In the aftermath of the poor performance of financial markets in 2008, one way that wary hedge fund investors sought shelter was by increased diversification — allocating to more than one fund of funds, or only investing in larger, better known fund of funds. This is often ineffective, however, because if the funds of funds invest in similar hedge funds, the investor isn’t truly gaining diversification by investing in more than one. Alternative methods of investing in great hedge funds that can weather storms like 2008 are available. Many times simplification is a sounder idea than diversification.
We envision this simplified structure as a smaller basket of hedge funds chosen through more rigorous analysis and monitored more rigorously.
Simple, Direct Investing in Hedge Funds May Be Better
One optimal alternative is direct investment in hedge funds by hedge fund investors, without funds of funds as (expensive) intermediaries. Among the advantages of the “direct” model is that it can be designed and customised for each particular investor. We think that most investors would be very well-suited holding a personally customised basket comprised of low beta, high alpha, low volatility funds which are rigorously selected and carefully monitored – for metrics such as low volatility, low drawdowns, and low correlation to equity and other financial markets.
Because the investor is investing itself, rather than through a fund of funds, the investor obtains the critical benefits of choice and transparency. The choice comes from direct investors being able to decide what funds to invest in, which they cannot do through funds of funds.
Peter Lynch advised us to know what you own. The simple tenet of having a very clear understanding of what the hedge fund actually does – through rigorous analysis and monitoring — will serve investors very well.
More Can Mean “Diworsification”
How can you be sure that adding more funds creates diversification? Without transparency, you can’t be.
We think it is more logical to select a few high quality funds which are well understood, as opposed to a broader group of poorly-understood funds, for the following reasons.
Opportunity Costs of Adding Incremental Funds are High
A key, and much overlooked, facet of the profit and loss formulas is the opportunity cost. Taking the “soft costs” into account, the incremental return from adding a fund is generally low.
There are more hedge funds than Starbucks per square block on the island of Manhattan. Many are not true hedge funds that actually hedge risk; instead, they merely capture beta. The process of finding just one worthy fund takes significant blocks of time, involving several face to face meetings, phone calls, and hours of work by analysts.
The distraction of shuffling money amongst a large number of managers can also incur more “soft costs” than is often understood. Time spent on rebalancing and monitoring managers that do much the same thing anyway could be spent on more productive activities such as economic forecasting, market analysis, monitoring for risk, overlap analysis, and performance attribution.
The cost of operational due diligence is high, and for more complex strategies, the time required can be months. Due diligence must be ongoing. Although operational due diligence is imperative, it is not an insurance policy and it is guarantees nothing. It is not foolproof.
A truly prudent fiduciary’s work is never done, because operational risks are usually significant, even for the soundest of vehicles. Circumstances are always subject to change; accordingly, investors are always potentially exposed and must always be vigilant. With more funds comes more vigilance.
Thus, the opportunity cost of each additional fund is high because adding a fund inexorably adds risk, no matter how well-vetted.
Bigger is Not Necessarily Better
It is common to see managers who would achieve better performance if they were managing less money. Some smaller managers may have an advantage because their smaller fund size can make them nimble. This flexibility may allow them to navigate more easily in and out of trades without impacting the markets they trade in. For strategies such as high frequency trading, microcap equities, long/short equity, and even global macro, these benefits can be quite significant. It is also important to understand the amount of time a manager spends marketing the business, as opposed to investing the fund’s capital. Extensive marketing may distract managers from focusing on maintaining a solid investment methodology. Smaller managers also often possess the psychological advantages, in that they are often hungry to build and expand their business. They often exhibit an investment “edge” that may have worn off for their larger counterparts.
Highly volatile funds are hard to use as diversification tools, and should be avoided. Consider the following example. Let’s say that there are six funds in a basket. Fund A is a highly leveraged fund which is down 15% in January. Fund B, Fund C, Fund D, Fund E, and Fund F are all low volatility strategies and are up 3% this month. Assuming equal weighting, the unsteadiness of just one fund has negated the good performance of the rest of the basket and – perhaps more importantly – the investor pays performance fees on the funds that show positive returns, but because the funds collectively show flat or negative performance, the investor does not have net gains justifying performance fees.
A New Design
For all of these reasons, we believe that for many investors, a portfolio of fewer funds, rigorously selected and monitored, and invested in directly is an excellent investment and value proposition. We also believe that investors should avoid funds of funds whose philosophy of diversification is investing in more funds than necessary that they neither fully understand nor rigorously select. We believe that the marketplace is also seeing the wisdom of this approach, as more investor dollars are being invested in hedge funds directly, using the approach we have outlined.
(This is a contributor post from Sara Grillo, CFA, Diamond Oak Capital Advisors, LLC)