Research

The case of funds of hedge funds: extra cost vs. diversification

The Eurekahedge Funds of Funds Index ended 2018 down 4.58%, trailing behind the average hedge fund which would have lost 4.08% throughout the year. The persistent underperformance of multi-manager funds in terms of net returns has sparked questions over the value proposition offered by such structure, which was supposed to provide investors access to a wider pool of fund managers, as well as cheaper due diligence costs for smaller investors planning to invest in multiple single manager hedge funds. As of December 2018, the multi manager fund industry asset under management (AUM) stood at US$439.6 billion, collectively managed by 2,649 funds of hedge funds. Both the industry asset size and the number of funds of funds have been subjected to a trend of decline since the end of 2010, signifying the insignificant level of investor interest over the recent years.

Figure 1: Funds of hedge funds industry growth
Funds of hedge funds industry growth


As funds of hedge funds failed to generate returns comparable to their hedge fund peers, their fee structure naturally came under investor scrutiny. Figure 2a and Figure 2b below provides the average fees charged by funds of hedge funds tracked by Eurekahedge based on the year they launched, as well as the annual number of launches since 2006 to illustrate the shrinking sample size. Launch activity within the sector has remained muted following the global financial crisis of 2008, similar to the trend observed within the hedge fund industry, albeit to a more severe extent. Funds of hedge funds which launched in 2018 charged 1.00% management fee on average, up from the 0.94% average charged by their predecessors which launched in 2017. On the other hand, the average performance fee went down from 5.47% in 2017 to 4.58% in 2018.

Figure 2a: Number of launches and
average management fees

Number of launches and
average management fees

Figure 2b: Number of launches and
average performance fees

Number of launches and
average performance fees

Figure 3 illustrates the proportion of fund of hedge funds launches charging relatively high fees. Barely over half of the multi-manager funds which started trading in 2018 charge their investors in excess of 5% performance fees, in contrast to how nearly 80% of the funds of hedge funds which launched back in 2010 charged greater than 5% performance fees. In a similar vein, the majority of funds of hedge funds launching over the past five years charged no more than 1% management fees.

Figure 4 below provides the performance comparison of funds of hedge funds against comparable investment vehicles, including hedge funds, long-only absolute return funds, as well as global equities as represented by the MSCI AC World Index IMI (Local). The Eurekahedge Fund of Funds Index has generated 2.32% return per annum since the end of 2009, trailing behind the 4.88% and 5.85% annualised returns recorded by their hedge fund and absolute return fund peers respectively over the same period.

Figure 3: Launches with >5% performance fees and
launches with >1% management fees

Launches with >5% performance fees and
launches with >1% management fees

Figure 4: Performance of funds of hedge funds against comparable investment vehicles since the end of 2009
Performance of funds of hedge funds against comparable investment vehicles since the end of 2009

Table 1 provides the detailed risk-return statistics of the four investment vehicles shown in Figure 4 over the last two, three and five year periods, as well as their annual returns since 2010. As seen from the table, the Eurekahedge Fund of Funds Index has failed to generate positive Sharpe ratio in any of the three aforementioned time periods, as they were unable to generate annualised returns beyond the assumed risk-free rate of 2%. Despite the supposedly added layer of diversification through investing in multiple hedge funds, funds of hedge funds have failed to provide superior downside protection during periods of market downturn such as 2011 and 2018, during which the Eurekahedge Fund of Funds Index underperformed the Eurekahedge Hedge Fund Index by 3.33% and 0.49% respectively.

Table 1: Performance in numbers - funds of hedge funds against comparable investment vehicles

Eurekahedge Fund of Funds Index
Eurekahedge Hedge Fund Index
Eurekahedge Long-Only Absolute Return Fund Index
MSCI ACWI IMI (Local)
2010
5.07%
11.55%
16.85%
9.99%
2011
(5.06%)
(1.73%)
(13.35%)
(9.02%)
2012
4.48%
7.39%
16.71%
13.56%
2013
8.15%
9.12%
12.63%
23.80%
2014
3.69%
5.13%
4.51%
6.82%
2015
0.46%
2.27%
(1.10%)
(0.52%)
2016
0.06%
4.82%
7.65%
7.33%
2017
7.17%
8.52%
20.37%
17.51%
2018
(4.58%)
(4.08%)
(10.91%)
(10.10%)
2 year annualised returns
1.13%
2.02%
3.56%
2.78%
2 year annualised volatility
3.54%
3.36%
7.25%
9.82%
2 year Sharpe ratio (RFR = 2%)
(0.25)
0.01
0.21
0.08
3 year annualised returns
0.77%
2.95%
4.90%
4.28%
3 year annualised volatility
3.50%
3.21%
8.09%
9.77%
3 year Sharpe ratio (RFR = 2%)
(0.35)
0.29
0.36
0.23
5 year annualised returns
1.29%
3.24%
3.60%
3.80%
5 year annualised volatility
3.40%
3.16%
8.03%
9.92%
5 year Sharpe ratio (RFR = 2%)
(0.21)
0.39
0.20
0.18
5 year maximum drawdown
(6.84%)
(5.95%)
(30.08%)
(28.99%)

Source: Eurekahedge

Table 2 below illustrates the correlation matrix between the four investment vehicles over the period starting from the end of 2009 until the end of 2018. The Eurekahedge Fund of Funds Index posted a correlation coefficient of 0.96 with the Eurekahedge Hedge Fund Index, implying that for investors already allocating into hedge funds, there is little additional diversification to be obtained by adding multi manager funds into their portfolios.

Table 2: Correlation matrix
Eurekahedge Funds of Hedge Funds Correlation matrix

Source: Eurekahedge


Figure 5 illustrates the 12-month rolling alpha of funds of hedge funds against the underlying global equity market as represented by the MSCI ACWI IMI (Local) over the past decade. For the purpose of comparison, the chart also includes the historical excess returns generated by hedge funds and absolute return funds against the same equity market index. We can observe that the Eurekahedge Fund of Funds Index almost consistently trails behind the Eurekahedge Hedge Fund Index in terms of excess returns over the global equity market, while on the other hand the Eurekahedge Long-Only Absolute Return Fund Index would generate greater alpha during bull market runs such as 2017, and generate negative alpha during market downturns.

Figure 5: 12-month rolling alpha against MSCI ACWI IMI (Local)
Eurekahedge 12-month rolling alpha against MSCI ACWI IMI (Local)

Figure 6a and Figure 6b provide the percentile distribution of the funds of hedge funds tracked by Eurekahedge throughout 2018, broken down across the geographic and strategic mandates employed by the funds. It is worth noting that the top 10% of the multi manager funds in each mandate were able to avoid recording negative returns throughout the year, despite the various political and economic concerns plaguing the equity and fixed income markets.

Figure 6a: 2018 returns distribution by
geographic mandate

2018 returns distribution by
geographic mandate


Figure 6b: 2018 returns distribution by
strategic mandate

2018 returns distribution by
strategic mandate


The percentile distribution of the funds of hedge funds on an annual basis since the global financial crisis in 2008 can be seen in Figure 6c. Roughly one in every four multi-manager funds tracked by Eurekahedge was able to post positive returns in 2018, and the top 10% of these funds of hedge funds returned in excess of 3.50% during the year. In contrast, less than 10% of these funds ended 2017 in the red.

Figure 6c: Annual returns distribution since 2008
Eurekahedge Annual returns distribution since 2008

 

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