Central to the success of any multi-fund portfolio is identifying and evaluating the hedge fund managers (HFs) to be ultimately included in the portfolio. With estimates as high as 10,000 HFs to choose from, this process can be overwhelming. The job is further complicated by the wide range of HF investment strategies, minimum investments, fee structures, leverage factors, capacity constraints, etc. It is really no wonder that many individual and institutional investors consider funds of funds (FOFs) rather than embark on this process alone.
Before screening and analysis can begin, a FOF first must gather sufficient HF data. From this pool of data, you will select and analyze individual managers, compare managers to their respective peer groups and build the fund of funds portfolio. Ultimately, this same database will be used to judge the ongoing performance of your FOF. Although there is no central clearinghouse for hedge fund information, it is imperative to screen the largest possible number of managers to avoid overlooking managers that could benefit the portfolio. Luckily, over the past decade, the emergence of commercial hedge fund databases has made the data collection process significantly easier.
Both fee-based and free databases offer FOFs a wealth of qualitative and quantitative information on hedge funds. Recognizing that each database vendor's unique methodology make comparisons difficult, costs range from USD 3,000 to USD 6,000 and each database contains approximately 2,000 HFs.
Each database covers a distinct subset of the HF world. This fact was confirmed by a recent study conducted by Strategic Financial Solutions LLC, the creators of PerTrac 2000 investment analysis software. That study indicated significant numbers of HFs choose to report to only one of the major databases . As such, some of the databases tend to attract smaller, emerging funds with short track records and less than USD 25 million under management while others cover more non-U.S. HFs, and still others include CTAs or long only funds. More recently, specialized databases have surfaced which may cover a specific geographic region or particular hedge fund strategies.
It is impossible to say whether there is a clear leader among the commercial hedge fund databases. One should always consider issues such as cost, coverage, accuracy, depth of detail and delivery method when evaluating hedge fund databases. However, one thing is clear: a FOF cannot depend on a single database as its sole source for finding managers. While convenient, there are some limitations and difficulties with hedge fund data collection that plague all of the major databases. These include double counting of "clone" funds and widespread disagreement about how to separate HFs into logical strategy categories. In addition, there are reporting issues to consider. A hedge fund is not obligated to report to any database. As a result, funds may stop reporting to a database unexpectedly, or performance may not be kept up to date.
To further complicate the matter, many of the most desirable HFs do not report to any of the databases. To gather information on these "unlisted" managers, FOFs must collect data on their own. Hedge fund publications, conferences and prime brokers can all serve as valuable sources of information for resourceful FOFs.
With sufficient HF data in place, the FOF must determine its investment mandate. During this phase, it is important to ask such questions as: Is the FOF being designed for individual or institutional investors? What qualitative constraints are the investors likely to expect? What is their risk tolerance? Should the FOF invest in HFs across the strategy spectrum or focus on a specific style? What liquidity will be required in order prudently manage the FOF while meeting investor withdrawal demands? When marketing the FOF, will I emphasize stability or total return? The answers can provide valuable guidance when choosing appropriate screening statistics. Some common screening statistics2 include Sharpe and Sortino ratios, drawdown, correlation analysis, and percent profitable months.
Finally, it is time to actually begin the screening process. Although investors often approach this task with arbitrary criteria, these statistical "wish lists" rarely yield the best results. Instead, it is a good idea to begin the screening process by analyzing all of the funds within a given strategy peer group and finding the statistical breakpoints for the top quartile or decile. Then, those data points can then be used as screening statistics. For example, assume the FOF investment mandate is to produce conservative, steady returns with a focus on arbitrage managers. We might screen our database for convertible arbitrage HFs and find that the top 25% have a compound annual return of 14.4% over the past five years. Then, we might re-screen the database and find that the top 25% have Sharpe ratios greater than 1.4 and more than 86% profitable months. We could then look for HFs that meet or exceeded those statistical breakpoints. Thus, we can be fairly certain of finding the top performers. While this may sound like an arduous process, analytical software, much of which is compatible with the major HF databases, significantly simplifies the process.
Once a group of managers has been identified, it is important to conduct a thorough correlation analysis to ensure that the portfolio is properly diversified. Additionally, portfolio simulations and stress tests can provide insight into the best and worst case performance scenarios for the FOF. Finally, no investment should be made without thorough background checks and a formal due diligence process.
The analysis of the underlying managers and the FOF does not stop after the initial investments have been made. The FOF must continuously re-evaluate the portfolio for possible additions, redemptions and reallocations. It is also important to regularly benchmark the FOF as a whole. Is it at the top of its strategy peer group for return? Risk control? Volatility? This information can then be used to develop marketing strategies to attract new capital and retain existing investors.
With all of the time and effort it takes to construct and monitor a FOF, it is no wonder that investors are willing to pay additional fees to a qualified FOF manager. For those starting a FOF, the key to a successful launch is careful data collection and analysis. However, the secret to long-term success is vigilant monitoring. If the FOF pays attention to both, the opportunities for both investors and FOF managers to profit can be substantial.
Strategic Financial Solutions
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