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Redemptions, Drop in Value Have Some Forecasting Gloom
Summary: "You are looking through a market that has been hit with a liquidity shock impacting all strategies, and hedge funds are more concerned about operational issues, reining back risks and holding cash in anticipation of redemptions," said Phil Irvine, co-founder of recently formed institutional consultant PiRho Investment Consulting, who predicts declines this year of 10% to 15% after a "pretty awful" September and despite a possible bounce in November and December.
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Some might reason that the funds' losses don't justify the 1% management and 10% performance fee funds of funds charge on top of 2% and 20% fees for individual hedge funds. Robert Howie, principal in Mercer's investment-consulting business, said funds of hedge funds will survive but take a "diminishing slice of a growing pie" as institutional investors and other sophisticated investing institutions launched their own investment programs.
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Mr. Howie predicted that well-resourced managers will launch more funds of funds focusing on specific strategies such as distressed debt or commodities -- as opposed to more generic hedge funds -- and there will be increased competition from infrastructure and clean technology funds, although he said investors were "not rushing into new investments."
Detail: Funds of Hedge Funds are Under Pressure
The following paper is the first to use quantile regression to analyze the impact of experience and size of funds of hedge funds (FHFs) on performance. In comparison to OLS regression, quantile regression provides a more detailed picture of the influence of size and experience on FHF return behaviour.
Hence, it allows us to study the relevance of these factors for various return and risk levels instead of average return and risk, as is the case with OLS regression. Because FHF size and age (as a proxy for experience) are available in a panel setting, researchers can perform estimations in an unbalanced stacked panel framework.
This study analyzes time series and descriptive variables of 649 FHFs drawn from the Lipper TASS Hedge Fund database for the time period January 1996 to August 2007. Our empirical results suggest that experience and size have a negative effect on performance, with a positive curvature at the higher quantiles. At the lower quantiles, however, size has a positive effect with a negative curvature. Both factors show no significant effect at the median.
Detail: The Performance of Funds of Hedge Funds: Do Experience and Size Matter?
Since the after-fee returns in funds-of-funds are, on average, lower than hedge fund returns, it appears that funds-of-funds do not add value. However, researchers in Columbia Business School and BlackRock show that funds-of-funds should not be evaluated relative to hedge fund returns from reported databases.
Instead, the correct fund-of-funds benchmark is the return an investor would achieve from direct hedge fund investments on her own without recourse to funds-of-funds. They use certainty equivalent concepts and revealed preference arguments to estimate attributes of the true, implied true fund-of-funds benchmark distribution. Since the benchmark characteristics seem reasonable, they conclude that, on average, funds-of-funds deserve their fees-on-fees.
Detail: Do Funds-of-Funds Deserve Their Fees-on-Fees?
Due diligence is an important source of alpha in a well designed hedge fund portfolio strategy. It is generally understood that the high returns possible in investing in hedge funds are somewhat offset by the relative lack of transparency on operational issues. The performance of a diversified hedge fund portfolio can be enhanced by excluding those funds likely to do poorly - or fail - due to operational risk concerns.
However, effective due diligence is an expensive concern. This implies that there is a strong competitive advantage to those funds of funds sufficiently large to absorb this fixed and necessary cost. The consequent economies of scale that researchers document in funds of funds are quite substantial and support the proposition that due diligence is a source of alpha in hedge fund investment.
Detail: Hedge Fund Due Diligence: A Source of Alpha in a Hedge Fund Portfolio Strategy
