Funds of Hedge Funds: Skilled, But Expensive
New research examines the manager selection ability of the shrinking funds-of-hedge-funds industry.
Funds of hedge funds may actually be pretty good at picking managers – just not good enough to overcome the additional fees they charge.
Researchers from Purdue University’s Krannert School of Management and Loyola Marymount University found that funds of funds display “significant” manager selection abilities, with their choices outperforming the hedge fund industry, according to their study published last month.
Purdue’s Chao Gao and Chengdong Yin and Loyola’s Tim Haight examined holdings data from funds of funds registered with the U.S. Securities and Exchange Commission between 2004 and 2015. They found that larger pools diversified over multiple styles are likely to have the best returns, but that having too many hedge-fund holdings could damage performance.
“These results provide some evidence that funds-of-hedge-funds managers are smart and allocate more assets to holdings with good future performance,” the researchers wrote.
Still, hedge fund of funds performed poorly over the last decade, with HFRI’s fund-of-funds composite index returning a mean of just 4 basis points a month between 2008 and 2016. They’ve seen substantial outflows as a result, with industry assets under management collapsing to $360 billion by the end of 2016, from $1.2 trillion in 2007, according to the study, which cited BarclayHedge data.
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Gao, Haight, and Yin say the low returns are not the result of poor manager selection but rather the double set of fees imposed on fund-of-funds investors, who must pay fees both on the fund of funds and the underlying investments.
The skills of funds-of-hedge-funds managers “significantly” increase performance before fees, the authors said. “Our findings suggest that any after-fee underperformance of funds of hedge funds is more likely to be driven by funds-of-hedge-funds’ double-layered fee structure.”
How to improve that fee structure, they added, is a subject for further study.