The performance of funds of hedge funds has apparently underperformed that of direct investments in hedge funds even after correcting for fees. Why is this?

Performance Table April 2003 to July 2010. A comparison of FOF, HF and a sample FOF

*HFRXGL is an investable hedge fund index, HFRIFWI is the HFRI hedge fund index, HFRI FOF is the HFRI fund of hedge funds index and Fund X is an actual FOF.

• Data issues are a big source of the measured underperformance of FOF to their underlying hedge funds. Many hedge fund databases suffer from survivorship and self reporting biases. This means that hedge fund indices like HFRI will show inflated returns compared with funds of funds indices like HFRI FOF even after correcting for the additional fees charged by FOF. HFRI FOF is a more representative benchmark for what is achievable in reality since they show the performance of actual portfolios of hedge funds. 
• HFRX GL is an investable hedge fund index. It is difficult to be truly representative of hedge fund performance since hedge funds value proposition lies in the individual unique edge of each manager.
• Investors have become disenchanted with funds of funds due to their underperformance relative to direct hedge fund exposure, especially when measured by indices.
• As in all things, not all funds are the same. Some funds of funds are better than others and consistently outperform their peers.
• Size is an issue for funds of funds. It is difficult to manage funds of funds beyond 2 to 3 billion USD in assets under management. There are many reasons for this; being forced to invest in larger, less nimble hedge funds one of the more serious problems.
• Expertise in hedge fund manager selection and portfolio construction is also highly varied. The divergence of performance between funds of hedge funds is high. It is important to select the right funds of funds manager.

Performance Table April 2003 to July 2010. A Selection of Actual Funds of Funds, compared with MSCI World Index

• Funds of funds remain an efficient means of investing in hedge funds. Selecting the right funds of funds manager can result in consistent absolute returns which are important for long term compound returns.
• Hedge funds remain a superior investment compared to passive long only equity investments. Even superior long only investment managers have to contend with volatility which imposes the issue of timing the investment correctly. Hedge fund investments exhibit low volatility and so timing of entry and exit is less important.
• Despite losing some 22% on average in the financial crisis of 2008, the value of hedge funds is clear in the context of the drawdowns of long only indices like the MSCI World which fell 56% in the crisis.
• Take a look at the Sharpe Ratios

 The performance of funds of hedge funds has apparently underperformed that of direct investments in hedge funds even after correcting for fees. Why is this? 

Performance Table April 2003 to July 2010. A comparison of FOF, HF and a sample FOF

*HFRXGL is an investable hedge fund index, HFRIFWI is the HFRI hedge fund index, HFRI FOF is the HFRI fund of hedge funds index and Fund X is an actual FOF.

• Data issues are a big source of the measured underperformance of FOF to their underlying hedge funds. Many hedge fund databases suffer from survivorship and self reporting biases. This means that hedge fund indices like HFRI will show inflated returns compared with funds of funds indices like HFRI FOF even after correcting for the additional fees charged by FOF. HFRI FOF is a more representative benchmark for what is achievable in reality since they show the performance of actual portfolios of hedge funds. 
• HFRX GL is an investable hedge fund index. It is difficult to be truly representative of hedge fund performance since hedge funds value proposition lies in the individual unique edge of each manager.
• Investors have become disenchanted with funds of funds due to their underperformance relative to direct hedge fund exposure, especially when measured by indices.
• As in all things, not all funds are the same. Some funds of funds are better than others and consistently outperform their peers.
• Size is an issue for funds of funds. It is difficult to manage funds of funds beyond 2 to 3 billion USD in assets under management. There are many reasons for this; being forced to invest in larger, less nimble hedge funds one of the more serious problems.
• Expertise in hedge fund manager selection and portfolio construction is also highly varied. The divergence of performance between funds of hedge funds is high. It is important to select the right funds of funds manager.

Performance Table April 2003 to July 2010. A Selection of Actual Funds of Funds, compared with MSCI World Index

• Funds of funds remain an efficient means of investing in hedge funds. Selecting the right funds of funds manager can result in consistent absolute returns which are important for long term compound returns.
• Hedge funds remain a superior investment compared to passive long only equity investments. Even superior long only investment managers have to contend with volatility which imposes the issue of timing the investment correctly. Hedge fund investments exhibit low volatility and so timing of entry and exit is less important.
• Despite losing some 22% on average in the financial crisis of 2008, the value of hedge funds is clear in the context of the drawdowns of long only indices like the MSCI World which fell 56% in the crisis.
• Take a look at the Sharpe Ratios

At the beginning of 2010 equity markets had benefited from almost a year of positive returns. At the beginning of 2009 it was clear that it would be fairly easy to make money in the market given the degree of pessimism in the market at the end of 2008 and how much equity markets had been sold down. The market unexpectedly turned around in March 2009 and began an almost year long rally. At the beginning of 2010 market direction was a lot less clear. Equities which were cheap in early January 2009 were no longer cheap given the sharp rally in 2009.

