Two of the issues frequently cited are the second layer of fees and the relatively disappointing performance during the financial crisis. For example, if we isolate January 2008 to the end of November 2009, various indices experienced the following returns:
[Table of Information]
On the surface it appears FoHFs did not deliver what they promised: diversified returns uncorrelated to long-only markets.
Other blows to this industry recently have been that numerous FoHFs were caught up in Madoff or other frauds; losses were exaggerated due to leverage and many were affected by the lock-ups on some of their underlying investments, thereby breaching trust by not returning capital as promised. For those FoHFs suffering more than one of the above consequences, the prognosis was quickly terminal.
Recent experiences have left many FoHF investors jaded, scared and saying ‘never again.’ This is a short-sighted and erroneous conclusion but one the hedge fund industry, and particularly FoHFs, are partially to blame for.
Unfortunately, the FoHF industry perpetuated an image of positive “absolute” returns no matter what crisis the markets may experience. Clearly, that was and is unrealistic and the industry would be in higher regard today if expectations had been better managed. What most investors are looking for is the long term compounding of returns and the biggest detractor is outsized losses. Even though the “absolute returns” advertised by many providers weren’t achieved given the extreme market conditions, investors should have been happy on a relative basis with the performance of their FoHFs.
For example, two of the funds Sussex Partners has been working with for the past several years had the following returns for the same isolated period of January 2008 to the end of November 2009:
[Table of Information]
These funds were chosen as the result of an intensive and rigorous selection process and were able to avoid the worst of the losses.
So long as the selection process is rigorous, the case for FoHFs remains strong. The shake-out from 2008/09 has lead to a reduction in capital chasing the same ideas. It is also a simple fact that at the most basic level having the ability to go short as well as long and the additional flexibility afforded to hedge fund managers in general should result in superior risk adjusted returns.
The rigour of a selection process is something many investors underestimate. Deeper due diligence, both operationally and on the investment side, is required. A clear understanding of the pricing policies in place at the underlying manager level, as well as at the FoHF level, and a detailed analysis of the liquidity profile of the funds in order to avoid a mismatch in the terms offered to investors at the FoHF level are key.
Diversification has been, and always will be, a key parameter of any well designed portfolio.
Portfolio construction at the FoHF level has evolved and is now much more dynamic. No longer is a FoHF able to justify fees simply by providing access to well known and often times closed managers in what is effectively a static portfolio. Events of recent years have taught FoHF managers that the ability to be nimble, and to turn over a large part of the portfolio frequently to reflect changes in the macroeconomic environment, is not just a vital success factor it is a key survival factor when extraordinary market events occur. Overlay strategies and direct market positions may then further enhance the risk return performance of the best managers.
The fact FoHFs charge a second layer of fees is both justified and irrelevant, so long as the risk adjusted returns, net of fees, are superior to alternatives. Dispassionate investment analysis should be fee blind. Paying a FoHF manager 50% of all returns if they are able to deliver a low volatility net return of 10% is preferable to a manager who may only charge a 1% management fee but delivers average net returns of 9%.
Top FoHFs are often able to renegotiate fees and terms with the underlying funds. Lock-ups and liquidity may be improved; language may be agreed dictating what occurs in the event of illiquidity in the underlying investments. The due diligence process for selecting underlying managers is most likely deeper and broader than what could be achieved internally at a family office and even at some banks. The recent challenges in the industry have forced it to become much more transparent for investors. This welcome change will further assist investors in better understanding their own risk exposures.
In short, FoHFs are nothing more than independent portfolio managers for hire. They live and die by the sword of net returns. They come with high compensation expectations but they deliver benefits that may go beyond the pure risk return profile they deliver. The paradigm for choosing FoHFs has shifted towards those with active management, high transparency and fundamentally sound operational due diligence systems in place.
