The process you undertake when selecting a FoHF is very different to that when selecting a portfolio of single managers.
A decision on which to use, FoHF or single manager, is generally dependent on two primary factors: the monetary size of your investment allocation, and the resources at your disposal.
The extra fee layer imposed when utilizing a FoHF structure is, in general, to pay for the resources used to source and select managers in addition to providing the investment vehicle.
It is important to get a match between the mandate you have and that on which the FoHF is based.
There are a number of factors that need to be considered in addition to those mentioned above when deciding whether to use a FoHF or collection of single managers; it is not a black and white decision.
Funds of hedge funds (FoHFs) have caused heated debate over the years no matter which side of the fence you are on. The main issue this debate revolves around has two parts:
Fees—that is, fees charged at the underlying manager level and then again at the FoHF level.
Control: Accepting that you don’t have the internal expertise and must pass control of the underlying fund selection to a FoHF manager can be difficult for some. They would rather have control even though they may not achieve the result they hoped for rather than hand over control for a result that isn’t of their own making—regardless of the outcome.
The first step in choosing between FoHF or single manager should be to look inside the firm for the knowledge, expertise, and experience required to source and select the underlying managers. In this article I will be looking at elements of the decision to invest either in a basket of single managers or in a FoHF product.
A FoHF, as the name implies is a fund which invests in a collection of hedge funds. The collection of funds is constructed in an effort to provide risk/return characteristics that achieve its mandate. Before I go any further it should be noted that a FoHF does not only apply to hedge funds; it is a portfolio construction process that is also utilized by long-only products, i.e. FoFs (funds of funds).
The basic premise of a FoHF is that a portfolio can be constructed in such a way as to generate a rate of return with lower volatility than may otherwise be the case if the investor constructed the portfolio himself, dependent of course on the investor (as I will discuss in the next section). As such, the FoHF manager is saying that it has the ability to source, research, and select funds which, when brought together to form a portfolio, can satisfy the investor’s investment mandate while reducing volatility.
Probably the two most often mentioned risks that a FoHF aims to reduce are manager risk and downside risk, which are in any event inextricably linked. Manager risk is reduced by the simple fact that more than one is involved in the product, thereby reducing the risk to that element of your portfolio which a single manager could bring. In other words, purely by having more managers in your portfolio you reduce the risk to your portfolio of any one of them failing, whether this be operationally, performance-wise, or in terms of strategy. The other primary risk that FoHFs aim to reduce is downside risk; arguably, one of the main benefits of a FoHF is not that it will “shoot the lights out” in terms of performance but that it will manage the downside risk.
Generally investors have certain characteristics that will encourage them to opt for a FoHF rather than a single manager, and vice versa. Of course, in addition to this are emotive factors related to fear, control, and, perhaps, misplaced confidence in one’s abilities.
Generally speaking, the greater the monetary value of the portfolio, the more likely an investor will go down the single-manager route. However, this leaves out one crucial element: the ability to select managers and construct a portfolio using a blend of managers to achieve a return target while minimizing risk.
Looking at Figure 1 we can draw certain conclusions as to the likelihood that—or more importantly whether—an investor should favor a FoHF strategy or a single-manager strategy when allocating to hedge funds.
The x-axis represents the ability of the investor to source and select individual managers. The “source” part is an important element as there are literally thousands of different funds that one can invest in, but the ability to get hold of a list of funds that you wish to consider further is an important part of the process and one that should not be taken for granted. The “select” element ties in the research part of the process as well. This is where you have managed to acquire a list of appropriate funds and are able to research them to the level of a hedge fund research professional. I use the prefix “hedge fund” in front of “research professional” as the kind of due diligence one applies to hedge funds, whatever the strategy, is very different to that required for long-only funds.
I have labeled the y-axis as the monetary size of the investment that the investor is seeking to allocate to hedge funds. The smaller this is, the less likely you will be able both to invest in the number of single managers necessary to satisfy diversification needs and meet minimum investment requirements.
Obviously, the descriptions of each of the four boxes illustrated in the diagram above are not mutually exclusive—there will be overlap, and other components will come into the decision; I have taken two of the primary drivers purely to discuss.
A: This is where not only is the size of the allocation to hedge funds low, but the investor also may not have sufficient ability to source and select single managers.
B: This is where problems can occur: the size of the allocation is high, so on first inspection the situation lends itself to a selection of single managers. However, on the x-axis the ability to source and select managers remains relatively low. Therefore, investors who fall into this box should really look to increase their expertise before allocating to single managers.
C: This area of the diagram clearly is where the single-manager route makes sense. Here a large allocation of funds is matched by a strong ability to source and select single hedge fund managers.
D: This area represents the investor who may have a strong ability as per C above to build a portfolio of single-manager hedge funds to satisfy allocation requirements but who may not have the funds needed to satisfy the minimum investment requirements of certain funds, which will limit his choice.
- Page 1 of 2
- Next section Advantages and Disadvantages