Chap 19 - Funds of Hedge Funds

Question 1

The primary advantages of a fund of funds are diversification, professional
manager selection, and portfolio management processes. The primary disadvantage
of a fund of funds is a second layer of fees imposed by the fund of funds manager.
Investors may also want to consider multistrategy funds, which manage multiple strategies within a single entity. Multistrategy funds offer strategy diversification
without the additional layer of fees, but there are also trade-offs involved when selecting these funds.

Answer 1

A fund of hedge funds is a diversified fund run by a single hedge fund manager, in
which assets are allocated among other hedge funds. This structure creates two layers of fees: the fees of the fund of funds structure, and the fees of the underlying
hedge fund investments. A key goal of investing in a fund of funds is to improve
portfolio diversification, as a fund of funds quickly diversifies both the risks of concentrated hedge fund styles and the idiosyncratic risks of investing with single hedge fund managers.

Question 2

What are the four important functions a Delegated management using a fund of funds (FoF) approach can provide investors with professional management ?

Answer 2

1. Strategy and manager selection: The FoF manager is responsible for selecting the strategies and the managers who will implement those strategies. FoF managers may have access to closed managers as well as insights regarding strategies that are likely to perform better going forward.
2. Portfolio construction: Once the strategies and managers have been
   selected, the FoF manager has to decide on how much to allocate to each
   strategy and manager. The allocation will depend on the risk and return characteristics of the individual managers and the expected correlations between
   funds, as well as other fund features, such as the lockup period, the liquidity
   of the positions, the size of the fund, and the length of each manager’s track
   record.
3. Risk management and monitoring: The FoF manager will monitor each
   hedge fund to ensure that its ongoing performance profile is consistent with the
   fund’s overall objectives. Some FoFs employ sophisticated risk-management processes to monitor the underlying hedge funds’ positions. Other FoFs may employ
   multifactor sensitivity analysis to gauge the risk exposure to various market factors and to analyze the funds’ potential tail risk.
4. Due diligence: For hedge fund investing, due diligence is the process of monitoring and reviewing the management and operations of a hedge fund manager.
   This is perhaps one of the more important functions and value-added features
   of an FoF manager to consider when deciding between a direct and a delegated
   hedge fund investment program. Unfortunately, some of the large FoFs have been
   marred by blowups and fraud scandals, which have caused some institutional
   investors to become wary about the value of an FoF’s due diligence process.

Question 3

What is Operational due diligence ?

Answer 3

Operational due diligence is the process of evaluating the policies, procedures, and internal controls of an asset management organization. Brown, Fraser, and Liang1 estimate that net of fees, the largest FoFs tend to outperform the smallest FoFs. Larger FoFs may outperform because their scale allows them to invest greater resources in due diligence and risk management processes.

Question 4

What are 11 benefits of investing in FoF ?

Answer 4

Investing in funds of funds (FoFs) offers several advantages, including:

1. Diversification: FoFs provide a well-diversified portfolio of hedge fund managers or strategies, reducing risk for investors.
2. Accessibility: Minimum investment requirements for FoFs are lower compared to single hedge funds, making hedge fund investments more affordable for individual investors and small institutions.
3. Economies of Scale: FoF investors share costs related to manager selection, reporting, and due diligence, reducing individual expenses.
4. Information Advantage: FoF managers have access to data from various sources, giving them an informational advantage over non-professional investors.
5. Liquidity: FoFs offer more flexible liquidity terms compared to individual hedge funds, with options for quarterly, monthly, or even daily liquidity.
6. Access to Top Managers: FoFs often provide access to the best hedge fund talent, even when certain hedge funds are closed to new investments.
7. Negotiated Fees: Some FoFs can negotiate reduced fees with managers due to their collective assets, a benefit beyond what most individual investors can achieve.
8. Regulation: FoFs registered in certain jurisdictions may offer better investor protection, ensuring transparency, oversight, and regular reporting.
9. Currency Hedging: FoFs may offer share classes denominated in various currencies with currency risk hedged, providing protection from currency fluctuations.
10. Leverage: Some FoFs can provide leverage to investors, potentially enhancing returns, as long as the returns surpass the interest costs associated with the leverage.
11. Educational Role: FoFs can serve as a learning platform for first-time hedge fund investors, allowing them to gain experience with hedge fund strategies and managers before considering direct investments.

These advantages make FoFs an attractive option for investors looking to access hedge funds while mitigating risks and enjoying cost efficiencies.

Question 5

What are 6 disadvantages of investing in FoF ?

