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Introduction
The fund of funds industry has grown exponentially since
the first fund, Leveraged Capital Holdings, was launched in
1969. There are currently estimated to be between 1,200 to
1,500 funds of funds globally, most of which were launched
in the past decade. The first Asia-specific fund of funds
was launched in 1993; it is called Asian Capital Holdings
and run by the same group (LCF Rothschild Asset Management)
that manages Leveraged Capital Holdings. There now appear
to be between 30 and 35 Asia/Japan-exclusive funds of funds.
However, most of these new funds of funds have assets below
US $100m.
There appears to be an over-supply of funds of funds, especially
in the US and Europe (a week does not go by without the announcement
of a new fund of funds launch); and a consolidation within
the industry appears likely in the near future. For those
that survive the consolidation, questions will still remain
among investors in alternatives regarding the benefits of
investing in a fund of funds over making a proprietary portfolio
of hedge funds.
Under the assumption that a well-managed portfolio of hedge
funds will produce higher returns with lower volatility than
a portfolio of long-only funds, we will in this study examine
the advantages and disadvantages of investing in funds of
funds over managing one's own portfolio of hedge funds. We
will then look at some comparative performance trends between
Asian and Global funds of funds.
Advantages of investing in funds of funds
- Active management should add value in an opaque and inefficient
industry.
There are approximately 5,000 hedge funds world-wide, with
many of the best names closed to new investors; the costs
are prohibitively high for a single private banker, advisor
or organisation to initiate a database to analyse even a small
portion of the entire hedge fund universe. Thus, one of the
main advantages of a fund of funds is the organisational structure
behind the investment process. Experienced managers supported
by numerous analysts, lawyers and risk-control systems should
be able to weed out the weaker players while providing investors
with exposure to those hedge funds that are closed. The ability
to get into top-tier, closed hedge funds through funds of
funds will become even more important in Asia if, as we expect,
there becomes a disconnect between demand (high) and supply
(low) in the industry.
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Funds of funds provide an inexpensive and efficient way to
diversify.
The hedge fund world is not homogenous. Even in Asia there
exist numerous strategies that are uncorrelated to each other;
providing the fund of funds manager the ability to hedge out
any strategy or style risk. Due to the costs discussed in
point 1 and the US $1 million minimum investment amount imposed
by most hedge funds, to run a proprietary portfolio would
be extremely expensive. An experienced fund of funds manager
who understands the risks involved in each strategy provides
a potentially less expensive alternative.
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Active qualitative, quantitative and regulatory due diligence
by funds of funds add value.
The fund of funds manager is responsible for the qualitative,
quantitative and regulatory due diligence of all prospective
and underlying hedge funds. This due diligence process is
expensive and time-consuming. The history of the hedge fund
world is littered, unfortunately, with ethically challenged
characters. As long as the industry remains loosely regulated,
cases of fraud and other dubious activities will be likely
to persist. It is the job of the fund of funds manager to
weed out those hedge fund managers that do not pass diligent
qualitative (i.e. management abilities, strategy, execution,
etc) and regulatory due diligence procedures. Since it is
counter-productive policy to have a short-term trading horizon
when investing in hedge funds (both for reputation and liquidity
reasons), it is important that the fund of funds manager understands
the underlying manager's strategy and risk profile before
making an initial investment.
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Ongoing portfolio and risk-management due diligence
Due diligence does not stop after the initial investment.
Hedge fund investors must continually monitor their holdings
for efficiency of execution, style drift, personnel turnover,
risk-control and the managers' overall happiness in their
personal and professional lives. To effectively run this ongoing
due diligence process takes time (i.e. travelling to meet
with the managers) and knowledge (both of the different strategies
that one is invested in and in being able to have access to
the manager). Unless one is willing to spend the time and
money for the needed ongoing due diligence, it appears to
be more beneficial to outsource this process to a fund of
funds group.
Disadvantages of funds of funds
- Funds of funds charge an additional layer of fees.
Most fund of funds managers will charge a 1.5% management
and 10% performance fees in addition to the fees charged by
the underlying hedge funds (on average: 1.5% management and
20% performance). This layering of fees will inevitably cut
into performance, and in bull markets it may be more cost-effective
to buy individual mutual funds. However, as shown in the four
advantages listed above, good fund of funds managers do provide
a value-added service that justifies the additional fees charged.
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Lack of transparency involves extreme faith in the manager.
Only the largest fund of funds managers (or the ones that
require segregated accounts) could possibly gain access to
their hedge funds' underlying holdings; and this knowledge,
if acquired by the manager, is rarely distributed to the fund
of funds' shareholders. More likely, the fund of funds management
firm will provide the investor a list of the fund's top five
to ten hedge fund holdings once or twice a year. This lack
of knowledge into what exactly the fund of funds manager is
investing in makes the investor place a great deal of faith
in the fund of funds manager.
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Boutique nature could portend greater risk.
Funds of funds, though fewer in number than hedge funds,
are usually managed by small, sometimes new, asset management
firms which are not connected with large investment or institutional
banks. This can cause concerns for a number of reasons: a)
a lack of a proper marketing structure means fewer assets
under management, b) small funds of funds don't have access
to the top tier of hedge fund managers and c) there is a higher
potential risk of a blow-up. It is important that investors
do their own due diligence on any fund of funds product before
a large investment is made. Like the mutual fund industry
twenty years ago, the number of boutique funds of funds is
likely to decrease due to consolidation and the large numbers
of funds of funds with assets under $100m will decline in
the long-term.
