Both the direct hedge fund industry and the fund-of-fund industry have been under significant scrutiny in recent weeks and months. The Bernard Madoff scandal was clearly the most high profile event that has drawn this negative attention. In addition, David Swensen, the highly regarded Yale endowment fund manager recently expressed a harsh view of the value proposition of fund of fund providers, saying “Fund of funds are a cancer on the institutional-investor world” and painting the fund of fund industry with a very negative and broad brush. According to Swensen, if you do not have the resources available to implement a direct hedge fund program, then you are simply better off investing “passively” in index funds. This is a very naive and myopic view and one that is deserving of some discussion.
The Yale endowment is by no means representative of the circumstances faced by the vast majority (99.9%) of investors on our planet. Endowment funds, especially large endowment funds like Yale have several inherent advantages relative to most investors (private and institutional). Probably the most significant of these differences are:
1. They have relatively predictable liability needs that are not impacted by the same uncertainties as those of pension funds and other public and private investors.
2. They tend to have highly experienced and informed oversight boards and investment staffs.
3. They do not have regulatory or political pressures like those faced by most public and private pension funds.
4. They do not, per se, invest assets on behalf of others who control the allocation of those assets.
5. With tens of billions of dollars to invest, they operate with economies of scale that cannot be matched by most investors.
These distinctions offer significant luxuries to endowment funds like Yale, to which Mr. Swensen seems somewhat oblivious and lacking in understanding and empathy.
Passive Investing Is A Fallacy
In addition, his suggestion that investing in “passive” index funds is the answer is also naive. “Passive investing” is simply a fallacy—an oxymoron; there is no such thing. Cash is the closest thing to a truly passive investment—which really should be classified as “saving,” as opposed to “investing.” And furthermore, as recent experience teaches, holding cash anywhere other than in one’s mattress (and probably even then, depending on your bedfellow) involves counterparty risk. The bank or money market fund that you are saving with, does in fact pose some risk of loss.
For most institutional investors, a well-designed “passive” investment program would actually be structured as a hedge to its estimated liability stream. For a pension fund, for example, this would consist of a duration or cash-matched bond portfolio with the same duration tenor points as its projected liabilities. Most pension funds rely on thoughtful professional advice in structuring this type of “passive” program.
Notwithstanding the fallacy of passive investing, Swensen’s argument is that if you cannot martial the resources (in his view, 20 to 25 investment professionals) to choose your own investments, then you shouldn’t even try, because you are doomed to fail. He says, if you can’t pick managers yourself, then you certainly can’t pick a trustworthy fiduciary to do so on your behalf.
By this reasoning, if I can’t practice law, then I shouldn’t hire a lawyer. If I can’t do my own taxes, then I shouldn’t hire a tax advisor. Upon reflection, it is hard to comprehend the logic or intentions of Mr. Swenson’s comments. Unfortunately in our opinion, the fraud perpetrated by Mr. Madoff has allowed too much attention to be focused on this type of careless hyperbole.
A Short Aside on Financial Stocks
I would posit that stock investors in a number of large respected financial institutions that have lost 70% of their investment value in the past year and those that had exposure to financial institutions through “passive” index funds and ETFs might be justified in having feelings similar to those who have been defrauded by the likes of Mr. Madoff. Fortunately for those investing in banks however the federal government (read “you, me and our children”) are there to backstop their losses at some level.
As such, it seems worthwhile to discuss the actual value proposition of a high quality fund of fund provider, (most of whom have avoided investments with fraudulent entities like that of Bernard Madoff).
Hedge Fund of Fund Value Proposition
The value proposition of a high quality fund of fund provider can broadly be organized into four overlapping categories.
1. Specialized expertise, resources and experience that can be accessed by clients
2. Risk management (related to the specialized expertise and resources)
3. Service and Other Sources of Value
4. Potential for delivering an attractive risk/return profile
In my view it is very reasonable to think that a fund of fund firm adds enough value to justify its fees. (A simple fee and expense thought experiment is included as an appendix to this note.) Further with the principals of many fund of fund providers investing alongside their clients, incentives are aligned often to a greater degree than can be achieved in other structures.
Below is more detail on each of these four categories.
Specialized expertise and resources
- Fund selection and monitoring skills: Significant fund of hedge fund providers employ between 10 and 50 people in research functions with experience understanding and evaluating the strategies employed by hedge fund managers. These people often are former portfolio managers, securities analysts or traders with specialized expertise in the segments of the market to which they are dedicated. In addition, highly trained quantitative analysts are employed to benchmark, evaluate and analyze fund performance in an effort to differentiate skill from luck. Further, these analysts conduct ongoing monitoring of fund investments. These are the same type of people employed by large endowment funds, though often with incentives better aligned with those of their clients through co-investment and ownership in their firms.
- Operational due diligence competency: Operational/Back-office due diligence is another related and specialized skill required for hedge fund selection and monitoring. A fund of fund provider may have between 1 and 5 or more people dedicated to this function. These professionals tend to have operations and accounting experience and focus on evaluating the operational aspects and control process of underlying managers. They also review audited financial statements of the funds in which the firm invests with an eye toward uncovering changes and inconsistencies in hedge fund manager’s processes and execution.
- Active strategy allocation skill: Opportunities to add value within and across the hedge fund universe are not static. Skilled portfolio managers at fund of hedge fund firms continually assess the available opportunity sets and deploy capital to the areas which they believe have the most attractive risk/reward profiles. This, in addition to manager selection can be an important source of value-added.
- Negotiation/buying power/transparency: Due to their size and significance fund of hedge funds have buying power with many hedge fund managers and can negotiate favorable provisions with respect to information transparency, liquidity terms, fees and other provisions.
