Fund of hedge funds face investor pressure due to disappointing performance

By James Langton

Funds of hedge funds are facing increasing pressure from investors to demonstrate their investment value, says a special Fitch Ratings report.

As a result of recent disappointing performance, investors are re-assessing the value proposition offered by fund of hedge funds, the report notes

“Over the last two years, there have been some interesting market events like the General Motors credit crisis in May 2005 and equity market drawdown in May 2006, which have had a significant impact on hedge funds’ performance. These events have also raised questions among investors about the total return attribute of hedge funds,” says Stephane Scimone, director at Fitch. Also, it notes, the diversification among hedge fund managers and of their strategies did not yield the full benefits expected by investors, with many funds of hedge funds producing negative returns.

Therefore, many investors are now wondering whether it is worth paying an extra layer of fees only to experience a disappointing performance, with funds of hedge funds unable to effectively diversify their risks. As a result, some outflows were seen in the second half of 2005 for the first time in a decade. “Funds of hedge funds now face increased competition, greater scrutiny from investors and are increasingly constrained by limited capacities and a higher correlation of hedge funds,” says Aymeric Poizot, director at Fitch.

In this context, it is essential to isolate best practices that can enhance the capacity of funds of hedge funds to select funds and construct portfolios that will offer an attractive risk/return profile and provide asset diversification benefits, the rating agency says. Before investing in a fund of hedge funds, Fitch says, investors must assess the quality of staff, the investment process, risk management practices, and levels of transparency offered by the managers.

At the end of 2005, the total number of hedge funds reached a record of approximately 9,000 with a total of US$1.1 trillion assets under management. Of this, one third is held through funds of hedge funds.

Funds of hedge funds have benefited from institutional investors’ search for alpha and diversification, and shown consistent strong growth figures over the last decade, it reports. “Most institutional investors have relied on funds of hedge funds managers’ understanding of the complexities of the various strategies and their ability to construct diversified portfolios, deliver access to better performing funds, and effectively execute the requisite risk management requirements,” it says.

Using alternative investment strategies and talented portfolio managers, hedge funds provide interesting risk/return profile products for institutional investors looking for asset diversification in their portfolios, Fitch says. “However, good hedge fund managers are scarce, and often the best ones are the ones that are the least publicized. Hence, there is an opportunity for fund of hedge fund managers as intermediaries. They can act as trusted partners to help select the best hedge funds and also define efficient asset allocation strategies,” it adds.