Research

Introduction

The fund of funds industry has grown exponentially since the first fund, Leveraged Capital Holdings, was launched in 1969. There are currently estimated to be between 1,200 to 1,500 funds of funds globally, most of which were launched in the past decade. The first Asia-specific fund of funds was launched in 1993; it is called Asian Capital Holdings and run by the same group (LCF Rothschild Asset Management) that manages Leveraged Capital Holdings. There now appear to be between 30 and 35 Asia/Japan-exclusive funds of funds. However, most of these new funds of funds have assets below US $100m.

There appears to be an over-supply of funds of funds, especially in the US and Europe (a week does not go by without the announcement of a new fund of funds launch); and a consolidation within the industry appears likely in the near future. For those that survive the consolidation, questions will still remain among investors in alternatives regarding the benefits of investing in a fund of funds over making a proprietary portfolio of hedge funds.

Under the assumption that a well-managed portfolio of hedge funds will produce higher returns with lower volatility than a portfolio of long-only funds, we will in this study examine the advantages and disadvantages of investing in funds of funds over managing one's own portfolio of hedge funds. We will then look at some comparative performance trends between Asian and Global funds of funds.

Advantages of investing in funds of funds

1. Active management should add value in an opaque and inefficient industry.
   
   There are approximately 5,000 hedge funds world-wide, with many of the best names closed to new investors; the costs are prohibitively high for a single private banker, advisor or organisation to initiate a database to analyse even a small portion of the entire hedge fund universe. Thus, one of the main advantages of a fund of funds is the organisational structure behind the investment process. Experienced managers supported by numerous analysts, lawyers and risk-control systems should be able to weed out the weaker players while providing investors with exposure to those hedge funds that are closed. The ability to get into top-tier, closed hedge funds through funds of funds will become even more important in Asia if, as we expect, there becomes a disconnect between demand (high) and supply (low) in the industry.




 
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3. Funds of funds provide an inexpensive and efficient way to diversify.
   
   The hedge fund world is not homogenous. Even in Asia there exist numerous strategies that are uncorrelated to each other; providing the fund of funds manager the ability to hedge out any strategy or style risk. Due to the costs discussed in point 1 and the US $1 million minimum investment amount imposed by most hedge funds, to run a proprietary portfolio would be extremely expensive. An experienced fund of funds manager who understands the risks involved in each strategy provides a potentially less expensive alternative.




 
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5. Active qualitative, quantitative and regulatory due diligence by funds of funds add value.
   
   The fund of funds manager is responsible for the qualitative, quantitative and regulatory due diligence of all prospective and underlying hedge funds. This due diligence process is expensive and time-consuming. The history of the hedge fund world is littered, unfortunately, with ethically challenged characters. As long as the industry remains loosely regulated, cases of fraud and other dubious activities will be likely to persist. It is the job of the fund of funds manager to weed out those hedge fund managers that do not pass diligent qualitative (i.e. management abilities, strategy, execution, etc) and regulatory due diligence procedures. Since it is counter-productive policy to have a short-term trading horizon when investing in hedge funds (both for reputation and liquidity reasons), it is important that the fund of funds manager understands the underlying manager's strategy and risk profile before making an initial investment.




 
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7. Ongoing portfolio and risk-management due diligence
   
   Due diligence does not stop after the initial investment. Hedge fund investors must continually monitor their holdings for efficiency of execution, style drift, personnel turnover, risk-control and the managers' overall happiness in their personal and professional lives. To effectively run this ongoing due diligence process takes time (i.e. travelling to meet with the managers) and knowledge (both of the different strategies that one is invested in and in being able to have access to the manager). Unless one is willing to spend the time and money for the needed ongoing due diligence, it appears to be more beneficial to outsource this process to a fund of funds group.

Disadvantages of funds of funds

1. Funds of funds charge an additional layer of fees.
   
   Most fund of funds managers will charge a 1.5% management and 10% performance fees in addition to the fees charged by the underlying hedge funds (on average: 1.5% management and 20% performance). This layering of fees will inevitably cut into performance, and in bull markets it may be more cost-effective to buy individual mutual funds. However, as shown in the four advantages listed above, good fund of funds managers do provide a value-added service that justifies the additional fees charged.




 
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3. Lack of transparency involves extreme faith in the manager.
   
   Only the largest fund of funds managers (or the ones that require segregated accounts) could possibly gain access to their hedge funds' underlying holdings; and this knowledge, if acquired by the manager, is rarely distributed to the fund of funds' shareholders. More likely, the fund of funds management firm will provide the investor a list of the fund's top five to ten hedge fund holdings once or twice a year. This lack of knowledge into what exactly the fund of funds manager is investing in makes the investor place a great deal of faith in the fund of funds manager.




 
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5. Boutique nature could portend greater risk.
   
