The Decline of Funds of Funds

The hedge fund industry continues to recover, but fund of funds firms are in decline as investors have lost interest in this way of investing in hedge funds. And you can’t blame them.

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Stephen Taub

Stephen Taub

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 can’t 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 world’s 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.

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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. That’s a huge difference over a 20-year period. During the same period, the S&P 500’s 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 don’t 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 FOF’s 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, I’ll 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 Return-Alpha magazines.

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