Answer 5

Investing in funds of funds (FoFs) comes with several disadvantages, including:

1. Double Layer of Fees: FoFs pass on fees from underlying hedge funds and charge an additional set of fees for their services. These fees can include a 1% management fee and a 10% performance fee, on top of fees charged by the hedge funds themselves. However, fees for FoFs have been decreasing in recent years.
2. Performance Fees Not Netted: FoF investors must pay performance fees for each profitable underlying hedge fund, regardless of the overall portfolio’s performance. This can lead to performance fees even when the aggregate portfolio doesn’t yield positive returns. Multistrategy funds may offer lower fees since performance fees are charged on a netted basis.
3. Taxation: Some hedge funds and FoFs registered offshore may be tax-inefficient for investors in certain countries. Non-compliance with tax regulations, as illustrated in Germany, can lead to taxation penalties that affect investors.
4. Lack of Transparency: Some FoF managers do not disclose their portfolio content or asset allocation, claiming it as a proprietary strategy. This lack of transparency can make it challenging for investors to understand risks and returns beyond net asset values.
5. Exposure to Other Investors’ Cash Flows: FoFs pool assets from multiple investors, and cash flows are affected collectively by inflows and outflows. Co-investors’ actions can lead to undesirable leveraging or sales of the most liquid funds first, potentially altering the FoF’s style. This issue doesn’t apply to custom portfolios (managed accounts).
6. Lack of Control: Investors in FoFs relinquish control over asset management and lose direct relationships with the hedge funds within the FoF’s portfolio. Direct investment in hedge funds allows for tailored allocations, while FoF investors can’t control style allocation, which may not align with their preferences or risk tolerance.

These disadvantages, such as higher fees and reduced control, should be carefully considered by investors when deciding whether to invest in FoFs.

Question 6

What are the Three Major Ways for FoF Managers to Add Value ?

Answer 6

The debate over whether funds of funds (FoFs) justify their second layer of fees centers on whether they add value compared to a direct investing approach involving the random selection of 20 to 40 hedge funds. FoF managers can add value through:

1. Strategic Allocations to Hedge Fund Styles: FoF managers must strategically allocate assets to various hedge fund styles. It’s not merely about assembling a large collection of good managers; this can still lead to concentrated risks without true diversification. FoF managers make long-term strategic asset allocation decisions, setting weights across strategies, such as allocating 20% to macro strategies and 30% to equity strategies. This involves analyzing the long-term risk and return profiles of different strategies and considering correlations in returns. Superior strategic asset allocations are a way for FoF managers to add value.
2. Tactical Allocations Across Hedge Fund Styles: Tactical asset allocation is an active strategy to enhance short-term portfolio performance by adjusting asset allocations based on changing market conditions. While many FoFs claim to implement a top-down tactical allocation process, their tactical allocations can be constrained by the liquidity of underlying hedge funds, unless they invest in highly liquid areas of alternative investments or use managed accounts. FoFs can add value by determining how much they adjust asset allocations in response to market changes, primarily by reallocating new investment flows to attractive tactical opportunities.
3. Selection of Individual Managers: FoF managers can add value within a strategy by deciding how much money to allocate to each manager. This decision must consider the liquidity of the funds, and FoF managers must balance the ability to add value through dynamic manager allocations in highly liquid funds with the potential contribution of less liquid funds, such as those with lock-up periods. The selection of individual managers can be a significant source of added value for FoF managers.

These three methods provide potential avenues for FoF managers to enhance returns and justify their fees, making their role more than just assembling a diversified collection of hedge funds.

Question 7

How Many Hedge Funds Provide Reasonable
Diversification?

Answer 7

Using the empirical approach, Fothergill and Coke suggest that a broadly diversified portfolio of between 15 and 20 hedge funds can reduce portfolio volatility to the
level of fixed-income investments.

Gregoriou states that portfolios of more than 40 hedge funds dilute manager skill and approach the risk and return of a hedge fund index.

Question 8

How does due diligence work ?

Answer 8

The next step, due diligence, is the most expensive and most
challenging, beginning with locating and meeting each hedge fund manager. Although
locating managers can be accomplished through database searches, many fund of
funds managers have an edge through proprietary knowledge of managers who do
not report their returns to databases. Large investors are also frequently contacted
by managers who wish to present their funds for investment consideration.

Question 9

What is a multistrategy fund ?

Answer 9

A growing number of hedge fund managers are adopting a multistrategy approach to
investing, in which a single hedge fund diversifies its trading and its positions across
the macro and managed futures, event-driven, relative value, and equity hedge fund
strategies. In many cases, the multistrategy fund designates one portfolio manager to
allocate funds across strategies to various sub-managers, moving assets across teams
trading each of the underlying strategies.

