LONDON (HedgeWorld.com)–The strongest first quarter for funds of funds in several years has led Standard & Poor’s to announce that it is stepping up its monitoring of the sector.

The ratings agency said in a statement that it would be “checking the reasons behind performance and potential flaws, such as rising correlation with equities, which could be problematic if a bear market looms.” The move follows data from the S&P Hedge Fund Index showing a 4% rise in the first quarter coupled with the average fund of funds beating the index with a return of 5.2%.

“The best performing funds were those with a directional bias, as in the second half of last year,” said Randal Goldsmith, S&P’s fund analyst, in a statement. “Groups that generally did well were HDF (its Global long-short and Eurovest funds returned 6.5% and 9.2% respectively) and Arundel (its Premier fund returned 8.4%). They specialize in equity long-short, along with Permal and Collins Stewart, who include long-only in their funds.”

However, the top-performing dollar-denominated fund of funds was GAM Multi-Emerging Markets, with a return of 9.1% for the three months to March 30. Mr. Goldsmith noted GAM fund manager Kier Boley’s increased relative success in capturing upside and his outperformance of Permal Emerging Markets, which returned 8%. This reversed Permal’s historic outperformance of GAM Multi-Emerging Markets.

“We are monitoring portfolio positioning and performance, to see whether this improved performance has come from tightening the process or from accepting more directionality and volatility,” Mr. Goldsmith said. He added that the same scrutiny was being applied to GAM Diversity, which returned 6.2% in the first quarter.

Goldsmith said S&P’s monitoring had already shown that GAM’s rated fund of funds looks to have become more correlated with equity markets during the past year. He said this could have been the result of enhancements to the group’s process coinciding with rising equity prices or greater use of leverage since the middle of 2005, to the extent that each of the rated funds contains significant allocations to equity long-short.

BMcIntosh@HedgeWorld.com