LONDON (HedgeWorld.com)–Edhec Group, a French Business School, issued its latest report, focusing on the actual management of multi-manager hedge funds in Europe.

Fimat Global Fund Services sponsored the survey of 61 asset managers handling more than EUR136 billion (US$165 billion). Professors found a number of differences relating to asset allocation, due diligence and risk management among firms and also discovered that the majority of investors and advisers are involved in funds of funds.

Asset managers were asked how they manage their portfolios and for their general views of the European hedge fund industry. Most of the managers interviewed were based in Switzerland (33% of managers interviewed) and run a fund of funds (68%). The majority also had more than EUR250 million in assets under management, with a total of 44% having in excess of EUR1 billion in assets.

Edhec found that the most prevalent investor base for funds of funds in Europe remains high-net-worth investors and that funds of funds managers struggle to provide diversified, risk-managed portfolios that can be benchmarked using hedge fund and traditional market indexes.

For the growing institutional investor base who is starting to allocate to funds of funds, they more than likely will find investment offerings focused on a specific type of hedge fund strategy. The motivation for funds of funds investors mainly lies in the vehicles’ diversification benefits and not just the selection of the best managers, according to Alternative Investment Management and Association research, Edhec cites.

It is precisely that diversification benefit that remains a challenge to European funds of funds operators, according to the Edhec report.

The survey showed that only 42% of European fund of funds offer funds that exhibit specific diversification attributes with other asset classes. Another 44% said that they didn’t offer specific diversification, while 7% said they didn’t but soon would.

Edhec officials believe that the managers’ lack of attention to the diversification benefits is linked to confusion about the fund selection tasks and what actions provide the real value in a fund of funds. In a presentation of its findings, Edhec said that managers of funds of funds continue to confuse portfolio allocation with the idea of choosing the best managers.

Constructing the Portfolio

The survey found that 75% of European funds of funds had a team dedicated to portfolio construction and return forecasting. That is coupled with the finding that only 47% of the managers questioned in the survey consider the correlation between funds when organizing the diversification of their portfolios. Most managers (65%) rely on qualitative investment approaches to asset allocation, although Edhec researchers say that results of quantitative allocations have been highlighted in academic research.

Much of that research has gone into how many funds are needed to provide adequate portfolio diversification. The optimal number of selections is often cited to be fewer than 15 hedge funds. Only 18% of European managers surveyed had fewer than 15 funds in their portfolios with most investing in between 15 and 20 hedge funds.

The researchers also looked at the use of indexes and found that most rely on market indexes, such as the MSCI Indexes and the Standard & Poor’s 500 stock index. But a number of them also rely on the HFR (27%), CSFB/Tremont* (27%) and Zurich (13%) indexes, which are specific hedge fund indexes.

But Edhec officials believe the use of such industry indexes may present problems in the form of structural biases. Officials created their index of hedge fund indexes earlier this year, trying to smooth out some of the inherent problems .

Due Diligence Trends

In looking at trends within fund selection and due diligence, officials found that performance databases play a central role for 67% of the funds of funds managers surveyed. The worry is that due diligence may be lagging within the funds of funds community. One-third of the European funds of funds don’t have a dedicated team for risk analysis, the survey found.

Funds of funds managers rely more on the reputation of service providers than on the operational analysis itself. According to Edhec, important information such as off-balance sheet operations is not considered at all by 27% of the survey respondents.

The due diligence dilemma may be simply an economic problem. This trend may continue as the current business model leads to more consolidation or outsourcing, according to Edhec.

Looking at the cost of due diligence, Edhec estimated that the due diligence process can’t be sustained by firms with between US$200 million and US$300 million in assets. Researchers found that while most managers (more than 75%) internally perform due diligence and select their underlying funds, a growing number (more than 10%) entirely outsource due diligence functions.

*Tremont Capital Management, Rye, N.Y., is a strategic partner of and a minority investor in HedgeWorld.com.

SBarreto@HedgeWorld.com