Conclusion
There have been many academic articles written on the return
and risk benefits of investing in a portfolio of hedge funds,
the general conclusion being that a well-run portfolio does
provide high returns with volatility levels similar to those
of bond funds. We believe that to produce this portfolio of
hedge funds, it is more cost-efficient to invest with a top
tier fund of funds manager than to develop a portfolio of
hedge funds from scratch.
Though due diligence is still needed in the selection process
of a fund of funds, and an investor will pay an extra layer
of fees, the time and money required for this type of investment
is less obtrusive and expensive than that required for investing
directly in hedge funds. One of the main purposes of this
directory is to assist the alternative asset investor in the
initial screening process of selecting a top tier fund of
funds.
Performance of Asian funds of funds
The first Asian fund of funds was launched in 1993, when
less than five Asia-specific hedge funds existed. Since that
time the number of Asia-specific and Japan-specific hedge
funds has exploded to over 200 and the list of Asia/Japan-exclusive
funds of funds have increased at almost the same rate (to
over 30 funds of funds).
Most of the Asia/Japan funds of funds have been launched
only in the past 12 months, and have less than US $100 million
under management. As to be expected in markets where the ability
to short and use complex derivatives is limited, these regional
funds of funds invest predominantly in long/short equity strategies.
Since December 2000, Asia/Japan funds of funds have outperformed
their global peers by nearly 4%. An index of Asia/Japan funds
of funds have returned 8.56% while an index of global funds
of funds has a return of 4.61%. Asia funds of funds have a
significantly higher volatility than global products, 4.07%
annualised standard deviation compared to 2.47% for global
funds of funds; this is not surprising considering the lack
of true diversification of Asia and Japan hedge funds (though
the diversification of Asia/Japan products should improve
with the likely launch of more than 50 new hedge funds in
2003). On a risk/return basis, Asia/Japan funds of funds have
a Sharpe ratio that is almost double that of their global
peers, 0.83 and 0.43, respectively (using a risk free rate
of 1.67%, current yield on 3 month U.S. treasuries).
The graph below illustrates the outperformance of Asia/Japan
funds of funds over the past 18 months.
Asia/Japan Funds of Funds vs. Global Funds of Funds
Performance since December 2000
| Statistics |
Asia |
Global |
| Worst month |
-1.81% |
-0.86% |
| Since December 2000 |
8.56% |
4.61% |
| 2001 return |
5.32% |
4.39% |
| YTD 2002 (August end) |
3.09% |
0.21% |
| Sharpe ratio |
83% |
43% |
| Annualised standard deviation |
4.07% |
2.47% |
| Max. drawdown |
-2.96% |
-1.68% |
| Percentage of up months |
65% |
65% |
Not surprisingly the main reason for the outperformance of
Asia/Japan funds of funds is that Asia and Japan-focused hedge
funds have been outperforming their peers in the US and Europe
over the past 18 months. The ABN Amro Eurekahedge Index of
Asia and Japan hedge funds is +10.24% since December 2000
while the CSFB/Tremont Hedge Index of hedge funds globally
is only +5.08% over the same time period.
We find three main reasons for the success of Asia and Japan-focused
hedge funds:
- Asia and Japan-focused hedge funds are mainly equity long/short,
a strategy that did exceptionally well during the equity market
bounce in the last quarter of 2001 and first quarter of 2002.
The hedge fund investment styles are more diverse in the United
States and Europe, and thus a wider range of performance returns
prevailed. CB Arbitrage funds, which are not prevalent in
Asia but are common in Europe and North America, have been
particular laggards since December 2001.
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Smallness is important. The average size of an Asia-centric
hedge fund is US $60 million; being small allows a manager
to be flexible and nimble in his investment process and to
liquidate quickly in volatile markets. Also, the smaller-sized
hedge funds have a tendency to invest more in smaller market-capitalisation
(small cap) stocks, where large hedge funds cannot afford
to tread because of liquidity reasons. The small cap sector
did especially well in 2001 and the first half of 2002. US
and European hedge funds on average are much larger, and were
not able to benefit from this rise.
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There existed, and still does exist, greater market inefficiencies
in Asian markets, especially in Japan, than in the west. Most
strategists would agree that Japan has more bankrupt companies
kept afloat for political reasons than in the US. This provides
excellent shorting opportunities for hedge fund managers.
On the flipside, many Asian companies at the end of 2000 were
incredibly oversold by foreign investors (particularly outside
of Japan). These inefficiencies began to be corrected in October
2001 and Asia-focused hedge fund managers capitalised.
Whether this outperformance continues is, understandably, not
known. On the whole, Asian hedge fund managers' absolute returns
will not be stellar without rising Asian equity markets. Global
fund of funds managers have a greater ability to diversify their
style risk, which has been helpful in the second half of 2002
and may well be for 2003. This directory provides the investor
with a useful, initial tool to analyse both Asian and global
funds of funds across the entire spectrum of investment styles
and processes so one can make a more informed investment decision.
For further performance information and filtering functions
please visit the online fund of funds directory (coming soon)
at www.eurekahedge.com.
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