Fund of Funds
A fund of funds (FOF) raises capital from limited partners and invests the proceeds in several hedge funds. Hedge fund of funds can potentially solve a number of the aforementioned problems. They may offer lower minimums, have more regular liquidity, but most important, they perform the due diligence and manager selection for you. If staffed by a competent group, this function can prove to be worth its weight in gold. Risk is also spread across a number of funds, from a low of a couple of funds to more than 100. However, selecting a FOF group is just like selecting any manager—it all depends on the quality of the manager chosen. Also important, the resulting fund should provide low correlated returns to the investor's current portfolio.
Table 6.1 Description of Strategies
Nondirectional Strategy Descriptions
Equity Market Neutral Convertible Arbitrage
Fixed-Income Arbitrage
Opportunistic Strategy
Long-Short Equity
Emerging Markets Dedicated Short Bias
Employ individual stock-selection strategies in a market-, industry-, and sector-neutral portfolio to identify return opportunities both long and short. Use quantitative risk control to minimize systematic risk and balance long and short positions.
Purchase convertible securities (often bonds) and sell short the underlying common stock to exploit perceived market inefficiency. Neutralize most risk factors outside of the bond's credit risk, earning coupon interest income and short rebates rather than trading on option volatility.
Employ strategies to exploit relative mispricings among related fixed-income securities. Strategies typically focus on mispricing relative to a single risk factor—duration, convexity, or yield curve changes—increasing risk control by neutralizing residual factors.
Descriptions
Take independent long and short stock positions by buying top-tier stocks and shorting those in the bottom tier, seeking to "double alpha." Portfolios often are net long or net short with systematic risk exposure and bets on size, industry, sector, and/or country risk factors.
Invest in emerging-market currencies and equity and fixed-income securities with the goal of exploiting perceived market inefficiencies considered to occur more frequently and yielding larger returns. Managers face unique risks in undeveloped markets that are typically characterized by limited information, lack of regulation, and instability.
Sell borrowed securities, hoping to later repurchase at a lower price and return them to the lender. Short selling earns a profit if prices fall. Interest is also received on the cash proceeds from the short sale.
Global Macro
Managed Futures
Event Driven
Bet on global macroeconomic events, anticipating shifts in government policy or market trends. Focus primarily on directional trades using currencies, derivatives, stocks, and bonds, rapidly shifting between perceived opportunities while taking on significant market risk (more when leveraged).
Success depends directly on the skill of the manager.
Rely on technical or fundamental trend-following models to invest in global options and futures based on currencies, interest rate and index derivatives, and commodities. Risks include unanticipated commodity shocks, incorrect forecasts, and poor trade timing or positioning.
Profit on firm events such as acquisitions, mergers, tender and/or exchange offers, capital structure change, the sale of entire assets or business lines, and entry into or exit from new markets. Returns tend to be highly dependent on a manager's ability to spot these opportunities. Do not hedge against factors such as a weak merger environment or the risk that deals are not completed.
Source: "Understanding alternative investments: A primer on hedge fund evaluation" by The Vanguard Group, 2006.
Academic Fund Managers
Swensen is not alone—some of the best funds are run by academics. The fourth biggest (and very likely the best) hedge fund is run by the mathematician James Simons. Founded in the 1980s, the Long Island-based fund Renaissance Technologies now manages over $30 billion. The flagship Medallion fund has consistently returned 35% a year after a 5% management fee and a 44% incentive fee (and has been closed to new investors since 1993)! With the exception of 1989, the fund has never had a down year. Simons is famous for only hiring Ph.D.s, and the fund's employees are largely former scientists from around the world with backgrounds in mathematics, physics, astrophysics, and statistics. Purely quant driven, Simons states, "We decided that systematic trading was best. Fundamental trading gave me ulcers." Simons shook the investment world recently by announcing a new fund with a total capacity of $100 billion.
The sixth biggest hedge fund D.E. Shaw was founded by Columbia University computer science professor David Shaw in 1988. Also quantitatively focused, the fund returned most investor capital in 1997.
Another famous academic is Richard Thaler, a professor of behavioral economics at University of Chicago's Graduate School of Business. He cofounded Fuller & Thaler Asset Management in 1993, and the company now manages more than $3 billion. Thaler is the author of numerous texts in the field of behavioral finance, and also the author of the recently published Nudge: Improving Decisions about Health, Wealth, and Happiness.
Ed Thorp, who obtained his Ph.D. from UCLA and is one of the developers of card counting theory in blackjack (he wrote the book Beat the Dealer), ran a successful hedge fund for many years. The fund, Princeton Newport Partners, returned 15% a year for 20 years with no down years and volatility around 10%. Thorp's fund only recorded three down
Academic Fund Managers (Continued )
months in those 20 years and was the first market neutral and quantitative hedge fund. The Harvard endowment was an early investor. (As an interesting aside, the most famous bond manager in the world—PIMCO's Bill Gross—paid his way through college counting cards in Lake Tahoe.)
