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Hedge funds are hot right now, and funds that invest in other hedge funds are the hottest of all.....But there's a problem with these so-called hedge "funds of funds: As a group, they haven't performed very well.....To add insult to injury, funds of funds are expensive: The underlying hedge fund managers typically charge 1% plus 20% of any profits, and the fund of funds manager tacks on an additional fee of about 1% plus 10% of the profits.....If you're thinking about investing in a hedge fund of funds (or any other kind of hedge fund), we encourage you to think again.....For most investors, including quite wealthy ones, a well-designed portfolio of garden-variety mutual funds is still a good way to go, even if it does lack the cocktail party glamor of a hedge fund.....But if you insist on something more exciting than a conventional mutual fund portfolio, you might want to consider a "mutual-fund fund of funds".....A mutual-fund fund of funds ("FOF") can give you exposure to some of the same strategies as a hedge fund (for example, the ability to sell short or go to cash when market conditions dicate) but with less cost, greater liquidity, and virtually zero chance of a dishonest (or fraudulent) fund operator.
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To help with this analysis, FundAlarm called upon our friend Greg Kushner, who runs an advisory firm for high-net worth individuals and family offices.....Greg also has experience designing mutual-fund funds of funds.....Basically, as Greg describes it, a mutual-fund FOF starts out by identifying those mutual funds that are already structured like hedge funds.....These mutual funds are then combined in a portfolio that's designed to reduce the volatility of the individual funds, while generating returns that beat the major hedge fund and stock market benchmarks -- the classic goal of all portfolio diversification strategies.
To give us an idea what a simple mutual-fund FOF might look, Greg ran an historical analysis using three "long-short" mutual funds that he's familiar with from his day-to-day practice (as the name implies, long-short funds can move between owning stocks outright, or "long," and taking short positions, in the expectation that those stocks will decline in value).....Here are the long-short funds that Greg used in designing his simple FOF, plus the S&P 500 benchmark, with performance statistics for the five years ended December 31, 2001:
| Caldwell &
Orkin
Mkt Opp | Needham
Growth | Quaker
Aggr Grth A | S&P
500
|
|---|
Rate of return*
| 13.15 | 24.57 | 26.63 | 10.73
|
|---|
Std. deviation*
| 9.67 | 29.63 | 18.77 | 17.77
|
|---|
| Sharpe ratio* | 0.84 | 0.66 | 1.15 | 0.32
|
|---|
* Five years ended December 31, 2001; annualized as appropriate
And here's what an equally-weighted portfolio of all three funds would have looked like -- in effect, a mutual-fund fund of funds, with a long-short bias:
| Mutual-fund
fund of funds
(Equal weights
of the
three funds
to the right) | Caldwell &
Orkin
Mkt Opp | Needham
Growth | Quaker
Aggr Grth A | S&P
500
|
|---|
Rate of return*
| 22.67 | 13.15 | 24.57 | 26.63 | 10.73
|
|---|
| Std. deviation* | 14.40 | 9.67 | 29.63 | 18.77 | 17.77
|
|---|
| Sharpe ratio* | 1.23 | 0.84 | 0.66 | 1.15 | 0.32
|
|---|
* Five years ended December 31, 2001; annualized as appropriate
Thus, the fund of funds would have underperformed two of its component funds over the past five years in terms of raw return, but it would have done so with considerably less volatility (i.e., lower standard deviation than the top performers).....In terms of Sharpe ratio, a measure of risk-adjusted performance where higher is better, the long-short fund of funds is the clear winner over any single component fund.
A few additional comments:
- In retrospect, it might seem smart to have selected only Quaker Aggressive Growth and forgotten about the other funds. But in retrospect, we'd all be rich. Remember, these are inherently volatile funds, and that's when diversification makes the most sense. As it turns out, Caldwell & Orkin was negatively correlated to both of the other funds within the FOF, so it was a wise addition to the portfolio, and it was the main reason for the high Sharpe ratio.
- A few more words on diversification: The mutual-fund FOF had a relatively modest correlation (.46) to the S&P 500, making it a potentially excellent counterweight to a traditional portfolio of stock funds. "Hedge" funds got their name because they were originally used as hedges against the market. Here, a simple mutual-fund FOF serves the same hedging function.
- In a real-world portfolio, the weighting of these funds could be adjusted to suit individual investment preferences, e.g., less emphasis on risk-adjusted performance, more emphasis on raw performance.
- Also in the real world, market-neutral mutual funds and the Merger fund (a merger arbitrage fund) could be added to the mix to produce a more custom-tailored (and more hedge-fund like) portfolio.
- Unlike the traditional hedge fund, where investor money is typically locked up for a quarter (or even a year) at a time, the owner of a mutual-fund fund of funds has daily liquidity if desired.
- Caldwell & Orkin is currently closed to new investors, but Greg says that a few independent financial advisors are still able to gain entry for their clients, even clients who are new to the fund.
- The fund of funds carries a blended expense ratio of 1.52% (adviser fees, if any, are of course additional). It's not a cheap strategy, but it's still cheaper than almost any hedge fund of funds.
- The investment minimum for this fund of funds is the sum of the minimum investments for each underlying fund, which works out to $10,000. However, advisers might set their own investment minimums higher than the fund minimums.
- Quaker Aggressive Growth carries a front-end load, but most independent advisers can arrange for their clients to avoid the load by investing at net-asset value.
- Of course, mutual-fund FOFs can't accomodate every investment purpose, and there may be legitimate reasons for some investors to consider hedge funds. For example, mutual funds may be limited in the amount of leverage they can employ, and mutual funds typically have liquidity needs that can get in the way of some investment strategies. But perhaps the biggest reason to consider a hedge fund over a mutual fund is also the most basic: Some of the best, most experienced managers simply don't run any mutual funds.
- FundAlarm and Greg make no promises.
Greg Kushner is President of Lido Advisors, Registered Investment Adviser, in Beverly Hills, California. Jeff Eisfelder, Vice President of Lido Advisors, assisted in developing this analysis.
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