Can someone please answer why institutional investors like pension funds/endowments/foundations invest in fund of hedge funds?
It’s really hard to pick the best manager and even if you do, their strategy might not perform well on an absolute basis. As such, FOFs offer diversification among (hopefully) the better managers.
In principle, it’s not that much different than owning 1 stock vs. owning a portfolio of several stocks…
institutional investors may lack expertise. there are people that track and evaluate hedge funds for a living. if the FoF manager has a nice track record, while factoring in the layered fee structure, then it makes sense to grab some extra diversification.
They are convinced of the above comments by salespeople at FoFs, and also because they observe other investment places are doing the same thing.
I mean, these guys are professional investors. All they do is choose investment companies. I don’t know if they can make an excuse that they don’t have a method to choose hedge funds…
I find it strange as well. Seems like fof could serve as an audit function ?
People don’t just use FoF for hedge funds. Also for other asset classes. It’s a way of outsourcing due diligence (often where the institution lacks internal resources to adequately perform DD) and of getting diversification quickly.
It can be a reasonable strategy if the fees are contained. The problem with hedge funds is that the fees are already disgustingly high. Think 2/20 or more when the average gross return now is single digits. So the double fee layer is a killer.
Your portfolio might have produced an 8% gross return last year, but you might end up with 2%-3% net. That’s the kind of experience a lot of FoF HF clients have been seeing in recent years.
Some FoF can be a ripoff, others serve a purpose. Here are a few examples of some that can add value:
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The FoF offers better terms than could be gotten with a single investment. PE company does a FoF that has better liquidity terms and diversification than one of their traditional call down funds. Same can be applied to a firm specializing in FoF, maybe they do coinvests too.
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The FoF has access to funds that the institution does not.
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The FoF actively manages exposures, taking exposure up or down for the underlying funds. Again, the FoF may be in a unique position to do this due to terms on the underlying funds that may not be available to the institutional investor.
Managing a portfolio of hedge funds can be a major PITA, especially if you are an institution balance liabilities with liquidity premium.
Ohai and Brain make some interesting points. FOFs has a place, but I agree that some institutions should be able to pick managers without a FOFs. Where FOFs does make a lot of sense is in the VC world because it offers both manager and vintage diversification.
see LTCM for why institutions prefer to spread risk among many funds. you don’t want to get wiped out because you’re not smart enough to be smarter than the smartest guys ever, and then lose your job.
everyone thinks they need alternatives because that’s what the finance guys have pushed for decades. look at the risk adjusted returns! except, risk adjusted doesn’t matter as much as long-term absolute returns for institutions given most of their infinite lifetimes.
I’ve also heard the argument of fee concessions to offset some of the double layering fees with FoFs.
Ok, bulk discount on fees is a valid reason, although I don’t know how everything looks altogether, including the FoF fees. Since someone mentioned this, how do long term returns compare between investors who pay a lot for services and those who pursue mostly low fee assets?
^Private Equity
smart money when they provide you a benefit will always find a way to extract it from you. lol
Having worked on this side w/ selection “methodology”—they are idiots, they couldn’t even pick their own nose, let alone a HF.
The auditors are idiots too. “PA we were reviewing the asset file you sent us, what is the HF line, that sounds risky, we need to ask so it appears we are doing our job?”. Oh that’s diversified or whatever, don’t worry about it. “Oh okay, thanks PA, audit complete!”
See Buffett bet.
You’re never going to convince me layering fees on fees for the myth of adjusted returns makes sense for a long term investor.
But then again, most of what happens in this industry makes little common sense and is basically driven by crowd following, agency issues arising from fee structures and responsibility aversion.
^^^^
“responsibility aversion”. That’s not bad.
Rampant everywhere in financial services, not just FOF institutional investing.
America has had an incredibly strong performance that overlapped with that bet… Yale is outperforming buffet, aren’t they? And they are in all kind of weird stuff.
MPI found that Yale and the other Ivy endowments displayed some skill at finding the best asset managers and they did outperform popular benchmarks.
Still, “we find that Yale’s superior performance as compared to other Ivies and a 60/40 proxy could be explained primarily by its much higher estimated risk,” wrote the authors of an MPI paper expected to be released later this week,
MPI has evaluated endowment returns using its patented process, called “Dynamic Style Analysis,” which was designed to model the behavior of otherwise secretive investments such as hedge funds or university portfolios. The annual results of Yale and the Ivy League colleges and universities, which have huge commitments to private investments, are closely watched by the industry. In addition to Yale, MPI analyzed the returns of Brown, Columbia, Cornell, Dartmouth, Harvard, Princeton, and the University of Pennsylvania.
MPI finds that the Sharpe Ratio, a measure of returns relative to the risk taken, of all the endowments are very close to each other as well as to a 60/40 portfolio. “There doesn’t seem to be any advantage in having endowments invest in private asset classes,” the authors wrote.
That’s interesting. I wonder how they are calculating the sharpe ratio? Reported volatility typically falls in portfolios with a lot of private assets, because they are only revalued once a quarter.
By the way, for anyone interested in FoF for private equity or VC you can ignore the traditional funds. You can get the same diversification benefits with shorter j-curves and lower fees in co-invest and secondary funds. Traditional primary FoFs are dying out in the PE world.
And valuation methodology is different for different funds/investments (carried at cost, marked to model, etc.) and can be pretty arbitrary in normal environments. Quantitative volatility in a traditional investing sense is pretty useless for private debt, for example.