Funds of funds: have they been 'misunderestimated'?

Mon Mar 30, 2009


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By Neil Wilson

Hedge funds have faced a lot of criticism over the past year - as many have struggled to cope with the global financial crisis. Not all of the criticism has been deserved, but we all know it has been a difficult time and that conditions continue to be very challenging.

The fund-of-funds sector has had arguably the most opprobrium heaped upon it during this tumultuous period. Although the mean returns from the single-manager universe were deeply disappointing, coming in at around -15% last year, the InvestHedge Composite shows that the median for funds of funds - after their extra layer of fees - was, of course, even worse at -16.63%. And, unlike at the single-manager level, only a small minority of multimanager portfolios - mostly those with a focus on specific strategies such as managed futures or macro - were up for the year.

It was a year when the much-vaunted diversification benefits of the multimanager approach simply failed to deliver in most cases. And to add insult to injury, the year ended with the revelation of the Bernie Madoff affair - which showed that all too many supposedly sophisticated allocators had not been clever enough to avoid the world's biggest-ever Ponzi scheme.

It would be surprising, therefore, if all of this should not lead to some serious soul-searching within the industry - about whether the fund-of-funds model itself is irrevocably broken, or whether it needs to be reinvented, and, if so, how?

Clearly, a lot of lessons can be learned from the experience of 2008. But, at the risk of flying in the face of conventional wisdom, I will stick my neck out and say that this is certainly not the end of the road for the multimanager approach.

For one thing, the statistics show that the industry still has considerable scale. The latest numbers on the InvestHedge Billion Dollar Club show that 137 fund-of-funds groups with assets of $1 billion or more are still operating, and together they had collective assets of some $744 billion at the end of 2008. This is down sharply - by about 30% from $1.1 trillion in mid-2008. But when you add in the assets of the 420 or so smaller multimanager groups, it is clear that about half of the $1.8 trillion now being managed in hedge funds is still being allocated via the fund-of-funds route.

As my colleague Niki Natarajan, editor of InvestHedge, succinctly put it: "The industry has taken a serious beating, but it is not an industry that is on the brink of extinction."

Significant consolidation appears inevitable as the boutique players who cannot differentiate themselves in a crowded market decide either to fold up or to team up with others. But it seems to me that some niche players will remain - as there will always be a need for those who can identify the skill sets required in specific areas, such as emerging markets or commodities.

Again, I concur with Niki's conclusion: "A clear-out was necessary, as there were too many sloppy practices in the industry. Everyone, large or small, is going back to the drawing board to make sure that their business can stand the highest level of scrutiny."

Not surprisingly, many expect that those who had exposure to Madoff will have a harder time - though for some, such as UBP or RMF, the exposure was so small relative to their massive pool of assets that they should be able to overcome it. In this context, it is worth noting that only about 30 fund-of-funds groups - out of 550-plus firms on the InvestHedge database - are known to have had exposure to Madoff.

Thousands of other investors, including many high-net-worth individuals, foundations and charities, invested directly or via feeder funds. So when the dust settles on this egregious Madoff affair, it is not clear to me that end investors will conclude that the best way to invest in hedge funds is to go direct and cut out the middleman.

InvestHedge held its annual awards dinner in mid-March in New York. Attendance was lower than in previous years - down from about 400 to just over 300 - which is not surprising following a year of such negative performance. But again, this does not appear to reflect an industry or sector that is suddenly about to disappear.

For the awards this time, InvestHedge took the precaution of ruling out of contention any fund that had exposure to Madoff - though, given the quantitative method used for the ranking, it is not surprising that hardly any funds that had had exposure would have featured anyway. More interesting, and also worth noting, is that only one out of the 20 winning funds from the previous year had exposure to Madoff. This appears to show that the methodology, although designed to reward those that achieve a smoother return profile, also managed to weed out those that tend to make the wrong sort of allocations.