- Systems and infrastructure: Most fund of hedge fund firms have developed significant systems infrastructure over time designed to assist in the analysis and monitoring of hedge funds investments. These systems have been developed and fine-tuned over time and represent a significant advantage to fund of fund firms in monitoring and analyzing hedge fund investments.
- Access to quality funds and closed funds: Many of the best potential investment opportunities in the hedge fund industry reside with managers who do not accept new investors. Many fund of fund firms have established relationships with these hedge funds, providing access to these closed managers. Further, new and emerging or lift-out managers often present compelling investment opportunities. Experienced fund of fund industry veterans often maintain professional networks that allow them a first look at these new opportunities. One claim made by Mr. Swensen is that the best funds do not accept fund of fund investments. There is no evidence that supports this claim, and in fact fund of funds do invest in some of the highest quality hedge funds in the world.
- Portfolio construction: Structuring a fund of hedge fund portfolio that is diversified by the sources of risk in the overall portfolio is a complicated process that requires specialized skills, tools and experience.—Diversification by strategy type, by manager, investment style, and risk factors are all important components of portfolio construction facilitated by a quality fund of hedge fund provider.
—Leverage and factor risk management are also important considerations in managing hedge fund investment portfolios. High quality fund of fund providers monitor leverage and factor risk and manage the overall portfolio in an effort to avoid concentration and potentially unintended and uncompensated risks.
—Stress testing and scenario analysis are also important in assessing and managing risk. Drawing on both qualitative and quantitative techniques, value-at-risk analysis and simulation techniques are employed.
- Ongoing risk monitoring: Ongoing due diligence and risk monitoring is a resource intensive and dynamic process across a variety of areas of focus. In general, the objective is to identify changes in manager behavior or fund characteristics that warrant further investigation across areas such as:—Concentration risk monitoring involves constant dialogue with managers to understand the most significant risk positions in a manager’s portfolio.
—Leverage risk monitoring involves quantitative and qualitative analysis of the long, short and net exposures of the manager and how those exposures are practically achieved.
—Liquidity risk monitoring involves understanding the liquidity profile of the manger’s portfolio and its implications.
—Basis risk monitoring attempts to identify and analyze the net risk exposures of a managers long and short positions.
—Style drift risk involves monitoring underlying portfolio style exposures relative to expectations.
—Financing and counterparty risk monitoring is designed to analyze the risk a manger is exposed to if its financing arrangements are materially altered.
—Fraud risk is one of the main risks that fund of fund managers seek to avoid through rigorous due diligence processes, analysis of financial statements, background checking, manager site visits and other forms of analysis.
- Fiduciary risk: Fiduciary risk for many plan sponsors is managed through the use of expert intermediaries such as registered fund of fund firms. As a result of time and resource limitations many plan sponsors and trustees must rely on financial intermediaries to help mitigate regulatory risk, headline risk and the associated career risk implications.
Service and Other Sources of Value
- Potentially better liquidity terms over direct fund investments: Fund of Funds can bundle a number of different strategy types and investors and as a result can potentially offer better liquidity terms than direct fund of fund investments. While liquidity intermediation has risks, some liquidity intermediation can be helpful and its risk is manageable.
- Portfolio accounting: Accounting for a portfolio of hedge fund managers is also complex, requiring monitoring of manager valuations, fee and expense charges, tax and regulatory assessments. These types of services often require specialized expertise and are a part of the service offering of many fund of fund firms.
- Custom reporting: Aggregating portfolios of fund managers, performance results, underlying exposures into useful reports is another role of the fund of fund manager.
- Education and training: High quality fund of fund providers offer a variety of investment committee, board, and trustee education and training modules that can help advance the knowledge and understanding of a variety of strategy types for most organizations.
Potentially attractive risk/return profile
Like any investment or service offering, there will be above average and below average firms as well as a wide distribution of service offerings and quality levels. One of the obvious places to look for evidence of value is the performance track record of various fund of hedge fund firms. We firmly believe that there is an attractive risk/adjusted performance profile that can be sustainably delivered by the high quality firms in our industry, and data supports this conclusion.
Appendix Discussion On Costs/Fees
It is difficult, if not impossible, for most investors to replicate the services provided by high quality fund of fund managers in house, simply due to the cost burden associated with maintaining this expertise in house. Let’s assume that a medium- sized fund of fund business employs 21 people across its investment functions including qualitative analysis, quantitative analysis, operational due diligence, accounting and reporting. Further assume that the average salary of these employees is about $165,000 + 35% for benefits and overhead. For any individual or institution to replicate just this aspect of the overall portfolio management process would cost over $4.5 million. Further assume that the all in fees (management fee plus performance fee) amounts to about 130 bps. This implies that from a pure run-rate cost standpoint, an investor would have to have about $400 million invested in hedge funds in order to break even through replicating just the personnel and associated costs required for a significant alternatives program, relative to the management fees they would pay for this service.
This is a very naive analysis since it assumes one does not have to invest in technology infrastructure, other analytics and travel expenses, and also has the available talent pool and management talent to execute an alternatives program. Other benefits and externalities, such as manager access, experience, networks, buying power, etc are also not accounted for by this naive hypothetical example, which suggests that the costs of replicating the service offering of a hedge fund program may be impractical unless an investor has $500 million to $1 billion or more allocated to hedge funds. And, even in these cases, there are a number of reasons, other than cost, that an investor may choose to outsource this activity.
Basis Point of Disclosure: This piece was written by a money manager whose firm has a hedge fund-of-funds division.