From the September 2006 issue of Wealth Manager Web • Subscribe!

Mixing It Up

Here's the situation: Either you have already invested some of your clients' money in one or more hedge funds, or you've decided that investing in hedge funds would be a good move for your clients. Now you're wondering if it would be better to take a mutual fund-like approach to hedge funds by investing in so-called funds of funds. What are the benefits? Are they worth the additional layer of management and incentive fees attached? In the sometimes less than transparent and often mysterious hedge fund world, such questions are important--though the answers are not easy to come by.

In any event, the time is ripe for looking at funds of funds, says Evan Rappaport, a principal with hedge fund research and services firm Hedgeco.net. "It's important for investment advisors to start looking at hedge funds or funds of funds as part of their asset allocation because if they don't, an investment manager who does will end up taking business away from them."

According to Rappaport, the more than 9,000 hedge funds managing around $1.5 trillion in assets pursue a wide range of investment strategies. Typically, they charge both management and incentive fees--often quoted as 2-and-20 or 1-and-30--meaning a management fee of 1 percent or 2 percent and an incentive fee of 20 or 30 percent, depending on the hedge fund. There are even funds that charge incentive fees as high as 50 percent. In all cases, however, the investor may have to pay the incentive fee only on positive results and sometimes only if the fund clears a specified hurdle--say, for example, a 5 percent positive return.

When you invest in hedge funds through a fund of funds, you incur additional fees--generally 1-and-10--although there are some funds of funds that only charge management fees. While performance and management fees for the 1,105 funds tracked by independent global hedge fund researcher Eurekahedge average 8.66 and 1.33 percent respectively, there are at least 366 funds of funds that charge performance fees of 5 percent or less and 241 that do not charge any performance fees--including some that have been around for 15 years and more.

Consequently, total fees could go as high as 3- and-40, although most run no higher than 3- and-30. But that's high enough and possibly too high, cry some critics. "I am a fan, philosophically, of the strategic advantage of hedge funds--particularly market-neutral funds--but I have a hard time frankly with the fees," says Steven Thorley, H. Taylor Peery professor of finance at Brigham Young University's Marriott School. "Generating enough return to overcome that hurdle is a daunting task."

In fact, historically it has been hard to track down investment return numbers on hedge funds in the first place, but that's changing. For example Eurekahedge claims that it tracks returns of some 7,000 hedge funds, including 2,000 funds of funds, in its database (see table on page 26). Through the end of April 2006, the year-to-date return on the company's Global Index of (2,234) Hedge Funds was 7.81 percent. By comparison, its Global Fund of Funds Index-- based on the performance of 844 funds of funds--returned 6.78 percent or 126 basis points less than the composite return on the underlying hedge funds, but 337 basis points more than the S&P 500's meager 1.08 percent performance for the same period.

Actually, funds of funds have been outperforming both mutual funds and the S&P 500 for the last 15 years--and with less volatility. "The idea of a quality fund of funds is to produce hedge fund-like returns with lower volatilities and without investors having to devote their resources to finding individual hedge fund managers," explains Alexander Mearns, managing director of Eurekahedge. "The downside is that funds of funds managers tend to produce lower returns and have an extra layer of fees." In fact, the annualized volatility of Eurekahedge's Global Fund of Funds Index since 1999 is just 3.7 percent, comparable to the volatility generally found in a fixed income fund.

Although 75 percent of funds of funds employ a multi-strategy approach, it is possible to find funds that invest in single strategies as well. For example, according to Eurekahedge, 12 percent of the funds of funds they track invest only in long-short hedge funds. Judging by the Eurekahedge Long-Short Fund of Funds Index of 153 funds, such investors were rewarded handsomely with a return of 10.98 percent in 2005, 325 basis points higher than the multi-strategy index. "There are some high-quality funds of funds out there consistently delivering returns," Mearns says. "But with 2,000 funds of funds, how do you find them?"

