Central to the
success of any multi-fund portfolio is identifying and evaluating
the hedge fund managers (HFs) to be ultimately included in the
portfolio. With estimates as high as 10,000 HFs to choose from,
this process can be overwhelming. The job is further complicated
by the wide range of HF investment strategies, minimum investments,
fee structures, leverage factors, capacity constraints, etc.
It is really no wonder that many individual and institutional
investors consider funds of funds (FOFs) rather than embark
on this process alone.
Before screening and analysis can begin, a FOF first must
gather sufficient HF data. From this pool of data, you will
select and analyze individual managers, compare managers to
their respective peer groups and build the fund of funds portfolio.
Ultimately, this same database will be used to judge the ongoing
performance of your FOF. Although there is no central clearinghouse
for hedge fund information, it is imperative to screen the
largest possible number of managers to avoid overlooking managers
that could benefit the portfolio. Luckily, over the past decade,
the emergence of commercial hedge fund databases has made
the data collection process significantly easier.
Both fee-based and free databases offer FOFs a wealth of
qualitative and quantitative information on hedge funds. Recognizing
that each database vendor's unique methodology make comparisons
difficult, costs range from USD 3,000 to USD 6,000 and each
database contains approximately 2,000 HFs.
Each database covers a distinct subset of the HF world. This
fact was confirmed by a recent study conducted by Strategic
Financial Solutions LLC, the creators of PerTrac 2000 investment
analysis software. That study indicated significant numbers
of HFs choose to report to only one of the major databases
. As such, some of the databases tend to attract smaller,
emerging funds with short track records and less than USD
25 million under management while others cover more non-U.S.
HFs, and still others include CTAs or long only funds. More
recently, specialized databases have surfaced which may cover
a specific geographic region or particular hedge fund strategies.
It is impossible to say whether there is a clear leader among
the commercial hedge fund databases. One should always consider
issues such as cost, coverage, accuracy, depth of detail and
delivery method when evaluating hedge fund databases. However,
one thing is clear: a FOF cannot depend on a single database
as its sole source for finding managers. While convenient,
there are some limitations and difficulties with hedge fund
data collection that plague all of the major databases. These
include double counting of "clone" funds and widespread
disagreement about how to separate HFs into logical strategy
categories. In addition, there are reporting issues to consider.
A hedge fund is not obligated to report to any database. As
a result, funds may stop reporting to a database unexpectedly,
or performance may not be kept up to date.
To further complicate the matter, many of the most desirable
HFs do not report to any of the databases. To gather information
on these "unlisted" managers, FOFs must collect
data on their own. Hedge fund publications, conferences and
prime brokers can all serve as valuable sources of information
for resourceful FOFs.
With sufficient HF data in place, the FOF must determine
its investment mandate. During this phase, it is important
to ask such questions as: Is the FOF being designed for individual
or institutional investors? What qualitative constraints are
the investors likely to expect? What is their risk tolerance?
Should the FOF invest in HFs across the strategy spectrum
or focus on a specific style? What liquidity will be required
in order prudently manage the FOF while meeting investor withdrawal
demands? When marketing the FOF, will I emphasize stability
or total return? The answers can provide valuable guidance
when choosing appropriate screening statistics. Some common
screening statistics2 include Sharpe and Sortino ratios, drawdown,
correlation analysis, and percent profitable months.
Finally, it is time to actually begin the screening process.
Although investors often approach this task with arbitrary
criteria, these statistical "wish lists" rarely
yield the best results. Instead, it is a good idea to begin
the screening process by analyzing all of the funds within
a given strategy peer group and finding the statistical breakpoints
for the top quartile or decile. Then, those data points can
then be used as screening statistics. For example, assume
the FOF investment mandate is to produce conservative, steady
returns with a focus on arbitrage managers. We might screen
our database for convertible arbitrage HFs and find that the
top 25% have a compound annual return of 14.4% over the past
five years. Then, we might re-screen the database and find
that the top 25% have Sharpe ratios greater than 1.4 and more
than 86% profitable months. We could then look for HFs that
meet or exceeded those statistical breakpoints. Thus, we can
be fairly certain of finding the top performers. While this
may sound like an arduous process, analytical software, much
of which is compatible with the major HF databases, significantly
simplifies the process.
Once a group of managers has been identified, it is important
to conduct a thorough correlation analysis to ensure that
the portfolio is properly diversified. Additionally, portfolio
simulations and stress tests can provide insight into the
best and worst case performance scenarios for the FOF. Finally,
no investment should be made without thorough background checks
and a formal due diligence process.
The analysis of the underlying managers and the FOF does
not stop after the initial investments have been made. The
FOF must continuously re-evaluate the portfolio for possible
additions, redemptions and reallocations. It is also important
to regularly benchmark the FOF as a whole. Is it at the top
of its strategy peer group for return? Risk control? Volatility?
This information can then be used to develop marketing strategies
to attract new capital and retain existing investors.
With all of the time and effort it takes to construct and
monitor a FOF, it is no wonder that investors are willing
to pay additional fees to a qualified FOF manager. For those
starting a FOF, the key to a successful launch is careful
data collection and analysis. However, the secret to long-term
success is vigilant monitoring. If the FOF pays attention
to both, the opportunities for both investors and FOF managers
to profit can be substantial.
1 For a copy of the database comparison, contact Strategic
Financial Solutions at
For a voice-accompanied presentation on common investment
Strategic Financial Solutions
+1 615 226 3575