Question 10

What is the key advantage of multistrategy funds ?

Answer 10

The key advantage of a multistrategy fund over a fund of funds is the lack of an
explicit second level of fees. Many multistrategy funds charge fees similar to those of
a single-strategy hedge fund manager, such as 1.5 and 17.5. Although funds of funds
pay each of their underlying managers similar fees, the fund of funds manager also
earns an additional fee, perhaps 0.5 and 7.5. The second layer of fees can cause a
fund of funds to have total fees of 2 and 25.

Question 11

Most multistrategy funds charge the incentive fee on the aggregated returns of the combined portfolio of underlying strategies. Fee netting, in the case of a multistrategy fund, is when the investor pays incentive fees based only on net profits of the combined strategies, rather than on all profitable strategies. This is a distinct advantage over a fund of funds. With a fund of funds arrangement, each underlying fund can charge 1.5 and 17.5, irrespective of the performance of other funds; there is no netting of profits and losses across funds in determining incentive fees charged by the underlying funds in an FoF.

Question 12

Incentive fees were discussed in Chapter 14 as call options on the NAVs of the
fund. Limited partners in funds with incentive fees can be viewed as having written call options to the managers. An investor in a fund of funds can be viewed as
having written a portfolio of call options, one on each fund. An investor in a multistrategy fund may be viewed as having written a call option on the portfolio of the aggregated strategies.

Answer 12

Lomtev, Woods, and Zdorovtsov estimate that the mean savings from fee
netting gives multistrategy managers a 0.23% annual return advantage relative to
funds of funds.

Question 13

Empirical evidence indicates that multistrategy funds have historically outperformed funds of funds on a risk-adjusted basis, predominantly due to the extra lay of fees charged by fund of funds managers. Agarwal and Kale estimate that multistrategy funds outperform funds of funds by a net-of-fees alpha of 3.0% to 3.6%
per year after accounting for exposure to market risks.

Answer 13

Agarwal and Kale attributethe superior performance of multistrategy managers to a self-selection effect. Theself-selection effect in this case is when only the most successful and confident singlestrategy hedge fund managers choose to become multistrategy managers by hiring a team of experts and expanding into the world of multistrategy funds. However, it can be argued that the best and brightest among the available hedge fund managers do not remain satisfied in the role of multistrategy fund manager, preferring to manage their own single-strategy fund in order to link their compensation to their own money management skill rather than to the performance of the managers they oversee.

Question 14

The primary purposes of funds of funds are to reduce the idiosyncratic risk of an
investment with any one hedge fund manager and to tap into the potential skill
of the fund of funds manager in selecting and monitoring hedge fund investments.

Question 15

What is a

Answer 15

A liquidity facility is a standby agreement with a major bank to provide temporary cash for specified needs with prespecified conditions.

Additionally, some funds of funds arrange to have a liquidity facility
that can bridge the fund’s mismatches between subscriptions and redemptions.

Question 16

What is Seeding funds ?

Answer 16

Seeding funds, or seeders, are funds of funds that invest in newly created individual hedge funds, often taking an equity stake in the management companies of the newly minted hedge funds. One reason that a seeding fund may create new funds is to obtain transparency and capacity in its underlying hedge fund managers, which can be difficult to obtain with existing hedge funds.

Question 17

Perhaps the best way for a fund
of funds to guarantee transparency and capacity over the long run with specific hedgefund managers is for the fund of funds to own a stake in the hedge fund management company.

Question 18

Whereas investors with a small amount to invest in hedge funds may find these fees to be cost-effective, larger investors need to compare the value of paying fees to funds of funds relative to building a portfolio of hedge funds using in-house resources.

Question 19

What are the disavantages of due dillegence ?

Answer 19

There are a number of costs involved with the hedge fund due diligence process.
It is expensive to subscribe to hedge fund databases, to hire and retain internal staff
skilled in manager selection and portfolio construction, and to fund the expenses of
visiting and evaluating each hedge fund manager. In addition, since the minimum investment in hedge funds tends to be rather large, only investors with very large
portfolios can hold a diversified portfolio of hedge funds.

Question 20

Liquid alternative investments are innovative products that democratize alternative investments by allowing all investors to easily access these strategies in an exchange-traded and transparent format.

Answer 20

As the quality and the number of liquid strategies increase, the business model of
funds of funds could be negatively affected. When individual investors can easilym access transparent, liquid hedge funds with a low minimum investment, the advantages of a fund of funds to diversify investments and offer a low minimum subscription become much less compelling.

Question 21

The investors attracted to liquid alternative products are those who may value the lower fees, greater transparency and liquidity, as well as the reduced risk of these products over the potentially higher returns from private placement products.

