NEW YORK — Morgan Stanley Alternative Investment Partners LP's mediocre hedge fund of funds performance last year proves bigger is not always better.
The $719 million Morgan Stanley Institutional Fund of Hedge Funds LP is the largest hedge fund of funds registered with the U.S. Securities and Exchange Commission. Still, it got caught by two of last year's hedge fund blowups, losing 70% of its combined $34.4 million investments in Beacon Hill Asset Management LLC's Safe Harbor Fund LP and Lancer Partners' Lancer Partners LP fund.
"Size is the enemy of performance, and so is overdiversification," said James R. Hedges, president of Naples, Fla.-based LJH Global Investments LLC, a hedge fund advisory firm.
Mr. Hedges thinks that Morgan Stanley, with 38 hedge fund investments in its fund of funds, made too many investments in too many large hedge funds.
"People believe they move away from single-manager risk by diversifying, but it can be the opposite. Morgan Stanley, with all their diversification, still managed to pick two (bad) managers," said Mr. Hedges.
Morgan Stanley officials disagree. Spokesman Bret Gallaway said managers of the fund believe having more managers is better than having fewer managers.
"We consider diversification as an asset to the risk management process," Mr. Gallaway said.
Mr. Hedges and Virginia Reynolds Parker, founder of the Stamford, Conn., hedge fund advisory firm Parker Global Strategies, reviewed the SEC filings from Morgan Stanley and two other registered funds of funds for Pensions & Investments.
Their findings offer insight into how hedge funds of funds differ in their composition and risk tolerances and how those differences can affect performance.
In addition to the Morgan Stanley fund, P&I also asked the pair to look under the hood of registered funds of funds offered by UBS PaineWebber Inc., New York, and Lazard Alternatives LLC, New York. They are the second- and third-largest registered hedge funds of funds that filed semiannual reports.
No two hedge funds of funds are exactly alike. Some take bigger bets on certain strategies; others seek to invest evenly across a broad array of different styles. Some charge higher fees than others. Performance benchmarks vary from fund to fund.
Most do not reveal anything about their composition to non-investors, making it impossible for outsiders to see which managers the funds select, how much they have with each manager, how those managers contributed to performance and how the composition of the funds changes over time.
The exceptions are those funds registered with the SEC. Hedge fund-of-fund managers choose to register for a variety of reasons, but mainly because doing so allows them to offer their funds to a wider audience of both retail and institutional investors. Unregistered funds are more restricted both in terms of who can invest and how much money they can accept from plan sponsors qualified under the Employee Retirement Income Security Act.
And just as the registered funds P&I reviewed differ from each other, so did some of Mr. Hedges' and Ms. Parker's views of the funds.
For example, Ms. Parker was a little easier on Morgan Stanley, calling the Safe Harbor and Lancer fund blowups "unusual and unfortunate" for Morgan Stanley.
"When hedge fund managers are doing tricky things, you can have very strong due diligence, but if people are not forthcoming with what's going on, sadly this kind of thing can happen," Ms. Parker said.