MSCI Earnings Yield Gap, Jan 2010.

Equity markets have been volatile in 2010 falling sharply in early 2010 then rallying hard into the Spring before falling sharply again on fears of sovereign default in Europe and renewed economic weakness in the US. Valuations, however, have improved, as corporate earnings improved while markets traded sideways with volatility.

MSCI Earnings Yield Gap, Sep 2010.

The prospects for equities remain attractive. Investors do not dispute the robustness of growth in the emerging markets, particularly in China, India and Brazil. Germany has been a bright spot in Europe relying on its export industries to support economic growth. The big question is once again economic growth in the US. Employment numbers have been poor and housing data has been dismal. Economist fear a double dip recession in the US, fixed income markets are pricing in Japan style deflation and markets have sold off once more. However, ISM data is indicative of economic recovery and there are reasons to be optimistic about this. ISM PMI data while softer in July remains above 50, indicative of expansion. More importantly, the data is supported by strength in exports. A similar pattern is exhibited in the ISM NMI (non-manufacturing).

The US is shaping up as an export economy. Current account as a percentage of GDP has recovered in the wake of the 2008 financial crisis. One thing to note here is that this series will be volatile in recovery as import volatility is higher than export volatility on account of the US being a more open economy than her trading partners. The trend in the current account is clear. Recovery.

US Current Account as a percentage of GDP

Economic growth is cyclical and this is a consequence of any dynamic system. Within the broader long term cycle there are shorter term gyrations. It is likely that the current weakness in employment data is volatility along a longer term trend of recovery. The ISM data is a very strong indicator of economic performance, more so than labour data. The current account data provides some insight into the source of that growth, namely, a newfound export competitiveness in the US.

In terms of the relative performance of markets, we see the largest yield gaps in the US, followed by HK and H shares. Europe, Australia, Canada and India look like the least value. The risk to this approach of valuations is of course that the basis of earnings calculations is course and open to gaming. Also, the yield gap is boosted by treasury yields which are at historical lows. A spike in inflation or higher rates could change the picture significantly. Putting these aside we have the following picture:

Experience tells us that you can have a rising equity market when economic growth is weak or even in recession. Conversely, it also tells us that equity markets can fall when the economy is growing. The lags and autocorrelations are not stable enough for us to measure econometrically, but it is sufficient to understand that fundamentals drive markets through psychology.

Markets have been driven by macro factors since the great financial crisis of 2008. They will likely continue to do so. Weak economic data is likely to precipitate further economic stimulus which the market is likely to take positively. On the other hand the underlying economy is healing and will drive longer term returns going forward. What presents today is a convex payoff to the intrepid equity market investor.

Forget about correlations.

Since Jan 1998, over 159 months,

Hedge funds were positive when equities were positive 80 months or 50.35% of the time.

Hedge funds were negative when equities were negative 47 months or 29.6% of the time.

Hedge funds were positive when equities were negative 25 months or 15.7% of the time.

And

Hedge funds were negative when equities were positive 7 months or 4.4% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 47 out of 72 or 65.3%.

When equities are up, the chances of your hedge fund losing money are 7 out of 87 or 8.1%

However:

Since Jan 2008, over 31 months,

Hedge funds were positive when equities were positive 15 months or 48.4% of the time.

Hedge funds were negative when equities were negative 14 months or 45.2% of the time.

Hedge funds were positive when equities were negative 2 months or 6.5% of the time.

And

Hedge funds were negative when equities were positive 0 months or 0.0% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 14 out of 16 or 87.5%.

Post 2008, the markets have begun to behave in a very volatile and erratic fashion that has confounded many hedge fund managers who had previously navigated market crises such as 1998 and 2001 successfully.

Forget about correlations.

Since Jan 1998, over 159 months,

Hedge funds were positive when equities were positive 80 months or 50.35% of the time.

Hedge funds were negative when equities were negative 47 months or 29.6% of the time.

Hedge funds were positive when equities were negative 25 months or 15.7% of the time.

And

Hedge funds were negative when equities were positive 7 months or 4.4% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 47 out of 72 or 65.3%.

When equities are up, the chances of your hedge fund losing money are 7 out of 87 or 8.1%

However:

Since Jan 2008, over 31 months,

Hedge funds were positive when equities were positive 15 months or 48.4% of the time.

Hedge funds were negative when equities were negative 14 months or 45.2% of the time.

Hedge funds were positive when equities were negative 2 months or 6.5% of the time.

And

Hedge funds were negative when equities were positive 0 months or 0.0% of the time.

Thus, when equities are down, the chances of your hedge fund losing money are: 14 out of 16 or 87.5%.

Post 2008, the markets have begun to behave in a very volatile and erratic fashion that has confounded many hedge fund managers who had previously navigated market crises such as 1998 and 2001 successfully.