Of course, there is also the flip side to this story including famous blowups like the one at Long-Term Capital Management (LTCM) in 1998; When Genius Failed by Roger Lowenstein is a great book on the topic. The roster of LTCM founders included two Nobel Laureates as well as a number of star traders from Salomon Brothers. The fund was the first fund to raise $1 billion and had great returns from 1994-1997, but had catastrophic losses of more than 95% in 1998 due to massive amounts of leverage and positions moving in unision in the wrong direction. The Harvard endowment was an investor in LTCM as well.
The biggest drawback of a FOF is fees. By the time an individual receives his returns from a FOF, the underlying hedge funds have collected 2% and 20%, and the FOF layers on another 1% and 10%. Let's do the math with the Ivy Portfolio. Since 1990, it has returned about 10% a year. To achieve similar returns at a FOF level, the underlying hedge funds must return:
Ivy Portfolio = 10%
Gross returns of FOF = (10% + 1%)/(100% - 10%) = 12.22%
Gross returns of hedge funds = (12.22% + 2%)/(100% - 20%) = 17.75%
So, the underlying hedge funds would have to return an additional 7% a year to achieve the same return as the basic buy and hold Ivy Portfolio. To achieve these returns, the FOF manager must either select a lot of really skilled alpha producers, leverage up the portfolio, or do a combination of both. These massive fees work against the individual investor.
A note about fees—they are relative to what is delivered. Some mutual funds and ETFs are expensive at 0.75% a year. Renaissance Technologies is probably cheap at a 5% management fee and a 44% performance fee. It all depends on the edge a manager has and the alpha he produces. Warren Buffett famously set up his partnership with a 25% performance fee over a 6% hurdle. That way he only got paid if his clients made more than 6% a year. A good rule of thumb is that the alpha should be split 25% to 33% to the manager, and 75% to 66% to the investor, regardless of how it is structured.
Now that we have talked about the pros and cons of hedge funds, the real question is: How have hedge funds performed over the years? For every Tudor, Caxton, and Renaissance Technologies, there are also plenty of Amaranths and Long-Term Capital Managements. Let's look at the data.
Problems with Using Hedge Fund Databases to Track Performance
One of the problems with defining hedge fund performance is that there is no index like there is for other asset classes. Because a hedge fund is a private partnership, there is no requirement to report or disclose performance numbers. There are numerous firms that compile their versions of hedge fund indexes, each with different rules. They have different numbers of underlying funds (60-5,000), some collect the data themselves while some do not, some include managed futures and some do not. No one really knows how many funds are in existence.
A database is simply a collection of hedge funds and their returns, and very likely will be replete with survivorship and backfilling biases. In a recent study, PerTrac estimates the number of funds from 11 databases at 22,000 (Benjamin, 2008). The estimating is complicated by the fact that a single manager can manage several hedge funds. Very few funds report to more than two or three databases, and only one reported to all of them. Over half of the funds only reported to one database.
Some of the biases included in the databases are:
• Selection—Manager can choose if and to what database he reports performance.
• Survivor—Hedge fund managers no longer in existence may be excluded from the database. This can include funds that blew up as well as funds that stopped reporting due to good performance.
• Backfill—Database provider backfills performance history of hedge fund introduced into index.
• Liquidation—Funds that go out of business stop reporting performance in advance of shutting their doors. They are still in the database but their last few months of bad performance are omitted.
Most studies have found that these biases add up to more than 4% in overstated returns. Add that to the fact that most databases only have data for 10-15 years, and you can see how these databases have lots of problems (Fung and Hsieh (2006), Malkiel and Saha (2005), Ibbotson and Chen (2005), and Van and Song (2004)).
Using Hedge Fund Indexes to Track Returns
In contrast to hedge fund databases, hedge fund indices calculate index returns on a going-forward basis, and any additions and deletions are reported in real time. Investable indices, if constructed properly, should be free from these aforementioned biases.
When hedge funds are combined into a portfolio, many of the unique and desirable hedge fund features diversify away. Indices no longer resemble hedge funds, but are mainly composed of stock and bond risk. You do not want to pay high fees for beta exposure. Some of the numerous hedge fund indices are listed in Table 6.2 '
An example of the differences in indexing can be seen in Table 6.3. For example, the February 2000 results for the long/short EACM and Zurich indices painted a very different picture for the universe of long/short funds. If you were following the Zurich index, it looked like long/short had a great month at 20.48%. The EACM Index conveys different information, with a reported return of -1.56%, a difference of over 20%!
