Fund of hedge funds: origins, role and future

P. Stevenson

Financial Stability Review, 2007, issue 10, 151-160

Abstract: The emergence of the fund of hedge funds (FoHF) was the natural evolutionary outcome of the appearance of the hedge fund itself and its consequential rapid rise to success as a result of offering absolute returns to a market where the generality of world savings was invested in relative returns. However, the lack of transparency, large minimum required investment and some early highly publicised accidents restricted access to this investment class mainly to high net worth individuals. To overcome this, the concept of packaging hedge funds into funds of hedge funds was born, though at fi rst with mainly institutional investors using these funds as providers of ill-defi ned alpha rather than introducing them into their portfolios as a particular style. From this simple beginning, the role of the fund of hedge funds has evolved into today’s fully-fledged multi-manager. This progression occurred naturally as the growing concern to identify more rigorously the type of risk from which hedge funds generated their returns and the need for managers to prove their added value meant that, increasingly, funds of hedge funds had to clarify their role in terms of risk management, asset allocation and reporting as they do today. A lack of experience, together with the complexity of risks to which hedge funds were exposed, highlighted both the importance of making a risk assessment prior to an investment, and the importance of risk management during the investment’s lifetime. Despite a better understanding of risk exposures and alpha sources, building a well-diversified multi-manager portfolio remains a diffi cult task. However, due to their in-depth knowledge of alternative styles and their use of an investment process combining top-down asset allocation and bottom-up manager selection, funds of hedge funds have been able to build robust portfolios, generating absolute returns over the long term. Furthermore, capitalising on their ability to consolidate and interpret information from various hedge fund managers has allowed funds of hedge funds to produce meaningful reports for their investors. Over the last few years, it has been thought that the huge infl ow of money into this universe would exhaust the source of alpha. However, this capacity constraint concern has since faded (to be replaced to a certain degree by manager constraints) and funds of hedge funds have been able to strengthen their role by providing secured access to a diversifi ed source of alpha as a result of their ability to identify, monitor and time risk factors. The knowledge acquired in understanding and evaluating the role of skills in producing absolute returns has also proved to be of value when applied to the traditional space, and has contributed to broadening the added value of the managers’ institutional proposition. As funds of hedge funds have become fully-fledged multi-managers in their own right, they are also now able to compete in the institutional sector with the traditional multi-manager.

Date: 2007
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