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Cathartic times for fund of funds

Date: Thursday, September 11, 2008
Author: Hugo Greenhalgh, Financial Times

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Recent figures have suggested that fund of hedge funds (FoHFs) are not the panacea for the ills of the investment world many financial advisers were hoping for.

While Standard & Poor's Fund Research revealed that year-to-date FoHFs fell less than mainstream funds, "it is somewhat disappointing to report that they have shown more directionality this time around than in the 2000-03 bear market", noted lead fund analyst Randal Goldsmith.

What this means in practice is that investors seeking non-correlated returns with the equity markets are likely to have watched in dismay as their returns went the same way as the more traditional markets.

For example, a recent Lipper HFIR research study found that nine out of the 13 CS/Tremont hedge fund sub-strategies had correlations with the CRB/Jefferies commodity index of over 0.70.

In English, this meant they were all highly correlated one way or another with the commodity market bull run, translates Ferenc Sanderson, a senior analyst at Lipper,

So are the days of FoHFs producing consistent and, more importantly, non-correlated absolute returns over? "It is a very challenging environment," admits Andrew Gibson, head of client management at International Asset Management.

A fund that is down by 3-4 per cent year-to-date in a strategy that has regularly been averaging an annual 12-15 per cent could be seen by clients as disappointing.

However, he adds: "Considering we have been going through the worst financial crisis of the past 30 years I don't think that our clients are feeling we have underperformed our mandate. It is very difficult to get the diversity benefit. When the markets tend to correlate, the fundamentals go out the door and everything becomes very sentiment driven."

What is likely to occur in this tough economic situation is many FoHFs - and their underlying hedge funds - will simply not survive. "What happens in this environment is that, as always, the strongest will survive," says Andrew Lodge, managing director of Ned Group Investments. "Some funds will go under."

To a certain extent, argues IAM's Mr Gibson, this is healthy. "It's a form of economic catharsis," he says. "You live and die by performance, which can happen in good markets, but is heightened in a period of volatility."

There could be a "massive turnover of hedge fund managers", adds S&P's Mr Sanderson. "If you do not perform then you are out. Approximate turnover was 20 per cent of a typical FoHF portfolio a few years ago; this may now be as high as 40 per cent for some FoHFs."

Those funds that are nimble - and perhaps smaller - are more likely to weather the oncoming storm, adds Paul Meader, a director of Corazon Capital. "We can look at a manager with $100m who is looking to close at $400m, but the very big funds of funds can't invest at that level," he says.

"Just as big asset gatherers and big household names are not necessarily the route to success in the traditional equity markets so too they are not always the route to success in alternative investments."

Hugo Greenhalgh is the editor of Investment Adviser