Funds of hedge funds are promoted as being a very sensible way for pension funds and other institutions to become involved in the world of hedge funds. However, institutional investors, especially pension funds, find the second layer of fees of the fund of fund manager as excessive; that is, they regard it as debatable whether fund of funds managers add value to justify their fees. After all, the fee structure of a single manager is already high when compared with relative return managers. In addition, fund of funds managers are being criticised as only being able to undertake investments in the larger funds, which is just at the point when hedge funds find it hardest to sustain their performance records.

Investment process and value proposition
The investment process of the fund of funds manager is based on two different tasks and two variables. The two tasks are an initial selection and an ongoing monitoring process. The two variables are the portfolio constituents (the single hedge fund managers) and the management of the portfolio. The former is a bottom-up task (due diligence) whereas the latter is top-down (asset allocation). Put simply, the fund of funds manager selects and monitors managers and selects and monitors the overall portfolio.
There is little doubt that the picking and monitoring of hedge fund managers is crucial to the success of any hedge fund portfolio. Currently, probably a majority of institutions have warmed up to the idea of investing in hedge funds. Many traditional asset managers have spotted the opportunity and have launched absolute return vehicles. The reason for this rather rapid change of heart is primarily attributed to the current bear market and the fact that the hedge fund industry has by and large preserved investors’ wealth during this difficult period, which can easily be classified as one of the most difficult periods in institutional money management. In other words, past performance sells.
Figure 1 shows the HFRI Fund of Funds index compared with the MSCI World Total Return index from January 1990 to end of January 2003. The figure shows the ‘underwater perspective’, that is, the index as a percentage of its previous all-time high. This graph allows one to visualise the magnitude of drawdowns from previously reached levels of wealth. The percentages on the right show the compound annual rate of return (CARR) for the whole period. The main message of this way of presenting data is that large drawdowns kill the rate at which investors compound their wealth over long periods of time, or, as the old saying goes: ‘The best way to make money is not to lose it’.
It is unclear why it has taken so long for the absolute return investment philosophy to gain wide institutional acceptance. Today, however, it seems to be common knowledge that a single hedge fund is risky whereas risky constituents can be formed into a conservative portfolio. The reason for hedge funds being risky is the fact that, to the investor, they are like investing in venture capitalists, with fairly large operational risk. The investment strategy of the hedge fund and therefore the financial risk to the investor might be directional (risky, but more often than not less risky than long-only exposure) or non-directional (less risky), but that still leaves the investor with exposure to operational risk. In other words, most hedge funds carry less financial risk than traditional long-only managers, but the risk to the operation of the hedge fund manager is higher than with an established multi-billion dollar traditional asset management house. This means that investors need to diversify single manager risk to unlock the value in the hedge fund industry. Fortunately, the operational risk is entirely non-systematic (idiosyncratic) risk. This means that operational risk can be nearly fully eliminated through diversification at the portfolio level.
The typical claim of fund of funds managers is that they add value on both tasks (essentially their marketing pitch), that is, by selecting and monitoring managers as well as portfolios. This may or may not be true. One way of assessing whether fund of funds managers add value is by analysing the barriers to entry for other, less experienced investors and whether the managers are operating in an inefficient market or not. The barriers to entry with respect to top-down asset allocation are probably low. Investors have moved up the learning curve pretty fast. Most strategies and esoteric risk characteristics of the strategies have entered the financial vocabulary of the prudent investment professional within the past three years. (A bear market has some positive educational side effects.) However, the barriers to entry are high for evaluating and monitoring managers. The fact that manager risk is non-systematic does not mean that the bottom-up due diligence process is not elementary to the success of the portfolio. The attrition rate in the hedge fund industry is very high. Potentially, the firing of managers is more important than the hiring. Anecdotal evidence suggests that avoiding losers is far more important to long-term financial health than picking winners.
The consensus estimate for the number of hedge fund managers is around 6,000, with huge variance around that figure. The figure is not that relevant for institutions because once the managers who do not have at least $10m (99.3m) under management and at least one audited report per year are filtered out, the number of funds decreases to around 600 world-wide. It is known that the dispersion among managers in most sub-categories is high. This is primarily because there is no market benchmark for managers to hug. (The positive side of the absence of a benchmark is that the industry is heterogeneous and returns between single managers, therefore, weakly correlated.) Chances are that a fund of funds operator with 10-20 full-time analysts with five to 15 years’ experience each and a multi-million dollar budget for due diligence will have a competitive advantage over a pension fund that might just recently have allocated two (certainly ambitious) analysts with two to three years’ experience in the industry and a much smaller budget to monitor managers globally and regularly.
Active management
The double fee argument does not relate fees to the value added by the fund of funds manager. If a random selection of hedge funds yields the same gross risk-adjusted returns as the fund of funds approach, then we would have to question the double fee structure. However, we doubt that the hedge fund industry is efficient. Most likely it is quite the opposite. Information is still scarce and costly. Visiting 200-300 managers per year is a major operation.
In theory, an active fee should be paid on active management and a passive (lower) fee for passive management. The main reason for passive management having lower fees is that the costs of getting exposure to efficient markets such as the US or UK stock market have continuously been falling. In other words, an active fee should be charged on exposure that is not available through indexation or other passive investment strategies. Put differently, excess returns attributed to skill (alpha) are scarce and costly while market exposure (beta) is not.
The market inefficiency, which essentially justifies a fee for active management, lies within the opaqueness of the information flow in the hedge funds industry. In selecting and managing hedge funds, the greatest barriers to entry are at the manager level. Given that fund of hedge funds managers operate in a market as inefficient and opaque as the hedge fund industry, we believe they have a strong value proposition for active management. However, economic logic suggests that over time the costs of active management (fees) are correlated with the set of exploitable opportunities and, therefore, inversely related to efficiency improvements of the marketplace. In the long term, that is.
The views and opinions expressed in this article are those of the author and are not necessarily those of UBS AG or an affiliate thereof (‘UBS’). UBS accepts no liability over the content of the article.
Alexander M Ineichen is managing director of UBS Warburg in London and author of ‘Absolute Returns’ (Wiley, New York)

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