Fund Of Hedge Funds: Cure Or Disease?

“Fund of funds are a cancer on the institutional-investor world…

Consultants make money by giving advice to as many people as possible. But you outperform by finding inefficiencies most of the market has not yet uncovered. So consultants ultimately end up doing a disservice to investors.”

David Swensen (CIO Yale Endowment and author of Pioneering Portfolio Management and Unconventional Success) made those remarks to the Wall Street Journal in January 2009. This was shortly after the massive Madoff fraud became front page news.  Within a matter of days it was clear that several European Funds of Hedge Funds (FoHFs) had been heavily invested.

Mr. Swensen believes that institutional investors should either: (1) build up a large, expensive, 20-25 person investment team in house, and make all investment decisions internally (the Yale model); or (2) limit themselves to passive index-investing (presumably managed by a skeleton staff). Investing through a FoHFs, relying on an investment management consultant, or outsourcing the CIO function, is a ‘casual attempt to beat the market’ that is destined to fail.

These comments sparked a fierce industry debate. The popular press of course focused on who had invested with Madoff and how much they stood to lose. The trade media focused on flaws in the FoHF due diligence model and, later in the year, on the redemption gates applied by single managers suffering liquidity events – ‘hot’ (‘unreliable’ to Mr. Swensen) FoHF money was often blamed. It was not long before the trade press and the conference circuit were inundated with sessions on managed account solutions – the new panacea for all that aisled institutional investors’ portfolios.

Kevin Quirk, a consultant at the leading investment management consultancy – CaseyQuirk – was prompted to give a spirited defence of the FoHFs industry (but interestingly not the consulting industry!). Mr. Quirk pointed out three ‘facts’ regarding FoHFs and Madoff:

1. very few FoHFs, and no leading institutional firms, were invested with Madoff (this was a fairly damning critique of UBP, Man Group and UBS whose FoHF units were all invested)

2. many investing funds were ‘feeder funds’ and not FoHFs

3. most FoHFs refused to invest in Madoff.

Robert Huebscher also pointed out that in 2008 the HFRI FoHF Composite Index (-20.7%) outperformed the S&P 500 (-37%) by over 16% and the Yale Endowment (-25%) by over 4%. The FoHF Index did this with less than half the volatility of the S&P 500 (and about the same as Yale).

Meanwhile the three most liquid hedge fund strategies (equity hedge, macro and managed futures) recorded -25%, +6% and +32% respectively in 2008. Comparative out-performance by absolute return strategies over a short time period though was hardly the key point – it is well known that managed futures have massively outperformed equities during every drawdown over the past decade.

In September 2010, Financial News again sounded the death-bell for FoHFs in an article headlined, ‘The slow death of funds of funds’. In January 2011, Reuters pointed to a coming wave of M&A and liquidation for the smaller, weakened FoHF players. HFR also came out with new estimates showing FoHF assets dropping 30%. This again prompted Casey Quirk to return to the debate, this time declaring “…the end of an era for fund of funds managers.”

The important lessons learned by the industry from 2008 were around liquidity management, transparency and counterparty risks. Several of the larger and more sophisticated institutional investors have worked over the past few years with the leading consultative FoHFs (think of Blackstone, Grosvenor and Permal for example) and investment management consultants – to build customised, diversified, liquid, FoHF portfolios around these themes or as completion portfolios.

I could be wrong of course but I do wonder whether Mr Swensen’s criticisms of FoHFs and investment consultants is premised upon an assumption that FoHFs simply deliver off-the-shelf  portfolios of 30-60 managers diversified across styles and strategies for 1/5 etc.  If this is in fact the case, it is an entirely outdated view of the industry, and how the business models of its participants have evolved.

The institutional, research driven FoHFs with a global presence, continue to offer significantly more developed sourcing/research models and portfolio construction/ management capabilities than an institutional investor can maintain in a ’20-25′ person investment team on a university campus. They can also provide expert ongoing risk management, market and economic guidance, board/ trustee support and education, managed account capabilities, co-investment and seeding opportunities etc. These services may be offered to strategic partners gratis or delivered and priced as individual components.

Mr. Swensen’s binary classification of institutional investors – and the sounding of the industry’s death bells by parts of the trade press – fails to capture the evolving realities of institutional investment management.

1. David Swensen’s website:
2. Transcript of David Swensen’s WSJ interview from
3. Kevin Quirk’s defence of the FoHF industry:
4. Robert Huebscher, Advisor Perspectives:
5. Reuters on FoHF consolidation