Table 6.2 Description of Indexes
Number
Table 6.2 Description of Indexes
Number
|
Index Provider |
Launch Date of Indices |
Start Date of Indices Database |
of Funds in the Database |
Number of Funds in the Indices |
Rebalancing Frequency |
|
Altvest |
2000 |
1993 |
+ 3,200 |
+ 2,200 |
Monthly |
|
Barclay Group |
2003 |
1997 |
+ 4,460 |
4,400 |
Monthly |
|
CISDM |
1994 |
1990 |
+ 7,600 |
3,892 |
Monthly |
|
CSFB/Tremont |
1999 |
1994 |
+ 4,500 |
413 |
Quarterly |
|
EACM |
1996 |
1996 |
100 |
100 |
Annual |
|
EDHEC |
2003 |
1997 |
NA |
NA |
Quarterly |
|
Hennessee |
1987 |
1987 |
+3,000 |
900 |
Annual |
|
HF Net |
1998 |
1976-1995* |
+ 5,000 |
+ 3,600 |
Monthly |
|
HFR |
1994 |
1990 |
2,300 |
+ 1,600 |
Monthly |
|
MSCI |
2002 |
2002 |
+ 2,000 |
+ 2,000 |
Quarterly |
|
Van Hedge |
1994 |
1988 |
+6,700 |
+2,000 |
Monthly |
Source: EDHEC Risk and Asset Management Research Centre (http://www.edhec-risk.com). *Depends on strategy.
Source: EDHEC Risk and Asset Management Research Centre (http://www.edhec-risk.com). *Depends on strategy.
Hedge Fund Research, Inc. (HFRI) publishes indices that track the hedge fund universe back to 1990, and we will examine the relative performance here because it represents one of the longest histories for a hedge fund index. The HFRI Weighted Composite Index (HFRIFWI) is an equal-weighted index of more than 1,600 hedge funds, excluding fund of funds, and results in a very general picture of performance across the hedge fund industry. The HFRI Fund of Fund Composite Index (HFRIFOF) is a similar index with approximately 750 fund of funds included.
A couple of characteristics of the index methodology must be noted. Because the indices are equal-weighted and there is no required asset-size minimum for fund inclusion, the results will be biased to smaller fund returns. There will be some survivorship bias in the results due to poorly performing managers electing not to report their returns once the results turn negative. It is difficult to determine the effects of this bias, but a comparison of the HFRX indices (the investable version,
Table 6.3 Variance in Index Returns
Maximum
Investment Styles Differences Date
Maximum
Investment Styles Differences Date
|
Convertible Arb |
7.55% |
Dec. 01 |
|
CTA |
5.09 |
Feb. 99 |
|
Distressed |
6.99 |
Feb. 00 |
|
Emerging Markets |
19.46 |
Aug. 98 |
|
Equity Market Neutral |
5.00 |
Dec. 99 |
|
Event Driven |
5.06 |
Aug. 98 |
|
Fixed Income Arb |
10.48 |
Oct. 98 |
|
FOFs |
8.01 |
Dec. 99 |
|
Global Macro |
14.17 |
Oct. 98 |
|
Long/Short Equity |
22.04 |
Feb. 00 |
|
Merger Arb |
2.71 |
Sept. 01 |
|
Relative Value |
10.47 |
Sept. 98 |
|
Short Selling |
21.13 |
Feb. 00 |
Source: EDHEC Risk and Asset Management Research Centre (www.edhec-risk.com).
Source: EDHEC Risk and Asset Management Research Centre (www.edhec-risk.com).
|
Corresponding Returns |
Versus |
|
EACM (-6.93%) |
Hennessee (0.62%) |
|
CSFB (-0.54) |
HF Net (4.55) |
|
EACM (1.23) |
Zurich (8.22) |
|
MAR (-26.65) |
Altvest (-7.20) |
|
Hennessee (0.20) |
Van Hedge (5.20) |
|
CSFB (-11.77) |
Altvest (-6.71) |
|
HF Net (-10.28) |
Van Hedge (0.20) |
|
MAR (2.41) |
Altvest (10.42) |
|
CSFB (-11.55) |
Altvest (2.62) |
|
EACM (-1.56) |
Zurich (20.48) |
|
EACM (-4.32) |
HF Net (-1.61) |
|
EACM (-6.08) |
Van Hedge (4.40) |
|
Van Hedge (-24.30) |
EACM (-3.17) |
available only since 2003) and the HFRI (a financially engineered time series) indices could give a clear view of any tracking error. An analysis we conducted found the effect to be over 4% for each substrategy—a very material difference.
