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Portfolio > Alternative Investments > Hedge Funds

What Are the Risks of Funds of Funds?

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Index March 2004 QTD YTD Description
S&P 500 Index* -1.64% 1.29% 1.29% Large-cap stocks
DJIA* -2.14% -0.92% -0.92% Large-cap stocks
Nasdaq Comp.* -1.75% -0.46% -0.46% Large-cap tech stocks
Russell 1000 Growth -1.73% 0.91% 0.91% Large-cap growth stocks
Russell 1000 Value -0.98% 2.92% 2.92% Large-cap value stocks
Russell 2000 Growth 0.46% 5.58% 5.58% Small-cap growth stocks
Russell 2000 Value 1.07% 6.59% 6.59% Small-cap value stocks
MSCI EAFE 0.60% 4.41% 4.41% Europe, Australasia & Far East Index
Lehman Aggregate 0.75% 2.66% 2.66% U.S. Government Bonds
Lehman High Yield 0.68% 2.34% 2.34% High-yield corporate bonds
Carr CTA Index** -1.50% 3.48% 3.48% Managed futures
3-month Treasury Bill . . 0.23%
Estimates as of March 31, 2004. *Return numbers do not include dividends. **Return numbers updated through March 29, 2004.

A hedge fund of funds (FoF) is simply that–a fund that invests in hedge funds. Such funds’ potential to diversify portfolios of traditional holdings, and their relatively smooth return streams, has made them the darling of asset allocators. Investors of all stripes have swarmed to FoFs in recent years. In fact, most knowledgeable observers believe that nearly 60% of all inflows into alternative investments end up in these vehicles.

But behind this seemingly low-risk method of diversification may lurk a beast with much more potential downside than anyone realizes. Consider a recent study by the Edhec Risk and Asset Management Research Centre, which is part of France’s Edhec Business School. According to “Fund of Hedge Fund Reporting: A Returns-Based Approach to Fund of Hedge Fund Reporting,” many funds of funds are not giving investors the information they need to quantify the risks taken in achieving their returns.

Consider, for example, the known tendency for hedge funds to invest in illiquid securities. When there is no market price available for these positions, some funds use the leeway in pricing to smooth out their returns, which may result in reported performance that appears much less risky than it actually is. The Edhec study therefore recommends that FoFs determine if such manager “sandbagging” is markedly affecting their returns.

Another of Edhec’s recommendations is for FoFs to provide investors with exposure information on the principal risk factors of the fund. This could take a number of forms; Edhec recommends that funds disclose the year-to-date return for each strategy and each fund in which the FoF invests, along with performance comparisons of the FoF to traditional indices, fund of fund indices, and the risk-free rate.

Edhec also suggests that FoFs provide information on the gross and net leverage employed at the fund of funds level; the extent of credit spread exposure of the fund; and calculations of skewness, kurtosis, and other measures of the distribution of returns.

Although there’s little doubt that this information would be useful for investors, the relative youth of the fund of funds industry should be considered. At a bare minimum, a 30-month track record would be needed to calculate the statistics suggested by Edhec, with longer track records resulting in more statistically significant results. Therefore, it would be problematic to compare the results of two funds of funds unless their performance history is similar in duration.

But what’s really troubling is just how much work is required to determine the risk in a fund of funds. Because of the tendency of alternative strategies to have some optionality, the distribution of returns is far from normal; as a result, it’s impossible to determine just how likely a big drop in NAV really is.

I realize that a big part of diversification is trading one form of risk for another. At the same time, what concerns me is that large investors are placing an increasingly big chunk of their net worth in vehicles that are so nebulously dangerous. I don’t have a problem with a 10% to 25% allocation to FoFs–I think such allocations make sense–but larger allocations shouldn’t be considered unless the advisor has in-depth knowledge of alternative portfolios.