With expanding sovereign credit needs colliding with slow private sector growth, volatile stock markets and low bond yields, investors are taking the view that they need more than asset allocation to be successful. 

This would appear to mean that hedge funds, particularly funds of hedge funds, will remain key investment vehicles for institutions and qualified individual investors. 

More flexible than traditional investment vehicles, hedge funds can navigate difficult markets by shorting stocks and bonds. They also provide exposure to interest rate fluctuations and foreign exchange markets and can profit from low-risk merger arbitrage. A fund of funds (FoF) hedge fund strategy-with an added layer of oversight and more diversification than a single-fund approach-may be expected to produce even more consistent, less-volatile returns. 

"Many individual hedge funds are not really hedged against risk," says Leo Marzen, partner at New York-based Bridgewater Advisors, with $850 million in assets under management. "One is more likely to gain such protection when one is in a fund of funds, whose pieces have been assembled to produce consistent performance."

Yet when you dig deeper and look at actual performance, FoFs have neither cut risk nor delivered superior returns in the short, medium or long run. Recent history also shows that some FoF managers have failed-sometimes in miserable fashion-to perform proper oversight.

Madoff Epiphany
Bernie Madoff certainly wasn't the first hedge fund thief, but it is difficult to find a more nefarious example. The fact that he made it into so many funds of funds made matters worse. How could Madoff have fooled so many sophisticated investors? What kind of due diligence are investors actually receiving for the additional layer of expense created by a fund of funds manager? (FoF managers typically charge a 1% annual management fee and a 10% performance bonus. This is on top of individual hedge fund manager expenses that are usually 2%/20%.)

Many financial advisors say the Madoff scandal actually emphasizes the need to go the FoF route.  Funds of funds that get burned by poor fund choices may suffer asset withdrawals, which could exacerbate losses during a down market, concedes Michael Mattise, chief investment officer of Philadelphia-based Radnor Financial Advisors, with $850 million in assets.  But he believes FoFs are better able than individual funds to withstand such a crisis. One need only look at the fate of individual investors who were exclusively in Madoff's fund to appreciate the value of a multi-fund approach.

Like many advisors, Mattise generally recommends that qualified investors have 12% to 15% exposure to hedge funds, which he achieves primarily through funds of funds. Over the eight years in which he has been providing clients with hedge FoFs, he has generally been pleased with the risk-adjusted returns.  "Returns have been better than cash and fixed income," he observes. "Funds of funds provide us with returns that are uncorrelated to the market, which is very important for the overall portfolio."
But according to Hedge Fund Research, the Chicago-based industry data tracker, over the past 12 months through April, the average individual hedge fund gained 19.73% while the average fund of funds gained 12.56%. Over the last three years, hedge funds gained an average of 1.95% annually while the average fund of funds lost 1.92%. 

The results are pretty much the same going back five years: Individual funds gained an average of 6.62% annually, outpacing funds of funds by 322 basis points a year.

By one measure, funds of funds appear less volatile than hedge funds.  Over the three trailing time periods, the annualized standard deviation of funds of funds is consistently lower than that of individual funds.

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