A further examination by Greenwich Alternative Investments found similar results in most of the investable indices (Johnson, 2007). The investable indices will not have the best hedge funds in them because these top performers are sufficiently capitalized and have closed the doors to new investors. One of the problems with the investable indices is that they are constructed with liquidity and investability in mind rather than representativeness of the industry.
Evaluating Historical Returns
Remember, these results must be taken with a grain of salt. With the understanding that the hedge fund indices returns will likely be overstated versus the investable versions, we present the year-by-year results of the HFRI and FOF indices in Table 6.4. (There will also be a slight diversification benefit from the index. It is like a FOF without the fees.)
The results of the HFRIFOF and the HFRIFWI are impressive as standalone products. However, adding the HFRIFOF index to the Ivy Portfolio does little to improve risk-adjusted returns. The reason is that the risk factors are very similar to a balanced portfolio. The HFRIFWI does a slightly better job, but once you factor in the underperformance of the investable version it maintains little appeal. Overall, we believe that these indices are fairly good proxies for the hedge fund universe, but the investable indices are not good investment choices.
Comparing Credit Suisse/Tremont
The Credit Suisse/Tremont Hedge Fund Index is asset-weighted, and all funds must have a minimum of $50 million in assets under management, a minimum one-year track record, and current audited financial statements. There are approximately 5,000 funds in the database, 500 funds in the index, no FOFs are included, and performance is net of
Table 6.4 HFR Returns for the Calendar Year Ending December 31, 2008
Table 6.4 HFR Returns for the Calendar Year Ending December 31, 2008
|
S&P 500 |
Ivy |
HFRIFOF |
HFRIFWI |
FOF 20% |
Hedge 20% | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
1990 |
-3.10% |
-1.10% |
17.53% |
5.81% |
2.62% |
0.28% | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
1991 |
30.46 |
18.19 |
14.50 |
32.19 |
17.45 |
20.99 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
1992 |
7.62 |
3.88 |
12.33 |
21.22 |
5.57 |
7.35 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
1993 |
10.08 |
11.90 |
26.32 |
30.88 |
14.79 |
15.70 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
1994 |
1.32 |
1.76 |
-3.48 |
4.10 |
0.72 |
2.23 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
1995 |
37.58 |
22.74 |
11.10 |
21.50 |
20.41 |
22.49 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
1996 |
22.96 |
19.32 |
14.39 |
21.10 |
18.33 |
19.68 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
1997 |
33.36 |
9.96 |
16.20 |
16.79 |
11.21 |
11.33 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
1998 |
28.58 |
0.49 |
-5.11 |
2.62 |
-1.41 |
0.13 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
1999 |
21.04 |
14.46 |
26.47 |
31.29 |
16.63 |
17.59 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
2000 |
-9.10 |
12.73 |
4.07 |
4.98 |
10.99 |
11.18 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
2001 |
-11.89 |
9.74 |
2.80 |
4.62 |
-7.23 |
-6.87 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
2002 |
-22.10 |
2.09 |
1.02 |
-1.45 |
1.78 |
1.38 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
2003 |
28.68 |
25.70 |
11.61 |
19.55 |
22.88 |
24.47 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
2004 |
10.88 |
17.44 |
6.86 |
9.03 |
15.33 |
15.76 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
|
2005 |
4.91 |
11.74 |
7.49 |
9.30 |
10.89 |
(Continued) Table 6.4 HFR Returns for the Calendar Year Ending December 31, 2008 (Continued) Table 6.4 HFR Returns for the Calendar Year Ending December 31, 2008 (Continued)
Source: Hedge Fund Research, Inc., © 2008, www.hedgefundresearch.com. Source: Hedge Fund Research, Inc., © 2008, www.hedgefundresearch.com. Table 6.5 CS/Tremont Return Statistics (January 1994-December 2008) Inception-to-date Annualized Total Annualized Statistics Return Volatility Sharpe Ratio Table 6.5 CS/Tremont Return Statistics (January 1994-December 2008) Inception-to-date Annualized Total Annualized Statistics Return Volatility Sharpe Ratio
Source: Copyright 2008, Credit Suisse/Tremont Index LLC. Source: Copyright 2008, Credit Suisse/Tremont Index LLC. all fees. Table 6.5 details the performance of the index along with all of the subindexes. A quick glance shows how difficult shorting is with negative annual returns ' Multistrategy, global macro, event driven, and market neutral have the best risk-adjusted returns. It is interesting to note that while the return and risk numbers for the HFR Index are a little different from those of the CS/Tremont, the Sharpe Ratio is nearly identical at around 0.6. While the composition of the index has changed a little bit over the years, the largest component has remained long/short equity. (See Table 6.6.) |
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