The recent disheartening performance of Funds of Hedge Funds (FoHFs) gave rise to a debate about whether their model is dying slowly or can still attract institutional money. The most popular investors in the FoHFs space are pension funds and insurance companies looking for safe and well-diversified products to allocate their assets, but their recent losses made them reconsider alternative strategies with similar characteristics. Multi-strategy funds (MS) will compete with FoHFs for assets and the current trend proves, that they are a formidable competitor, as their assets grew from $292bn in Q3 2015 to $316.3bn in Q1 2016 according to BarclayHedge. The industry’s data provider exhibits a plunge in the assets of FoHFs over the same period, as their assets decreased from $448.3bn to $396.5bn. It is clear from the graph below how the strategies converge after 2007 and the financial crisis of 2008.
Starting from the fee structure, which is all over the press, FoHFs typically charge 1/10 on the top of the existing typical 2/20 fee structure of hedge funds, costing investors eventually 3/30 of their allocation. On the other hand, MS as a sole provider of these strategies charge normally 2/20 fees, a clear advantage in terms of fees for investors. A study from Lomtev, Woods and Zdorovtsov in 2007 found that the netting of fees give MS investors a mean premium of 23 basis points. Fee netting is the payment of investors for profits on combined strategies and not on each one profitable strategy, which is how the profit-sharing models of FoHFs work. In the same study, the authors support MS in terms of transparency, a view that this perspective does not share, considering MS switching trading strategies’ makes an evaluation more opaque. This opacity gives rise to agency risks associated with MS investing, which according to Agarwal and Kale (2007) should add a premium for MS investors. FoHFs on the other side, by offering managed accounts for their investors, allow for better evaluation of their skills. They also consider MS funds to have better market timing skills, which leads to support Gregoriou (2004) findings about bad market timing of FoHFs.
Moving further to our analysis, we create an equally-weighted index for MS strategies across the different classification in the HFRI Index and we create a correlation table between our created index, HFRI FoF Index, equities with S&P500 as proxy and fixed income with BofA Merrill Lynch Corporate Master Index as proxy.
The formulas used for the above statistical analysis are below:
This analysis ex-post and should not be exclusively used for investment decisions. It is based on external use of data. The data for the model is provided by David Hsieh’s Data Library and can be found here. Furthermore, the analysis is based on indices (portfolio level) and not on individual fund basis, which should be taken into serious consideration as it differentiates investment decisions. Each fund should be analysed thoroughly based on factor and other portfolio exposures and preferences.
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