Hedge Funds: A Comparison of Investment Vehicles

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There can be no mistake - hedge funds are here to stay. It is estimated that institutional investors will account for more than 50% of the total flows into hedge funds through 2010, with retirement plans representing 65% of total institutional flows.¹ This popularity has led to the proliferation of "Institutional Quality" hedge fund investment vehicles. As more and more pension plans allocate assets to hedge funds, questions arise about the optimal way to start an investment program. Should a plan invest in single strategy funds? How about using the multi-strategy approach where allocations are made across the spectrum of hedge fund investments through a single firm? Or perhaps an allocation to a reputable fund of funds is the best way to establish an exposure to hedge fund investing. In this article, we will review the advantages and disadvantages of each method so investors can choose the investment vehicle that is most appropriate for their goals.

Fund of Funds Investments

Many investors who are starting an allocation to hedge funds find that the fund of funds route is the smoothest road to successful implementation of a hedge fund program. This approach is especially advantageous for investors who have had limited exposure to alternative assets in general and who lack the necessary expertise in the hedge fund space.

In a fund of funds investment, a third party provider constructs a portfolio of various single strategy hedge funds to achieve a particular risk/return profile. The fund of funds manager is responsible for all research, which results in the hiring and termination of managers in the underlying portfolio, as well as program construction and fee negotiation. One significant responsibility of the provider is a thorough review and examination of the hedge fund manager's operational capabilities. This can protect against "event risk" or individual manager blow-ups.

Most fund of funds providers usually develop one or more core portfolios that they feel offer a well-diversified exposure to the hedge fund marketplace, while meeting the objectives and risk profiles of a large percentage of investors. Many also customize their portfolios based on an investor's unique circumstances and requirements.

There are obvious advantages to the choice of a fund of funds program. The first is the expertise the provider brings to the asset allocation, selection, termination and due diligence processes. As an example, most fund of funds require a minimum degree of portfolio transparency before they will hire a manager. The average investor may not be given access to this information. The provider also has access to a wide selection of funds, some of which are closed to outside investors. This well-diversified portfolio of investments can protect the investor from experiencing large losses due to the underperformance or failure of a single strategy. Many fund of funds are expert at sourcing talented, undiscovered managers who are usually "under the radar" or not available to the broader investment community. Third party providers can also use scale to negotiate reduced lock-up periods, thereby lessening liquidity risk.

The greatest perceived disadvantage of investing with a fund of funds complex is the additional layer of fees charged to the investor. Typically, providers charge a management fee plus a performance fee over a hurdle or minimum rate of return. Accordingly, costs can be a significant issue for investors.

The number of funds included in one fund of funds portfolio can also cause problems for the investor. If a large group of single strategy funds is assembled, the possibility of duplicate holdings can increase the concentration risk of the overall portfolio. Too many funds may also increase systematic risk and increase correlations to traditional asset classes. Limited or no access to the underlying hedge fund manager and portfolio rebalancing issues caused by a lack of liquidity can also be problematic for the investor in fund of funds products.

Multi-Strategy Investments

For investors who cannot accept the additional fees or the other issues associated with fund of funds, multi-strategy hedge fund vehicles may be an attractive alternative. Their objective is to deliver consistently positive returns regardless of the directional movement in the equity, fixed income, or currency markets. Multi-strategy funds consist of different hedge fund investments offered in a single portfolio structure by one firm. Such an approach may be appropriate for clients who have strong convictions about the investment acumen of a particular firm across different hedge fund strategies. Similar to fund of fund complexes, multi-strategy firms can offer portfolios with more generic risk/return characteristics as well as funds customized to meet the investor's specific requirements.

One obvious advantage of multi-strategy funds that is similar to the fund of funds model is the diversification benefits of allocating your investment across different hedge fund sectors. However, unlike fund of funds, there is no additional layer of performance-based fees. Managers in a multi-strategy vehicle net performance fees so the investor does not pay for poor performance.

Since they are not subject to restrictions placed upon them by outside managers, multi-strategy funds can offer the investor increased liquidity and transparency when compared to most fund of funds. An additional advantage to using the multi-strategy approach is institutional-quality client service and reporting, which is not always available from smaller, boutique hedge fund organizations due to a lack of resources.

Single strategy funds, which we will discuss below, are limited in the scope of their investment opportunities. When their investment "advantage" disappears, managers may have to reduce exposure by shifting to cash or remaining in underperforming investments. In contrast to single strategy funds, running multiple strategies in-house allows for the quick movement of capital to whatever investments are working well across any asset class. There are also capacity constraints associated with single strategy funds that are less of a consideration for multi-strategy products.

The most convincing argument against the multi-strategy approach is the risk of being exposed to the possible operational difficulties of a single firm. Fund of funds tend to moderate this risk through sheer numbers of underlying managers. Studies have shown that the majority of fund failures can be attributed to operational problems.

Another shortcoming associated with multi-strategy funds is the difficulty in attracting and retaining talented investment professionals across different strategies. The best managers have traditionally concentrated on a single or narrow group of strategies. Also, while multi-strategy funds offer a broad degree of portfolio diversification, these benefits may be lower than those available through a fund of funds structure. If investment teams are closely aligned or comprised of similarly trained personnel across different individual funds, there can be a decrease of independent ideas and an increase in concentration risk.

Single Strategy Investments

Some investors forego the fund of funds or multi-strategy approach by building their own portfolio of single strategy funds. Managers of single funds have actual or perceived expertise in a specific hedge fund strategy or similar strategies. These investments are typically offered in a commingled vehicle.

Considerable and effective due diligence is required for selecting top managers in the hedge fund space. Accordingly, the investor will need to have significant expertise to evaluate a series of different hedge fund strategies. Extensive knowledge of this space is also required to implement an asset allocation across strategies in order to achieve the correct risk-return profile for the investor. Finally, expertise is vital to successfully perform the ongoing due diligence necessary for the manager program.

If an appropriate level of in-house proficiency exists, investing in several single strategy hedge funds can be a viable alternative to the fund of funds or multi-strategy models. This approach has the potential for higher return, albeit at a higher level of risk. Investors may also be able to implement a more customized program. Fees are also typically lower than when using other types of hedge fund investment vehicles.

Similar to the other approaches discussed, there are definite drawbacks to single strategy investing. Due diligence is time-consuming and usually expensive. Why spend 50% of your staff's time and resources to oversee a small (typically 5-10%) allocation? Access to the top managers in each category can be very difficult due to the "word of mouth" nature of the business as well as high account minimums. It may also be difficult for the average investor to access the network of "star" and up-and-coming managers. Investor liquidity and transparency requirements may also reduce the universe of managers that can be hired. Building the appropriate asset allocation can also be difficult if the required expertise and experience are not present in the internal group.

Conclusion

Many investors are recognizing that hedge funds represent an attractive addition to their portfolio. However, plans should proceed with caution since the experience and expertise needed to ensure that proper due diligence is performed on single strategy funds is still in short supply outside of the hedge fund industry. In addition, most plan sponsors are not sufficiently staffed to handle the increased research effort needed to pick quality funds. As a result, it appears that fund of funds offer the novice hedge fund investor the best combination of knowledge, due diligence, diversification, risk management and access to top performing hedge fund managers. Further, the "institutionalization" of the hedge fund industry should lead to more flexibility on fees.

Multi-strategy funds are a good second alternative if one can tolerate the single firm risk, both from an investment process and business perspective. However, single strategy fund investing, while advantageous from a fee perspective, should be limited to the more sophisticated, experienced and knowledgeable investor.

¹ Infovest21, July 2007.