Funds of funds stumble

Hedge funds of funds squeaked past single-manager hedge funds in the July performance race, but got hit hard in August when the credit crunch caught up with them.

Industry observers said hedge funds of funds fell victim to poor performance of the underlying hedge funds in their portfolios during the severe credit market turmoil that occurred between July 19 and Aug. 9. That’s when many hedge funds had to pony up to cover the margin calls on their investments in subprime mortgages by selling their higher-quality, more liquid large-capitalization holdings. That, in turn, caused a market meltdown and a drop in global equity prices.

Underperformance by hedge fund-of-funds managers in August is bad news for institutional investors because most get their hedge fund exposure through funds of funds.

According to early reports from Morningstar Inc., Chicago, funds of funds were down an average of 2% in the month; single-manager hedge funds were down 1.61%.

Indexes also showed funds of funds underperformed single-strategy funds last month. Hedge Fund Research Inc.’s fund-of-funds composite index was down 2.31% in August, while its fund-weighted composite index was down 1.31%.

All hedge funds and funds of funds underperformed major stock and bond indexes in August. The Standard & Poor’s 500 returned 1.29% for the month; the Lehman Brothers Intermediate Government/Corporate Bond index, 1.21%; and the Russell 2000, 2.27%.

In July, by contrast, the average hedge fund of funds returned 0.51% vs. 0.3% for single-manager funds, according to Morningstar data. The HFRI fund-of-funds index returned 0.32%; the single-fund index, 0.14%.

Funds of funds also outperformed year to date and for the year ended July 31.

Morningstar reported that hedge funds of funds returned an average 8.61% year to date, while single-manager funds returned 7.31%. For the 12 months, funds of funds returned an average 16.01% vs. 14.65% for single-strategy funds.

More to come

An executive at a hedge fund-of-funds firm, who asked not to be identified, said the period of worst damage to hedge fund portfolios stretched from July 23 through Aug. 9. She noted that final August returns will show far more of the real effects of the turmoil, despite a strong performance bounce-back in many hedge fund portfolios in the latter two-thirds of August.

David Tsujimoto, director of portfolio management for alternative investments and head of hedge funds of funds at Russell Investment Group, Tacoma, Wash., agreed. “It was a bad month for everyone. No hedge fund — or fund of funds — strategies escaped damage in the month,” he said.

Still, unusually wide performance dispersion occurred among fund-of-funds managers in July and August.

For instance, 168 institutional funds of funds — those with at least $100 million each in assets that are offered by firms managing at least $1 billion for institutional investors — returned an average of 0.26% in July. This was 25 basis points less than the average return for Morningstar’s overall universe of 2,210 hedge funds of funds.

Year to date through July 31, however, the 168 institutional funds outperformed the full universe, returning 8.78% vs. 7.96% for the bigger universe.

The five top-performing institutional funds of funds in July were three La Fayette Asia funds, the Investcorp Event Driven Hedge Fund and the Cadogan Partners fund.

The five poorest performers were three Aetos Capital Management LP funds, the Lighthouse Partners Managed Futures Composite fund and the Arden ERISA fund.

(The July performance of all 168 institutional hedge fund of funds in P&I’s universe is available on our website at pionline.com/hfofjuly).

Although portfolio construction and manager bets account for the lion’s share of performance, the primary culprits in July and August were liquidity constraints anddiversification, said Ryan Tagal, Morningstar’s director of hedge funds and alternative investments.

Mr. Tagal said fund-of-funds performance “came down to diversification. With virtually all hedge fund styles down in August and all heavily correlated to each other, it was hard to get the diversification benefits you usually do with hedge funds of funds. Hedge fund of funds performance really bore the brunt in August of tight liquidity and correlation between hedge fund styles.”

‘Period of crisis’

Russell’s Mr. Tsujimoto agreed that hedge fund of funds were the victims of “a period of crisis when correlations went down to one. That’s what happened in late July and early August. Investors want hedge funds without correlation to each other, but periods of market stress tend to severely reduce correlations, making it hard to find return.”

Some observers were more sanguine.

David Gold, manager research consultant in the New York office of Watson Wyatt Worldwide, said diversification did benefit hedge fund-of-funds managers in August, but everything depended on “the strength of your convictions and when you acted on them.”

Low low-volatility, relative value hedge funds of funds heavily used by institutional investors performed as expected in August, he said, in the -1% to -3% range. Performance depended on the way the funds of funds weighted specific strategies. Those that shorted subprime specialist hedge funds obviously performed much better, Mr. Gold noted.