to the HFR Market Microstructure Industry Report recently released.  Liquidations were disproportionately skewed towards FOFs, with 102 closing in the quarter.  This marks the 7th consecutive quarter in which FOF liquidations have exceeded new launches.

Fee pressure is finally making itself present in the industry.  Average incentive fees declined by 8 basis points to 19.12% in the 1st quarter of 2010, the steepest drop since the 2nd quarter of 2008, although average management fees were unchanged at 1.58%.   Variance between the best and worst deciles of performance narrowed in the less volatile period, with the top decile of all hedge funds returning an average of 15.2%, while the bottom decile lost an average of 8.6%.

“Both investors and fund managers are continuing to exhibit a heightened sensitivity to leverage and risk, even with the benefit of the performance recovery from 2009,” said Ken Heinz, President of HFR.  “Managers are employing lower levels of leverage in response to higher realized asset volatility and higher costs of obtaining leverage, as well as investor preference for a less volatile return profile.”

Caveat emptor.  What this all should tell you is that if the people who spend every day talking to hedge funds, analysing their returns and statistically measuring how much value they add can be fooled, so can you.  Another reason to avoid this entire industry.

Marko's Take