   Funds of funds, though fewer in number than hedge funds, are usually managed by small, sometimes new, asset management firms which are not connected with large investment or institutional banks. This can cause concerns for a number of reasons: a) a lack of a proper marketing structure means fewer assets under management, b) small funds of funds don't have access to the top tier of hedge fund managers and c) there is a higher potential risk of a blow-up. It is important that investors do their own due diligence on any fund of funds product before a large investment is made. Like the mutual fund industry twenty years ago, the number of boutique funds of funds is likely to decrease due to consolidation and the large numbers of funds of funds with assets under $100m will decline in the long-term.

Conclusion

There have been many academic articles written on the return and risk benefits of investing in a portfolio of hedge funds, the general conclusion being that a well-run portfolio does provide high returns with volatility levels similar to those of bond funds. We believe that to produce this portfolio of hedge funds, it is more cost-efficient to invest with a top tier fund of funds manager than to develop a portfolio of hedge funds from scratch.

Though due diligence is still needed in the selection process of a fund of funds, and an investor will pay an extra layer of fees, the time and money required for this type of investment is less obtrusive and expensive than that required for investing directly in hedge funds. One of the main purposes of this directory is to assist the alternative asset investor in the initial screening process of selecting a top tier fund of funds.

Performance of Asian funds of funds

The first Asian fund of funds was launched in 1993, when less than five Asia-specific hedge funds existed. Since that time the number of Asia-specific and Japan-specific hedge funds has exploded to over 200 and the list of Asia/Japan-exclusive funds of funds have increased at almost the same rate (to over 30 funds of funds).

Most of the Asia/Japan funds of funds have been launched only in the past 12 months, and have less than US $100 million under management. As to be expected in markets where the ability to short and use complex derivatives is limited, these regional funds of funds invest predominantly in long/short equity strategies.

Since December 2000, Asia/Japan funds of funds have outperformed their global peers by nearly 4%. An index of Asia/Japan funds of funds have returned 8.56% while an index of global funds of funds has a return of 4.61%. Asia funds of funds have a significantly higher volatility than global products, 4.07% annualised standard deviation compared to 2.47% for global funds of funds; this is not surprising considering the lack of true diversification of Asia and Japan hedge funds (though the diversification of Asia/Japan products should improve with the likely launch of more than 50 new hedge funds in 2003). On a risk/return basis, Asia/Japan funds of funds have a Sharpe ratio that is almost double that of their global peers, 0.83 and 0.43, respectively (using a risk free rate of 1.67%, current yield on 3 month U.S. treasuries).

The graph below illustrates the outperformance of Asia/Japan funds of funds over the past 18 months.

Asia/Japan Funds of Funds vs. Global Funds of Funds

Performance since December 2000

Not surprisingly the main reason for the outperformance of Asia/Japan funds of funds is that Asia and Japan-focused hedge funds have been outperforming their peers in the US and Europe over the past 18 months. The ABN Amro Eurekahedge Index of Asia and Japan hedge funds is +10.24% since December 2000 while the CSFB/Tremont Hedge Index of hedge funds globally is only +5.08% over the same time period.

We find three main reasons for the success of Asia and Japan-focused hedge funds:

1. Asia and Japan-focused hedge funds are mainly equity long/short, a strategy that did exceptionally well during the equity market bounce in the last quarter of 2001 and first quarter of 2002. The hedge fund investment styles are more diverse in the United States and Europe, and thus a wider range of performance returns prevailed. CB Arbitrage funds, which are not prevalent in Asia but are common in Europe and North America, have been particular laggards since December 2001.




 
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3. Smallness is important. The average size of an Asia-centric hedge fund is US $60 million; being small allows a manager to be flexible and nimble in his investment process and to liquidate quickly in volatile markets. Also, the smaller-sized hedge funds have a tendency to invest more in smaller market-capitalisation (small cap) stocks, where large hedge funds cannot afford to tread because of liquidity reasons. The small cap sector did especially well in 2001 and the first half of 2002. US and European hedge funds on average are much larger, and were not able to benefit from this rise.




 
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5. There existed, and still does exist, greater market inefficiencies in Asian markets, especially in Japan, than in the west. Most strategists would agree that Japan has more bankrupt companies kept afloat for political reasons than in the US. This provides excellent shorting opportunities for hedge fund managers. On the flipside, many Asian companies at the end of 2000 were incredibly oversold by foreign investors (particularly outside of Japan). These inefficiencies began to be corrected in October 2001 and Asia-focused hedge fund managers capitalised.

Whether this outperformance continues is, understandably, not known. On the whole, Asian hedge fund managers' absolute returns will not be stellar without rising Asian equity markets. Global fund of funds managers have a greater ability to diversify their style risk, which has been helpful in the second half of 2002 and may well be for 2003. This directory provides the investor with a useful, initial tool to analyse both Asian and global funds of funds across the entire spectrum of investment styles and processes so one can make a more informed investment decision. For further performance information and filtering functions please visit the online fund of funds directory (coming soon) at www.eurekahedge.com.