Don't dismiss funds of funds

Thu Jun 27, 2013

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Why pay top dollar to analyze companies but not to analyze managers?


  Neal Berger of Eagle's View Capital Management
 

By Neal Berger

It has become quite fashionable these days to dismiss fund of funds as providing little value to the investor while simply adding an extra layer of fees. To be sure, this is absolutely true in many cases. However, it is a major fallacy in others.

A fund of funds manager should actually be considered a portfolio manager of hedge funds. Investors think nothing of hiring a portfolio manager to select, monitor, size, and manage the risk of a portfolio of equities or other securities. Most investors are very willing to pay top dollar for managers who can do this effectively and who add value creating attractive risk/reward portfolios. For some strange reason, many seem to believe that doing this same job when it comes to navigating and properly managing the universe of roughly 10,000 hedge funds is of lesser value or skill than navigating a universe of a similar (if not fewer) listed equities in the U.S.

Analyzing, managing, sizing, and trading a portfolio of hedge funds successfully are not an easy task. Having been a portfolio manager myself for more than a dozen years, I would suggest that it is a lot more challenging. The breadth of knowledge and skill of a truly good fund of funds manager are on par or greater than those of a portfolio manager in publically traded securities. There are many more variables, non-public, and often hard to obtain information that a good fund of funds manager needs to consider when managing a portfolio of hedge funds compared with managing a portfolio of mainstream securities. At the very least, public equities are required to disclose an enormity of information that is not as easily obtained when dealing with private hedge fund investments.

Countless hours of sourcing, strategy knowledge, manager meetings, statistical analysis, due diligence, investment skill, and portfolio management are prerequisites to doing the job correctly. A fund of funds that holds a portfolio of mainstream, large, and well known hedge funds may be akin to a mutual fund manager who holds a portfolio of large, well-known, blue chip stocks. These funds of funds, while still providing a valuable service to many, deserve to be compensated in a manner similar to the type of compensation afforded to a large mutual fund manager.

For those funds of funds that are managing an active portfolio of hedge fund "securities" in an effort to produce a unique source of alpha for investors, and who engage in active due diligence, portfolio and risk management, should be viewed, measured, and compensated in much the same way as an active portfolio manager of any other security.

Fund of funds should be measured by their ability to properly navigate and produce solid, uncorrelated, risk adjusted returns within an industry that is fraught with potential pitfalls. In short, anyone who thinks managing a portfolio of hedge funds is simple, or that a good practitioner in this regard adds little value, is sorely mistaken and likely will be in for a rude awakening when market tide ebbs.

Neal Berger is president of Eagle's View Capital Management, a New York-based hedge fund advisory firm and manager to a variety of onshore and offshore funds of funds.