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Where fund of hedge funds went wrong Investors in Fund of Hedge Funds (FoHFs) were sold the proposition of uncorrelated, absolute returns. During the crisis, when this is what their investors really needed, they failed to deliver, almost universally. That 97% of FoHFs lost money in 2008, and that 87% lost more than 10% is not only shocking, it is unforgiveable, considering that approximately 1/3rd of single manager Hedge Funds were up in the same period, and 1/5th by more than 10%. But returns are only half the story. Investor surveys consistently highlight low correlation as the most important reason for allocating to hedge funds. How did FoHFs fare? The evidence is just as damning; since 2005, the HFR FoHF Composite Index has shown stubbornly high correlation of between 70% and 90% to the MSCI World Index, a significant increase from the previous decade. What prompted this almost wholesale failure by the FoHFs industry? From 2002 to 2005, FoHFs’ assets grew tenfold and doubled again over the following two years. In the main, this was new money from pension funds and private banks as they increased their allocations considerably, in many instances from zero. This weight of money forced the industry to change. The message was clear; if you wanted to win big, institutional mandates, you needed to be big and institutional. No coincidence – as assets grew, so did correlation Correlation 1.0 High ‘11 ‘09 ‘07 ‘05 ‘03 ‘01 ‘99 ‘97 ‘95 HFRI Fund of Funds Composite Index 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 Low Medium 100 300 500 700 900 Growth in FoHFs assets FoHFs correlation to MSCI World ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 AUM (USDbn) Year 32x increase 809 25 1,000% 3 yr asset growth = a ruined inv process = high correlation As FoHFs institutionalised, their process and quality of selection began to break down. In pursuit of the mainstream, the senior team moved from selecting funds themselves to making top-down asset allocation macro calls. Junior analysts, generally following a selection formula, were then tasked with creating a short-list of funds to reflect this macro view, which was passed back up to the senior team to make the final investment decision. While this may have the appearance of an impressive, institutional process, it is fundamentally flawed, with too much of the fund selection process delegated to junior analysts, having neither the experience nor the skill set to undertake such a pivotal role. Ten years ago senior staff, and often the principals of FoHFs, were responsible for fund selection and therefore were involved in the “pilot-to-pilot” meetings with hedge fund managers. Suddenly young, inexperienced, employees were shortlisting managers. One outcome has been an unhealthy focus on larger managers resulting in 7% of hedge funds – the so- called ‘billion dollar club’ – controlling 84% of all hedge fund assets. Yet this idea that ‘bigger is better’ runs counter to what the hedge fund industry used to be about: smaller managers operating below the radar screen and nimble enough to pick off the bigger firms. Today, smaller and mid-sized managers are all too often ignored. Unhealthy industry concentration 93% 7% 84% Funds > $1bn Funds < $1bn of industry assets A whopping 84% of industry assets are invested in just 7% of the industry's funds. How it should be done Rory Hills of Hilltop Fund Management has a talent for spotting talent. With 26 years’ experience speaking to fund managers, and over 10 years’ hedge fund experience, he has reviewed over 1,500 hedge funds, and has been involved in more than 1,000 FoHFs – and how it should be done HT The Trade Press feature.indd 1 22/10/2012 16:57
