Do funds-of-funds deserve their fees-on-fees?

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Betty Thomas
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1 Do funds-of-funds deserve their fees-on-fees? Discussant Andrew Ang Matthew Rhodes-Kropf Rui Zhao Stephen J. Brown NYU Stern School of Business

2 Overview Historical context for funds of funds Role of due diligence Willingness to pay argument Pesky data issues

3 The History of Hedge Funds The first hedge fund: Alfred Winslow Jones (1949) Limited Partnership (exempt from 40 Act) Long-short strategy 20% of profit, no fixed fee Used short positions and leverage Hedge Fund (Fortune magazine 1966) Tiger Fund (Institutional Investor 1986) George Soros $3.2Billion raid on the ERM (1992) CalPERS (2000)

4 Financial Risk Percent of risk 10 0 % 90% 80% 70 % 60% 50% 40% 30% 20% 10 % 0% Equit ies S&P500 risk Size of port folio Source: Elton and Gruber 1995

5 Effect of Diversification: Hedge Funds Percent of risk 10 0 % 90% 80% 70 % 60% 50% 40% 30% 20% 10 % 0% Equit ies Hedge Funds S&P500 risk Hedge Fund risk Size of port folio

6 Operational Risk Fract ion of Funds Surviving CTAs Hedge Fund Durat ion (Mont hs) Source: Tremont TASS (Europe) Limited

7 Funds of Hedge Funds Fund of Funds Hedge Fund 1 Hedge Fund 2 Hedge Fund 3

8 Funds of Hedge Funds Fund of Funds Hedge Fund 1 Hedge Fund 2 Hedge Fund 3 Provides

9 Funds of Hedge Funds Fund of Funds Hedge Fund 1 Hedge Fund 2 Hedge Fund 3 Provides Diversification lower value at risk

10 Funds of Hedge Funds Fund of Funds Hedge Fund 1 Hedge Fund 2 Hedge Fund 3 Provides Diversification lower value at risk Smaller unit size of investment

11 Funds of Hedge Funds Fund of Funds Hedge Fund 1 Hedge Fund 2 Hedge Fund 3 Provides Diversification lower value at risk Smaller unit size of investment Professional management / Due diligence

12 Funds of Hedge Funds Fund of Funds Hedge Fund 1 Hedge Fund 2 Hedge Fund 3 Provides Diversification lower value at risk Smaller unit size of investment Professional management / Due diligence Access to otherwise closed funds

13 Funds of Hedge Funds Fund of Funds Hedge Fund 1 Hedge Fund 2 Hedge Fund 3 Provides Diversification lower value at risk Smaller unit size of investment Professional management / Due diligence Access to otherwise closed funds

14 Institutions love FoF Spectacular growth of Funds of Funds 2000: 15% of all Hedge funds were FoF 2003: 18% of all Hedge funds were FoF 2005: 27% of all Hedge funds were FoF Institutional attraction of Funds of Funds Risk management Due diligence

15 Funds of funds are different Fund of Funds Hedge funds N Mean Std. Dev. N Mean Std. Dev. Difference (t-value) Return (month) % 0.56% % 1.41% Std. deviation % 2.33% % 0.02% Lower 5% fractile % 4.20% % 6.55% Assets ($M) 827 $119 $ $128 $ Personal invest % 46% % 49% Management fee Incentive fee Minimum invest ($000) 856 $370 $ $780 $5,

16 Willingness to pay argument New Yorkers wait half an hour to cross the Brooklyn Bridge to avoid a $4.50 toll We infer that New Yorkers value time at less than $9.00 an hour

17 Funds of Funds and the Market 6 5 Value (1900 = $1) CRSP Value Weight ed Market CISDM Fund of Funds index Source: CRSP and CISDM

18 FoFs dominate the market in period of study Period of study Value (1900 = $1) CRSP Value Weight ed Market CISDM Fund of Funds index Source: CRSP and CISDM

19 Median Monthly Returns by Year Funds of Funds Excluding Funds of Funds All Hedge Funds % 0.27% 0.40% % 0.31% 0.25% % 0.29% 0.09% % 1.15% 0.88% % 0.12% 0.45% % 0.28% 0.34% Source: TASS Tremont

20 Median Sharpe Ratios by Year Funds of Funds Excluding Funds of Funds All Hedge Funds Source: TASS Tremont

21 Median Sharpe Ratios by Year Funds of Funds Excluding Funds of Funds All Hedge Funds Source: TASS Tremont

22 Median Sharpe Ratios by Scale All Funds of Funds in TASS universe Smallest Q2 Q3 Q4 Largest All Funds Source: TASS Tremont

23 Median Sharpe Ratios by Scale All Funds of Funds in TASS universe Smallest Q2 Q3 Q4 Largest All Funds Source: TASS Tremont

24 Median Sharpe Ratio by Style Convertible Arbitrage Dedicated Short Bias Emerging Markets Equity Market Neutral Event Driven Fixed Income Arbitrage Global Macro Long/Short Equity Hedge Managed Futures Multi-Strategy Fund of Funds Total (excluding 2003)

25 Median Sharpe Ratio by Style Convertible Arbitrage Dedicated Short Bias Emerging Markets Equity Market Neutral Event Driven Fixed Income Arbitrage Global Macro Long/Short Equity Hedge Managed Futures Multi-Strategy Fund of Funds Total (excluding 2003)

26 Median Sharpe Ratio by Style Convertible Arbitrage Dedicated Short Bias Emerging Markets Equity Market Neutral Event Driven Fixed Income Arbitrage Global Macro Long/Short Equity Hedge Managed Futures Multi-Strategy Fund of Funds Total (excluding 2003)

27 Conclusion Investors are clearly willing to pay for due diligence

28 Conclusion Investors are clearly willing to pay for due diligence Does that mean that current level of fees is appropriate?

29 Conclusion Investors are clearly willing to pay for due diligence Does that mean that current level of fees is appropriate? Results seem time period specific Results seem to depend on identity of median fund

30 Conclusion Investors are clearly willing to pay for due diligence Does that mean that current level of fees is appropriate? Results seem time period specific Results seem to depend on identity of median fund Who is the median fund?

31 Conclusion Investors are clearly willing to pay for due diligence Does that mean that current level of fees is appropriate? Results seem time period specific Results seem to depend on identity of median fund Who is the median fund? Tell me, so I can invest in it!

Lessons from Hedge Fund Registration. Stephen Brown, William Goetzmann, Bing Liang, Christopher Schwarz

Lessons from Hedge Fund Registration Stephen Brown, William Goetzmann, Bing Liang, Christopher Schwarz Motivation Operational Risk Not Market Risk SEC registration: file a Form ADV by February 1 st, 2006.