Can Funds of Funds Consistently Pick Winners
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Investors who want diversified hedge fund exposure often look to Funds of Funds (FoF) investments instead of investing directly. Recently this option has picked up in popularity again with AUM up to $363bln which is up 25% in the last 2 years. FoF’s appeal to investors who want hedge fund returns but are looking to spread risk across a broad set of the best hedge funds carefully selected by FoF managers. In reality FoF managers charge high fees and clients experience worse results than if they invested in the funds directly.
The chart below shows the cumulative return of the Barcaly Hedge Fund of Funds Index relative to a blended average hedge fund indexes all net of fees.
The returns that an investor will realize via an investment in a FoF is directly impacted by the ability of the FoF manager to pick winner hedge funds. As shown below the opportunity cost of investing in a FoF with returns below the 80th percentile is huge.
But can a FoF manager consistently pick the best hedge funds and deliver returns to justify their incremental fee? To answer this question we bucketed the average annual returns of each FoF in the TASS database for the period from 2002 to 2021 into quintiles. Then we calculated the empirical probability of each fund being in any one of the quintiles the following year. The resulting transition matrix is displayed in graphical form below:
Based on this data set, it does not appear as though FoF managers can consistently pick winners. The probability of a FoF being in the top quintile for 2 consecutive years is 0.3. In addition, there is quite a bit of movement among all of the rankings. For instance, if a FoF is in quintile 5 in year two, there is a 20% probability that it will be in quintile 1 the following year, a 15% chance that it will be in the second quintile, and only a 16% that it will be in the 4th quintile.
At Unlimited we believe that a better solution to get diversified exposure to hedge fund returns is through low-cost index replication. Such a product offers an extremely competitive option compared to paying additional FoF fees on top of manager fees that are already not worth the cost.