Answer 21

There is also evidence of retail investors, or those not legally lowed to access private placement products due to low net worth levels, increasingly investing in liquid alternative products to diversify their portfolios in ways that were previously not possible.

Question 22

What are the UCITS regulations over time and how do they vary from hedge funds ?

Answer 22

1. UCITS III (2001): UCITS regulations initially focused on traditional long-only stock and bond funds. UCITS III, enacted in 2001, marked a significant change by permitting the use of options, futures, and other strategies in UCITS-compliant funds. This expansion allowed managers to offer hedge-fund-like strategies within the UCITS framework.
2. UCITS IV (2011): The UCITS IV regulations, introduced in 2011, further enhanced the flexibility of UCITS-compliant funds. It allowed for fund mergers and master-feeder structures, providing hedge fund managers with even greater options for structuring their funds.
3. UCITS V (2016): UCITS V, enacted in 2016, focused on tightening asset custody requirements. It mandated the use of a single depository responsible for explicit safekeeping requirements.
4. Transparency and Reporting: UCITS regulations impose strict requirements for transparency, risk management, and liquidity. UCITS-compliant funds are required to report their holdings at least every two weeks, enabling investors to monitor their fund’s composition regularly.
5. Less Flexibility Compared to U.S. Regulations: While UCITS regulations have evolved to accommodate a broader range of strategies, they are generally less flexible than the regulations under the U.S. Investment Company Act of 1940. For example, UCITS funds typically do not permit investments in property, private equity, or commodities.
6. Leverage and Concentration Control: UCITS regulations impose strict controls on leverage and concentration risks. Typically, leverage is limited to 200% of Net Asset Value (NAV) or the risk of the underlying index. UCITS-compliant funds are required to be highly diversified, with limits on the size of specific holdings within each fund.
7. Diversification Limits: UCITS regulations specify limits on holdings, such as a 35% limit on holdings of a single European Union sovereign debt issuer, a 20% limit on holdings of a single investment fund, a 10% limit on illiquid investments, and a 20% limit on assets deposited within a single institution. Furthermore, there are limits on holdings of a single corporate issuer (10% or 20% when derivatives are included).

Question 23

What are the symmetric performances fees from 40’ Acts and the difference with the perfromance fees of hedge funds ?

Answer 23

Hedge fund managers typically have incentive fee structures that
allow managers to receive 20% of all fund profits without the requirement of compensating investors for 20% of their losses. This asymmetric fee structure, which is very attractive to managers of private placement products, is not compliant with the regulations of the ’40 Act. Although most managers of ’40 Act funds do not charge performance fees, there are a few managers who charge symmetric performance fees. These performance-based fees are unlikely to ever be as popular with liquid alternative managers as the asymmetric performance fees that can be earned in the private placement world.

Question 24

19.6 KEY OBSERVATIONS REGARDING HISTORICAL RETURNS OF FUNDS OF FUNDS

Answer 24

• Market-Defensive Funds of Funds: These funds tend to have underlying short positions and engage in short-biased strategies, such as short selling and managed futures. Ideally, they should have low to negative correlations with major market indices.
• Conservative Funds of Funds: These funds seek consistent returns by investing in more “conservative” strategies, including Equity Market Neutral, Fixed Income Arbitrage, and Convertible Arbitrage.
• Strategic Funds of Funds: These funds tend to make directional bets and aim for superior returns by investing in more opportunistic strategies like Emerging Markets, Sector Specific, and Equity Hedge.
• Diversified Funds of Funds: These funds represent a mix of various strategies from multiple managers.
• Composite Index of Funds of Funds: This index invests across the different styles of funds of funds investments.

Key observations on funds of funds returns include:

1. Historic Return Volatility: The return volatility of all fund of funds sub-indices and the composite index is generally less than one-third of that of world equities. The strategic index has slightly less than one-half of the volatility.
2. Return Skewness and Kurtosis: Only the conservative index exhibits returns that are significantly negatively skewed and has very large positive excess kurtosis.
3. Return Autocorrelation: All fund of funds sub-indices and the composite index exhibit high first-order return autocorrelation, except for the defensive index.
4. Maximum Drawdown: All fund of funds sub-indices and the composite index experience less than half the maximum drawdown of world equities. The defensive index, in particular, has a maximum drawdown of only 10.9%, which is less than one-fifth of that of world equities.

In summary, funds of funds have historically shown lower volatility, lower drawdowns, and significant autocorrelation in their returns compared to world equities. The various styles of funds of funds exhibit unique characteristics in terms of their strategies and return profiles.