Funds of funds reinventing themselves

Infovest21, a New-York based provider of information and research to the hedge fund industry, has just released its 2010 fund of hedge funds survey. The main finding, brought forward in the firm’s related announcement, is that “Funds of funds add more nimble managers, prefer small to medium-sized managers”. The contrary would have surprised me.


The last financial crisis has allowed investors to distinguish between the good and the bad (less the lucky ones) in the fund of funds industry. During the glorious years for hedge funds, between 2003 and 2007, managing a fund of funds was a reasonably easy task. According to the Dow Jones Credit Suisse Hedge Fund index, the hedge funds delivered a total net return of almost 75%, corresponding to a compound annualized ROR of 11.79%, during those 5 years. The low barrier to entry drove to the industry a lot of managers who realized the strong potential to earn over 2% (based on the standard 1% management fee and 10% performance fee) on managed assets with little research costs (who ever heard about due diligence at that time anyway). According to the Infovest21 survey, today the average fee structure is a 1.1% management fee with a 6.1% performance fee. All those new entries brought strong competition for assets amongst fund of funds managers and therefore a need to develop a real edge. The development of a real competitive advantage was not about adding leverage or investing in exotic/ not well known “alphabet soup” strategies but it was about building a strong research and adheres to high due diligence standards. The ones who picked the first two options are probably no longer in existence today or are still struggling to liquidate their portfolios.

According to the survey’s respondents, who were themselves above this threshold, on average, at least $1.4 billion is needed to "survive and thrive". With this level of assets, the managers earn on average (assuming an 8% annualized return) an annual fee of approximately $25 million. When considering making an investment with a fund of funds manager, investors should be mindful of how much budget is allocated to the company’s resources and not entrust their money with a manager who is looking to increase his margin at the expense of his investors (inadequate resources are the recipe for future disaster).

The move toward smaller hedge fund managers is not really a surprise. Post 2008, in the urgency, fund of funds managers had to rebuild quickly the confidence of their investors and achieved that by moving assets toward the well known, large and liquid hedge fund managers. Most of those managers are today well above their end of 2007 AUM due to this flight to “size” and are therefore likely to close to new assets soon. Furthermore, those managers founded in the late 80’s, early 90’s have to think proactively about their succession planning. Investors need to assess what will be the impact of the historical founders stepping down on the business and on the returns. Chris Shumway, Stanley Druckenmiller, John Horseman and Leon M. Wagner are a few examples of star fund managers who stepped down and retuned assets to investors in the last twelve months. Also big is not always beautiful, several academic studies have demonstrated that smaller and nimbler funds tend to outperform their larger peers. An additional incentive for fund of funds to diversify away from the blue chips is to differentiate themselves from the competition. An investment analyst in one of the big Swiss private bank recently told me that the biggest problem today was the high level of overlap between funds of funds’ underlying positions. In order to stand apart, the managers need to go off-road and find the gems wherever they are. Furthermore, institutional investors are more and more contemplating investing directly into hedge funds and if they realize that the end game is just to pick funds among the larger ones, they will certainly conclude that they can do it on their own.

Another interesting trend highlighted by the survey is the move toward industry consolidation. Almost two-thirds of the respondents have considered a strategic partnership while almost one-half considered acquiring another entity. Another 30% have considered merging or have merged with another firm. Adding to assets and/or distribution channels was the main motivation in these efforts.

The fund of hedge funds industry is changing fast to rebuild investors’ confidence and to prove that they can add value. I hope that they really learned the lessons from the last crisis and that bad habits are gone for good. Unfortunately complacency and greediness are very sticky within the finance industry and investors need to keep vigilant for not falling in the next trap.

Useful links page

I have compile a list of useful links to facilitate the search of public information about your favorite hedge fund managers.

Click here to access the list or clisk on the "Useful links" tab on the menu at the top of the page.

I hope you will find this ressource useful.

Don't hesitate to suggest additional ressources.

Operational staff challenged by investors' expectations

In order to raise assets for your hedge fund, it is no longer enough to involve the portfolio manager and a client rep. Every employee of the firm need to work at meeting the investors' expectations.

The good news for investors is that, according to a poll recently released by SEI, it appears that CFOs are aware of this new obligation.

According to the poll, conducted recently at the company’s annual Hedge Fund CFO Forum, addressing new regulatory requirements and meeting evolving investor expectations are the biggest challenges for 2011.

Read the press release from SEI here.

A new Star(r) in the Wall Street's hall of shame

Kenneth Ira Starr was arrested in May 2010 for a fraudulent scheme he ran for about a year and through which he had been able to misappropriate over $9 million from his advisory clients.


According to the claim brought by the SEC against him, Starr prior to his arrest managed over $700 million through Starr Investment Advisors LLC on behalf of around thirty high net worth clients.

The scheme was made possible since Starr had power of attorney or signatory authority over many banks and investment accounts belonging to his clients. Furthermore, Starr had custody of some of his clients’ assets also he was not a qualified custodian. Moreover, certain clients’ assets were held in a physical form in a safe at Starr’s office.

What does volatility teach us about mean deviation?

If you think, like many, that “an instrument that has a daily standard deviation of 1% should move 1% a day on average", you should read the following article:

Goldstein, Daniel G. and Taleb, Nassim Nicholas, We Don't Quite Know What We are Talking About When We Talk About Volatility (March 28, 2007). Journal of Portfolio Management, Vol. 33, No. 4, 2007. Available at SSRN: http://ssrn.com/abstract=970480

The due diligence process according to John Mauldin

John Mauldin is among other things a serial writer and an acute investment professional. I enjoy very much reading his Thoughts from the Frontline e-letter or the various articles he features in his outside the box letter.


He has posted a draft chapter of his new upcoming book about Absolute returns on his website (http://www.accreditedinvestor.ws/downloads/Due_Diligence.pdf). The name of the chapter is "Evaluating Hedge Funds" and describes his approach to due diligence.

Also it is quite challenging to describe a due diligence process in only 22 pages, I noticed a few ideas which are worth considering in your analysis of an hedge fund:

• Some hedge fund managers are good and some are just lucky. You do not want to invest in the lucky one, as luck always run out, typically just after you invest.

• The business side of the fund is as important as the investment side.

• The most important thing to understand about a fund is "Why" it makes money. If you cannot understand the "Why" of a fund, you should not be investing.

• A brilliant manager who can't follow through on the paperwork is a disaster in the making.

• Second level references are far more informative that the given references

Hedge Fund Appraisal annonces the launch of the Research Gateway

Learn how it works by watching our multimedia presentation

The research gateway presentation

View more webinars from hfappraisal.