The much-maligned fund of hedge funds (FOHF) business model got a boost from an academic study. Academics at Purdue University and Loyola Marymount University found that active FOHF management “out perform their style indices” and that the diversified investment methodology “adds significant value.” The report, however, found “mixed evidence” of FOHF to allocate based on “style allocation abilities,” while pointing to the added layer of Fund Of Fund fees, not lack of hedge fund selection skill, as causation lower performance.

Fund Of Fund fees

Fund Of Fund fees – Onerous “double” fee structure is the problem with the model, not skill in selecting managers

The FOHF business model has been much derided due to the duplicitous fee structure. In addition to paying a management and incentive fee to the underlying hedge funds that determine actual investments, the fund of fund fees  structure  adds another fee layer to compensate for its selection and management capabilities. At its extreme, thesr fund of fund fees could double the standard 2% management fee / 20% incentive fee charged by the underlying hedge funds.

The doubling of fund of fund fees is often the headline that has typically been accompanied by stories of poor performance relative to stock market benchmarks – from 2008 to 2016 the HFRI Fund of Funds Composite Index delivered 4 basis points of mean performance relative to the S&P 500 delivering 50 basis points. Poor net performance and faltering returns resulted in dwindling assets under management under management.

Prior to the financial crisis, FOHFs were quite popular, having grown from $108.75 billion in assets managed in 2000 to $1.2 trillion in 2007, according to BarclayHedge data. This dramatic rise also came with a fall, as in the aftermath of the crisis, when much FOHF’s performance was revealed highly correlated to the stock market, by 2016 AUM fell to $360 billion.

While this paints a bleak picture, the reality is different, point out report authors Chao Gao, Tim Haight and Chengdong Yin.

Fund Of Fund fees drag while strategy diversification and investment is a major FOHF strength

There are sometimes overlooked benefits of investing in FOHF, and measuring performance should be done based on the often complex and nuanced investment strategy, which isn’t always to “beat” a stock market index.

A significant component of the Fund Of Fund fees paid would be otherwise spent by the institutional investor towards due diligence, selection decisions, and management costs. FOHFs play an important role in the institutional portfolio because they provide strategy diversification, the report notes, citing previous research. In addition to the cost of due diligence and diversification, FOHFs also might have access to investments that others might not.

The report lauds the funds for their selection abilities to find hedge fund investments that outperform indices before the FOHF’s fee overlay is applied. “We show that FOHF managers add value by selecting hedge funds with superior performance and by skillfully managing existing holdings, while style allocation strategies play a limited role at best.” The “style allocation” component referred to the ability to “time the performance of different investment styles and allocate capital accordingly.”

Much of the study was dependent on the ability of the fund managers to cull stock holding levels through analysis of SEC data using a complex algorithm to simulate a portfolio. Depending on the regulatory jurisdiction, such a study methodology does not include short holdings or certain derivatives exposure to the same extent as long stock holdings.

Individual hedge funds held by Fund Of Funds outperform not only their style indices but also the majority funds in the TASS database. In addition, FOHFs’ holdings with positive flows outperform those with negative flows. Thus, FOHFs are smart in that they add value when they adjust their holdings over time. Nevertheless, FOHFs do not exhibit consistently strong style allocation abilities, which may reflect lower importance placed on style allocation abilities (relative to fund selection abilities) in the hedge fund industry.

When selecting a fund of funds, investors might do well to consider larger funds that engage in a wide variety of investment strategies. But the problem, as has been the common mantra, is the added fees.

“Our results … indicate that FOHFs do have the skills to select well-performing hedge funds,” the report opined. “Thus, the poor performance of Fund Of Fund is more likely due to the double layer of fees, rather than the lack of skills.”

Read the full report: Gao, Chao and Haight, Tim and Yin, Chengdong, Fund Selection and Style Allocation Abilities: Evidence from Funds of Hedge Funds’ Holdings (July 12, 2017). Available at SSRN: https://ssrn.com/abstract=3001166

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