Of course, a major reason for looking at these funds to begin with is that there are close to five times as many individual hedge funds. In short, the hedge fund playing field is so large, and the rules of the game so diverse, that many investors and their advisors are timid about venturing onto the field in the first place. And that is the first argument fund of funds managers make to justify the fees they charge. "Funds of funds are important because a lot of people who need to be in alternative investments simply don't have the ability to perform the due diligence or to follow the wide universe of investment managers that run hedge funds," argues Jay Gould, partner in the San Francisco law firm Pillsbury Winthrop Shaw Pittman.

And the due diligence process, done correctly, is demanding, going well beyond simply picking one or more hedge funds. In its basic aspects, the process is much like the three-part process a traditional money manager follows: Pick securities; do the proper asset allocation within the portfolio; then manage day to day. However, rather than individual securities, the fund of funds manager is choosing individual hedge funds, each of which may follow a strategy that varies--slightly to radically--from the hedge fund next door. According to Cynthia Nicoll, chief investment officer of New York-based fund of funds firm Tremont Capital Management, that is no easy task, especially for the uninitiated. "Ultimately, we are trying to identify opportunities for alpha. To identify operationally good managers, to understand whether or not someone is running a proper hedge fund business, requires a tremendous skill set," Nicoll asserts. "Further, you need to understand what the risks of shorting are, what it means to trade and deliver a derivative to attain leverage and the like. All those things you know if you have experience in this industry."

Depending on the strategy a fund of funds is pursuing, its management team chooses a hedge fund manager based on how he or she intends to asset allocate--something quite different from allocating across various classes of stocks and bonds. In this case, allocation can cross over a variety of strategies and go within various niches inside each strategy. It's here that fund of funds managers have another advantage: They talk regularly to anywhere from 300 to 400 hedge fund managers. They not only know the players; they're on speaking terms with them. They know their investment approach. "So our insights into the market come from a much bigger range of managers," Nicoll continues. "That provides benefits in terms of how we rate certain strategies in a portfolio at any given time."

Finally, a good fund of funds will perform ongoing risk assessment. "We don't think of volatility as a measure of risk," Nicoll says. "We are an absolute return business. The goal is to not lose money." That said, an effective fund of funds manager works to understand how a hedge fund makes money, and that requires a lot of ongoing digging. Do they buy options to protect the downside? Does the way they trade cut risk at the appropriate time? If relevant, are they running a balanced book of long and short positions? The questions are as endless as they are esoteric. "What we're looking at is how do they manage money to make as much money as they can when the markets are good and then protect themselves when the market turns against them," says Nicoll. "We really try to focus on the future: Will our portfolio withstand different market conditions? In the hedge fund industry, you want to manage your downside."

In addition to due diligence, diversification and risk management, funds of funds--at least some of them, anyway--can often wag the dog, bringing your clients lower fees and that even rarer and more valuable commodity--transparency. In fact, a good fund of funds manager will know what's in a hedge fund's portfolio right down to the security level. They will know whether a fund had 100 shares of Microsoft last month and traded 50 shares yesterday, something most individual investors will never know. "We're going to know all that, and we are going to make sure that they are managing according to the mandate in their documents," explains Patricia Watters, chief operating officer at Irvine, Calif.-based Pacific Alternative Asset Management Company. "If they tell us in their documents that they are going to do relative value trades, and all of a sudden we see some evidence that they are not doing that, then we talk to them. Sometimes what they're doing is defensible, and sometimes it's not."

In the end, fund of funds managers are selling an expertise gained, generally, from long years in the hedge fund industry. They know the players, they know the jargon, and they know the many different approaches to investing a dollar in something other than a long position in the stock market. According to Patricia Watters, at least one major pension fund manager thinks there is no way to avoid the cost: "You're either going to pay the fund of funds, or hire your own staff to do the job, or you're going pay with lower performance." There may be a fourth option in there somewhere, but it, too, will certainly cost.

Gregory Taggart (gtaggart@fiber.net), a former practicing attorney who has worked in insurance and financial planning, teaches writing at Brigham Young University.

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