FoHFs sustainability questioned in new academic research

Date: Tuesday, October 18, 2011
Author: Charles Gubert, COO Connect

Just 5.56% of funds of hedge funds (FoHFs) delivered alpha above the alpha of the hedge fund indices, according to research by the Solvay Brussels School of Economics and Management.

“Only a small fraction of FoHFs deliver alpha above the one already delivered by the universe of single manager hedge funds. This means that the additional layer of fees that FoHFs charge investors eats away any manager added value,” read the report. Institutional investors have predictably been pushing FoHFs to reduce their fees from the traditional 1 and 10 model. “Any fund picking skills (if existent) are diluted by the additional layer of management and incentive fees,” added the report.

The report, which surveyed 1,315 FoHFs between January 1994 and August 2009, revealed 47.5% of these institutions delivered negative alpha raising further doubts about these firms’ sustainability. FoHFs have had a woeful time since the crisis. Many underperformed during 2008 while some had exposure to Bernard Madoff and other high profile frauds prompting questions about the rigour of their operational due diligence processes.

More recently, there have been criticisms that FoHFs lack diversification by allocating to brand name managers – who have had either low or negative performance returns over the last year. FoHFs' assets under management (AUM) now stand at $667 billion – well below their 2007 peak of $799 billion, according to data from the Chicago-based Hedge Fund Research.

The average FoHF has seen an asset decline of approximately 50% with the mean FoHF currently managing $2.18 billion in 2011 compared with $2.75 billion in 2010, and $4.78 billion in 2008, highlighted research specialists Preqin. Investors have been weary of these businesses ever since Madoff, said Preqin.

However, some have argued that it is unfair to write FoHFs off just yet. The Solway Brussels School’s research ended in 2009, when FoHFs were at their nadir. FoHFs have actually outperformed hedge funds by 60 basis points and the S&P 500 Index by 560 basis points since May 2011 indicating a possible reversal of fortunes, according to studies by BarclayHedge and TrimTabs Investment Research. Many FoHFs are also marketing their operational due diligence expertise as a value add to investors, particularly pension funds who do not have that much experience of direct hedge fund investing.

Despite such solid returns, FoHFs have experienced $7.1 billion in capital outflows since the beginning of 2010 while single managers have attracted $103.3 billion from investors over this timeframe.

* Assessing the Performance of Funds of hedge funds by Benoît Dewaele, Hugues Pirotte, N. Tuchschmid and E. Wallerstein