By Robert C. Pozen
Over the last decade, hedge funds have soared to more than $1 trillion in assets from less than $200 billion. Today the hottest subcategory is the fund of funds, which holds more than 45% of hedge fund assets and garners over 60% of hedge fund sales. Yet the advantages of funds of funds, or FoFs, do not seem to outweigh their disadvantages on average. To find above-average FoFs, investors would need a better system of performance reporting.
Funds of funds are popular for three main reasons:
Access: By using a fund of funds, investors with smaller portfolios can meet the minimum requirements of most hedge funds, often $1 million or more. However, FoFs do not guarantee access to the best hedge funds, which might accept investments solely from long-standing partners.
Diversification: Investors can achieve the benefits of diversification through FoFs, which can hold a large number of hedge funds with different strategies. Survey estimates of the median number of hedge funds held by FoFs have ranged from five to 40. But it is unclear to what degree the investment strategies of the hedge funds held by most FoFs are correlated.
Expertise: Investors choose a fund of funds because they are seeking expertise in selecting and monitoring the underlying hedge funds. While most FoF managers do evaluate the investment process and personnel quality at many hedge funds, they charge a second layer of fees for their services. The most common structure for FoFs is a base fee of 1% of assets plus an incentive fee equal to 10% of gains. These fees are in addition to the typical fees charged by hedge funds — a base fee of 1% to 2% of assets plus an incentive fee of 15% to 25% of gains.
Have FoFs delivered incremental returns that justify this additional layer of fees? According to a working paper the returns of FoFs were lower on average than the returns of hedge funds for the period 1994-2003. Although the paper showed that FoFs generally exhibited lower volatility than individual hedge funds, risk-adjusted returns were lower for FoFs than for hedge funds on average. (The paper is "Fees on Fees in Funds of Funds," by Stephen J. Brown, professor of finance, Stern School of Business, New York University; William N. Goetzmann, professor of finance and management and director of the International Center for Finance, Yale University School of Management, New Haven, Conn.; and Bing Liang, associate professor of finance, University of Massachusetts, Amherst.)
While investors will try to find above-average FoF managers, they will be challenged by the weakness of performance statistics for FoFs and individual hedge funds. Most FoF managers are registered under the Investment Advisers Act, and many hedge fund managers will register under that act in early 2006. However, registration does not require the disclosure of performance statistics; it mainly involves record keeping and Securities and Exchange Commission inspections. Thus, the main sources of comparative statistics on the performance of these managers are the databases of private vendors.
These private databases have systematically overstated annual returns by hedge funds and FoFs by as much as four percentage points, as demonstrated by Burton G. Malkiel, professor of economics at Princeton University, Princeton, N.J.; and Atanu Saha, managing principal at Analysis Group, New York, in their article "Hedge Funds: Risk and Returns" in the Financial Analysts Journal.
There are four main methodological concerns with these databases:
Voluntary reporting: No private vendor can force managers of hedge funds or FoFs to submit regular reports. Naturally, managers with better performance tend to report to these vendors more than managers with weak performance.
Selective starting dates: When entities begin to submit performance statistics to a private vendor, they can select the starting date that maximizes their returns. For instance, a hedge fund that began in 1995 can report its performance starting in 1997.
Survivor bias: The databases of some private vendors are biased toward those hedge funds and FoFs that survive by doing well. These databases do not take into account the significant number of hedge funds that go out of existence after three or four years because of poor performance.
Non-standardized returns: Private databases are not in a position to insist that hedge funds and FoFs follow a uniform methodology for reporting returns. By contrast, the SEC and the mutual fund industry took several years to agree on a standardized methodology and format for reporting returns.
To allow investors to engage in comparative shopping, the key regulators in each country — such as the Financial Services Authority in the United Kingdom and the SEC in the United States — should convene a task force to set ground rules for performance reporting by FoFs and hedge funds. If the task force could reach an agreement on such ground rules, they would quickly be adopted by private vendors. Furthermore, the task force should establish two guidelines for private vendors — they should accept the submission of performance data from FoFs or hedge funds only starting from the first full year of operations, and they should correct for survivor bias by continuing to include the performance of FoFs and hedge funds that have closed down for any reason.
Robert C. Pozen is chairman of MFS Investment Management, Boston.