A choice between risk and return?
By Dunny P. Moonesawmy. Head of Fund Research for Lipper in Western Europe/Middle East and Africa. The views expressed are his own.
Hedge funds have delivered decent risk-return results over the past ten years. And as transparency and liquidity increased post-credit crisis, they have regained their appeal as providers of absolute return opportunities for investors. In addition, an increasing lack of market visibility globally has played to hedge funds’ supposed strengths, with total industry assets under management now exceeding the $2 trillion, according to Hedge Fund Research.
There is a divide, however, with the industry split between single hedge funds — totaling more than 11,000 in the Lipper database — and some 867 funds of hedge funds (FoHFs). The general perception is that single-manager hedge funds are the more risky investment and to cushion that risk, some investors prefer to diversify their portfolio by investing in FoHFs instead. But is it worth it?
An analysis of single hedge funds and FoHFs during the past ten years shows interesting results in terms of performance and risk. Indeed, whether on a cumulative basis over 3-, 5- or 10-years or accounting for calendar years in 2008, 2009 and 2010, single manager hedge funds performed significantly better on average than FoHFs.
For details of performance, click on this link.
Outperformance of single-manager hedge funds is clear during these periods but since the beginning of the year both single managers and multi-managers have performed poorly, in euro terms, with a little advantage for multi-manager funds.
On a risk level, we have an opposite situation. Funds of hedge funds demonstrated better resistance to the downturn, with a maximum drawdown over 3 years of -19.42 percent against -24.55 percent for single hedge funds. If we take their volatility into account, we have similar results, with FoHFs showing smoother performance pattern over 3, 5 and 10 years. We have here the mirror image of the performance factor, with FoHFs demonstrating strong risk-management compared to single hedge funds.
RETURNS COMPARISON
These results show that FoFHs played their role in cushioning volatility and restricting the impact of the downturn but the diversification factor (through the investment in different underlying funds) had an important counterpart: it prevented funds from performing. Indeed, among the 46 Multi-strategy FoFHs with a 10-year track record, only two funds recorded a performance above 50 percent, with the best performer increasing by 86.16 percent over the period. Conversely 18 single-manager Multi-strategy funds out of 67 funds delivered a performance above 200 percent over the last 10 years.
Clearly there is a big gap in performance between single-manager hedge funds and multi-manager hedge funds. Part of the gap can be explained by the double layer of fees charged by funds of funds to investors (charges from the underlying funds and from the FoHF manager). But the gap in performance can also be explained by another factor: too much focus on risk management leading to limited performance.
This is particularly true when market is volatile and visibility is low, a market environment we have been experiencing these past few years. Multi-managers, in that case, tend to limit portfolio rotation, missing market rebound opportunities.
There is also pressure on multi-managers to keep volatility in a defined range, making it difficult for an alternative fund to be managed properly. Talent and entrepreneurships are also important factors: while single-manager hedge funds are often the results of managers setting up their own business, it is less the case with multi-managers. Indeed, when a fund manager invests his own money in the fund (which is the case for entrepreneurial single-manager funds), we usually note better performance and the conventional wisdom is that such managers give more of themselves to make sure the business succeeds.
Investors are thus in an uncomfortable position when deciding whether to invest in a single hedge fund or a FoHF: they have to choose between return and risk. It might be wiser, if time-consuming, to bring in single-manager hedge funds to a diversified portfolio to access return opportunities from their non-directional strategies and enhancing the diversification factor. Whether you have the confidence and skill to do that is another question; as is the case in any fund selection process, a strong due diligence process is fundamental before selecting a hedge fund.
