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Fund Of Hedge Funds Assets Up But Should Investors Be Digging Deeper Before Allocating?

The rise of more customised hedge fund portfolios partly accounts for the falling out of favour of the off-the-shelf fund of hedge fund products since the Global Financial Crisis, but data from HFR suggests that appetite for these products might be returning; assets were added back into the fund of hedge funds industry in the first quarter of this year with net inflows of $1.7bn representing the first time this part of the hedge fund industry has enjoyed inflows since 2007.

Fund of hedge funds offer many benefits; the reduction of single manager risk, the ease of dealing with only one firm instead of many and access to numerous underlying asset classes and different sources of return to name a few. According to one hedge fund consultant, however, investors considering these products should be mindful of what they are really getting from their fund of hedge funds allocation.

“When you invest in a hedge fund, there might be some overlapping of the underlying directional risk exposures of the market it is operating within with the exposure you might have already through your direct, liquid allocations,” said Karl Rogers, Managing Partner of Athlon Family Office. “In fund of hedge fund products or in a diversified portfolio of hedge funds, that’s exacerbated because you will have many underlying managers. Investors should be doing their homework to try and make sure that the positions held by the underlying managers don’t significantly overlap with the long exposure they already have in their cheaper and more liquid book.”

Getting that degree of granularity is difficult. After all, many hedge fund managers trade in and out of their chosen asset class comparatively frequently, and often the manager won’t disclose all of the underlying positions. Additionally, systematic-based strategies trade so often that it’s almost impossible to avoid doubling up on existing exposure in some positions. Rogers accepts that, but says that identifying managers trading markets with low or no beta availability within a fund of hedge funds product means that the benefits of fund of hedge fund products - such as diversification of single manager risk and access to many underlying asset classes - remains, whilst the overlapping of underlying exposures is removed.

“Obviously, equity hedge funds tend to be the ones in the news and they’re the most common. But plenty of managers trade more esoteric markets and strategies like electricity and index arb. Creating a portfolio of these managers enables access to true alpha and they offer something genuinely uncorrelated to long equities and bonds,” he said. “Because of a hedge fund’s longer liquidity lock-up, and ability to trade non-traditional markets, hedge funds should be hired to bring something different to a portfolio than exposure you can get via conventional means.”

Some investors will mention they have a ‘hedge fund allocation’ and indeed, they may well have one. Rogers says that the definition of that phrase can be misleading, however, because hedge funds simply offer a different way to access underlying markets and consequently investors should look past the term ‘hedge fund’ and analyse what’s underneath it.

“Hedge funds are an investment vehicle, not an asset class. Allocating to a hedge fund can give you exposure to many asset classes and/or strategies. Investing in a hedge fund does not inherently mean you have different exposure than what the general market provides you. I can be in a long-only equity hedge fund and have very similar exposure to equity markets or I can be in a hedge fund that trades shipping markets using a trend-following strategy,” he said.

Ultimately, for Rogers, it all comes down to how much true alpha a hedge fund manager is delivering.

“It’s critical to understand that hedge fund alpha is only brought in by idiosyncratic risk exposure. That’s what these underlying managers are paid to discover, whether they are equity, event-driven, relative value, commodities, etc., but most managers and strategies tend to bring in a combination of idiosyncratic-driven returns and systematic-driven returns,” he said. “You can get systematic exposure at a much lower cost so breaking their return stream down to see the extent of the managers’ idiosyncratic return is key. If you’re going to allocate to a fund of hedge funds product, you want the fees paid to bring you in true alpha and diversification through no overlapping of the cheaper market exposure you already have which is not easy to find in a fund of hedge fund product.

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