But another measure of risk tells a different story. Maximum drawdown-the largest decline during a downturn before a fund or FoF reclaims a former high-is slightly larger for funds of funds over the trailing three- and five-year periods. The market collapse that bottomed in early 2009 is the worst such drawdown for both periods: 22.20% for funds of funds versus 21.42% for individual hedge funds.
Advocates of funds of funds may argue that these conclusions have been skewed by a historic few months. But Sol Waksman, the founder and director of BarclayHedge, another prominent data tracker, says that it would be wrong to eliminate the late 2008/early 2009 time period as an outlier. By the same token, the performance gap was unusual, he notes. In 2009, individual hedge funds returned more than 21.5% while the average fund of funds gained only 9.4%. "Occasionally, funds of funds significantly underperform the industry," he says. 5% or 10% deviation in a given year does happen."
Yet Waksman thinks the risk of an individual fund blowup-due to fraud, a rogue trader, misjudged risk or significant strategy drift-is reason enough to find safe haven in a multi-fund strategy. "Most investors don't have sufficient capital to diversify across a series of individual hedge funds to protect themselves from a meltdown," says Waksman. "So I think investors would be wiser to give up some performance in exchange for the security of multi-fund exposure."
A Remarkably Lousy Year
Why did funds of funds underperform so badly in 2009? Should the reasons still be a concern?
First, some FoFs found themselves locked into underlying funds that either restricted redemptions or kept substantial portions of illiquid investments locked up in so-called "side pockets" that couldn't be sold to meet redemptions. Not having access to all their capital prevented fund of funds managers from rotating into strategies that were rebounding in 2009.
Second, there may have been some reluctance by FoF managers to jump aggressively back into the market after having failed to protect assets in 2008, observes Kristoffer Houlihan, director of risk management at Pacific Alternative Asset Management Company, a fund of funds manager with $9 billion in assets. (The average fund of hedge funds lost 22.18% in 2008, underperforming the average individual hedge fund by 55 basis points.)
Third, funds of funds experienced the worst net asset flow in their 20-year history in 2009, with more than $118 billion leaving the industry, according to HFR. This made it more difficult for fund of funds managers to invest and exploit the rally.
Fourth, but as important as any other factor, there was a significant reduction in leverage. FoF managers typically employ leverage to boost returns and cover their additional expenses. In the area of asset-backed loans-a traditionally profitable, low-risk strategy-the sudden elimination of leverage froze nearly all funds of funds focused on this strategy.
Funds of funds that utilized asset-backed loans were forced to return billions of dollars to banks who pulled their leverage during the credit crisis by redeeming shares in underlying funds, says Jonathan Kanterman, managing director at Stillwater Capital Partners. This transformed a patient medium-term strategy into something it was not-a short-term trade. Without sufficient liquidity to meet rising investor redemptions, more than 150 of these funds were forced to gate, temporarily suspend or wind down their operations.
Citing data from HedgeFund.net, Kanterman believes FoF leverage has dropped from a 2008 peak of around 80% of net assets to now under 40%.