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.