History repeats itself - only differently. This contradictory phrase notes the inherent difficulty in forecasting the future. More often than not the soothsayers get it wrong. The comment making the rounds is that fund of hedge funds (FoHFs) have seen their day and will be replaced by multi-strategy funds. Should one believe this to be correct? Any trend forecasted indefinitely into the future is incorrect in its assumptions. Does a 7% growth rate in public sector jobs imply one day in the future everyone will be working for the government?)

Yes, with FoHFs there is a second layer of fees and some of the benefits of FoHFs can be achieved with multi-strategy funds. However the key word is "some" not all. Multi-strategy funds can replicate diversification by strategy. However, this brings us to a "Jack of All Trades" scenario. The best managers in our industry have generally concentrated on a single or narrow group of strategies. The question to ask yourself is whether your chosen multi-strategy manager can assemble and effectively manage top-tier talent across multiple strategies. This is a far more difficult task than initially perceived and is compounded by the widely differing needs of managers of varying and divergent strategies.

Provided that multi-strategy funds can meet your needs by diversification of strategies, you still lack the safety net of being optimally diversified by number of funds. Few to no multi-strategy funds employ as many separate funds as a well diversified FoHF.

This brings us to the most compelling argument that FoHFs should not be replaced by multi-strategy funds - operational risk. Fund of hedge funds mitigate the operational risk of the underlying managers with diversification by sheer numbers. The oft-cited study by Capco showed that approximately 55% of fund failures were attributed to operational difficulties. In FoHFs, this risk is spread over 20, 30 or more management firms. With a multi-strategy fund, this risk is concentrated within one firm. Should this given asset manager have company-wide operational problems, it will extend to each of the components of their multi-strategy funds.

While we are comparing apples to oranges, FoHFs themselves are undergoing changes. Within the FoHF universe, we see a lot of consolidation and some believe that smaller and mid-size FoHFs will disappear. Many would agree that the ease of entry for new FoHFs is too low and that the bar should be raised. There is a growing consensus that the real problem in the industry is a "wall of mediocrity". So, what do smaller FoHFs have to offer that their multi-billion dollar cousins do not?

Small and mid-size FoHFs add value in that

1. They provide "bundling" of small managers. Smaller FoHFs are able to spread investment across talented new and/or smaller managers that due to their size and circumstances would not attract institutional size investment.
   
   

2. They provide local due diligence. A FoHF specialising in a certain geographical area has an advantage over many of the larger fund houses which concentrate on the more widely invested areas.

3. They may provide geographic area expertise in their distinct markets. At a minimum they may offer themselves as a potential joint venture partner to enter a new area.

4. Lastly, they can provide a myriad of bespoke offerings to HNWs and family offices that may not be offered by the largest of the FoHF managers.

A primary argument promoted by FoHF naysayers is that the second layer of fees substantially erodes returns to investors. However, in comparing recent returns by selected indices there seems to be negligible differences. One data provider's indices show their multi-strategy composite to be only 0.02% greater than their FoHF composite during the same 12-month rolling period.

So what is happening in the FoHF space now? In one study, over the last year a representative cross-section of FoHFs from continental Europe, the UK and North America showed an increase of 56% on an AUM-weighted basis to July of this year and 62% on an equal-weighted basis. The bulk of the growth in their AUM (85%) came from inflows of institutional investor money, with the rest made up of HNW inflows and performance gain over the period. So are FoHFs dead? The real picture is summed up in the statement once made by Mark Twain "I regret to inform that the news of my untimely death has been greatly exaggerated".

This article originally appeared in the AIMA Journal (Winter 2005 issue), published by the Alternative Investment Management Association.