The hedge fund industry continues to recover. Hedge Fund
Research (HFR) reports total industry capital topped $1.67
trillion in the first quarter, the second highest total after a
peak of $1.93 trillion in the second quarter of 2008. You can
almost hear the corks on the champagne bottles popping in the
marketing departments of hedge fund firms.
However, at the funds of funds firms, the sounds you hear
are nerves rattling in the market departments. The industry is
contracting as investors have lost interest in this way of
investing in hedge funds. And you cant blame them.
Total assets slipped to $570 billion at the end of the first
quarter, and are now down nearly 29 percent from their peak,
even though they staged a brief rally in the last two quarters
of 2009. The top firms in the Fund of Funds 50, Institutional
Investor 's ranking of the worlds biggest
multimanager hedge fund firms, have seen their assets fall
43 percent during the past 18 months, to $503 billion. The
number of funds of funds was down to 2,117 from 2,462 at the
end of 2007.
There are a bunch of reasons given by industry experts for
the decline or failure to recover. Their due diligence
was called into question after a number of them were caught
having given money to Bernie Madoff.
Many funds of funds suspended redemptions after 2008 because
many of the underlying funds did so as well. Funds of funds
that used leverage to goose returns or pay for the added
fees on top of fees had trouble borrowing money after
the financial crisis.
After the 2008 meltdown, a number of well-known hedge funds
reopened after being closed for many years. So, an increasing
number of institutions started to invest directly in
single-manager hedge funds. Also, consolidation has been slow
to take hold, forcing a number of firms to go out of business,
such as Ivy Asset Management.
Funds of funds had lower barriers to entry but higher
barriers for sustainability, says Ted Gooden, managing
director at Berkshire Capital Securities, an investment bank
specializing in M&A in the financial services sector.
Ultimately, however, funds of funds just have not lived up
to what they were supposed to be. Since 1990, the funds of
funds composite has only beaten the single-manager composite in
three of the years.
According to HFR, during this period, funds of funds
generated an 8.17 percent annualized return versus 12.15
percent for single manager funds. Thats a huge difference
over a 20-year period. During the same period, the S&P
500s annualized return worked out to 8.37 percent. So,
funds of funds actually lagged the S&P 500. The
under-performance was probably worse, since the hedge fund
databases suffer from suffer bias they dont
include some funds that went out of business or simply chose
not to report their performance if they do lousy.
They did worse than the individual index and became
illiquid, says Jonathan Kanterman, Managing Director of
Stillwater Capital Partners, which manages $900 million in
funds of funds.
Yet, investors are paying a hefty fee for this privilege. In
addition to the typical 2+20 charged by the funds in the
underlying portfolio (maybe slightly less if they make some
sort of deal), the fund of funds charges, on average, a 1.27
management fee and 6.94 percent performance fee, according to
Ken Heinz, President at Hedge Fund Research.
Investors can do better by simply putting their money in a
plain vanilla, S&P 500 index fund or exchange traded fund,
whose fees are virtually nil.
Of course, the FOF marketing people will tell you that
FOFs experience much less volatility. And they are right.
Their standard deviation is only 6 percent compared with 15
percent for the S&P 500. But, Ill take that extra
agita if it means I can save nearly the entire management fee
and not pay a performance fee altogether.
Stephen Taub, who has covered the hedge fund industry
for 30 years, is a contributing editor to Institutional
Investor and Absolute