Romanek, Director Alternative Investments
Merchant Banking, Fortis
History repeats itself - only differently.
This contradictory phrase notes the inherent
difficulty in forecasting the future. More
often than not the soothsayers get it wrong.
The comment making the rounds is that fund
of hedge funds (FoHFs) have seen their day
and will be replaced by multi-strategy funds.
Should one believe this to be correct? Any
trend forecasted indefinitely into the future
is incorrect in its assumptions. Does a
7% growth rate in public sector jobs imply
one day in the future everyone will be working
for the government?)
Yes, with FoHFs there is a second layer
of fees and some of the benefits of FoHFs
can be achieved with
multi-strategy funds. However the key word
is "some" not all. Multi-strategy
funds can replicate diversification by strategy.
However, this brings us to a "Jack
of All Trades" scenario. The best managers
in our industry have generally concentrated
on a single or narrow group of strategies.
The question to ask yourself is whether
your chosen multi-strategy manager can assemble
and effectively manage top-tier talent across
multiple strategies. This is a far more
difficult task than initially perceived
and is compounded by the widely differing
needs of managers of varying and divergent
Provided that multi-strategy funds can
meet your needs by diversification of strategies,
you still lack the safety net of being optimally
diversified by number of funds. Few to no
multi-strategy funds employ as many separate
funds as a well diversified FoHF.
This brings us to the most compelling argument
that FoHFs should not be replaced by multi-strategy
funds - operational risk. Fund of hedge
funds mitigate the operational risk of the
underlying managers with diversification
by sheer numbers. The oft-cited study by
Capco showed that approximately 55% of fund
failures were attributed to operational
difficulties. In FoHFs, this risk is spread
over 20, 30 or more management firms. With
a multi-strategy fund, this risk is concentrated
within one firm. Should this given asset
manager have company-wide operational problems,
it will extend to each of the components
of their multi-strategy funds.
While we are comparing apples to oranges,
FoHFs themselves are undergoing changes.
Within the FoHF universe, we see a lot of
consolidation and some believe that smaller
and mid-size FoHFs will disappear. Many
would agree that the ease of entry for new
FoHFs is too low and that the bar should
be raised. There is a growing consensus
that the real problem in the industry is
a "wall of mediocrity". So, what
do smaller FoHFs have to offer that their
multi-billion dollar cousins do not?
Small and mid-size FoHFs add value in that
They provide "bundling" of
small managers. Smaller FoHFs are able
to spread investment across talented new
and/or smaller managers that due to their
size and circumstances would not attract
institutional size investment.
They provide local due diligence. A
FoHF specialising in a certain geographical
area has an advantage over many of the
larger fund houses which concentrate
on the more widely invested areas.
They may provide geographic area expertise
in their distinct markets. At a minimum
they may offer themselves as a potential
joint venture partner to enter a new
Lastly, they can provide a myriad of
bespoke offerings to HNWs and family
offices that may not be offered by the
largest of the FoHF managers.
A primary argument promoted by FoHF naysayers
is that the second layer of fees substantially
erodes returns to investors. However, in
comparing recent returns by selected indices
there seems to be negligible differences.
One data provider's indices show their multi-strategy
composite to be only 0.02% greater than
their FoHF composite during the same 12-month
So what is happening in the FoHF space
now? In one study, over the last year a
representative cross-section of FoHFs from
continental Europe, the UK and North America
showed an increase of 56% on an AUM-weighted
basis to July of this year and 62% on an
equal-weighted basis. The bulk of the growth
in their AUM (85%) came from inflows of
institutional investor money, with the rest
made up of HNW inflows and performance gain
over the period. So are FoHFs dead? The
real picture is summed up in the statement
once made by Mark Twain "I regret to
inform that the news of my untimely death
has been greatly exaggerated".
This article originally
appeared in the AIMA Journal (Winter 2005
issue), published by the Alternative Investment