Pooled fund of funds have waned in popularity over the past decade. However, building a portfolio of commingled hedge funds remains the preeminent approach to accessing the asset class.
With this comes the ever-present cost of allocation in some form, and so fund of fund (FoF) indices continue to be a popular choice of benchmark. In theory, FoF indices should present a more challenging hurdle because of their focus on active fund selection. Yet, historically, they have consistently underperformed their passive peers.1
We present an empirical comparison of the active fund of hedge fund benchmark, the HFRI Fund of Fund Composite Index, and its passive comparator, the HFRI 500 Index.
Factor exposures
One potential cause of the difference in performance could be the difference in strategy allocations — and therefore risk factors — between active and passive benchmarks. However, the chart on the right shows the measured betas of both benchmarks against a range of market risk factors. Notwithstanding some small differences, they appear to look very similar in terms of the risks. Therefore, we can surmise that exposure differences haven’t caused active benchmarks to underperform.
Chart 1: Measured market factor sensitivities of HFRI 500 and HFRI Fund of Fund indices since January 2005
All sources (unless otherwise indicated): abrdn plc, 31 August 2021.Global Equities is MXWO Index; Global Bonds is LEGATRUU Index; Global High Yields is LG30TRUU Index; Dollar is DXY Index; Gold is ZAU Curncy
Active versus passive tracking error
The measured relationship between the active and passive benchmarks over time further supports this suggestion of equivalent exposures. The adjacent chart illustrates the historically high correlation between the two (ranging 0.95 to 0.99 over 36-month rolling windows since inception of the HFRI 500 Index). As a result, we see relatively low month tracking error (the standard deviation of the differences between the monthly returns of each benchmark).
Chart 2: Measured rolling correlation and tracking error between HFRI 500 and HFRI Fund of Fund indices
Source: abrdn plc, 31 August 2021. Global Equities is MXWO Index; Global Bonds is LEGATRUU Index; Global High Yields is LG30TRUU Index; Dollar is DXY Index; Gold is ZAU Curncy
Performance drag
As the above analysis demonstrates, active and passive hedge fund benchmarks represent much of the same risk in terms of factor exposures and they’re highly correlated.
Yet the HFRI 500 Index has delivered an annualized return 2.04% higher than the HFRI Fund of Fund Composite since inception (January 2005).
Furthermore, this has come with an upside capture of 120% compared to the active benchmark and a downside capture of 95%, resulting in an attractive upside/downside capture ration of 1.25.
Chart 3: HRFI 500 Index vs HFRI Fund of Fund Composite Index upside/downside capture
Source: abrdn, August 31, 2021.
So, one could naturally conclude that active benchmarks have historically underperformed because fund of hedge funds have produced negative alpha through fund selection. While this may be the case, there’s one other factor that could be leading to underperformance: the extra layer of costs associated with fund of funds.
Fees: double trouble
The extra layer of fund of fund costs can be split into three parts:
- Management fees
- Incentive fees
- Expenses
The first two are relatively straightforward to quantify, thanks to manager reporting. The average management fee in the equally weighted HFRI Fund of Fund Composite Index is 1.12%2 and the average incentive fee is 6.11%.
Taking the management fee alone into account explains a considerable amount of the annualized underperformance of the active benchmark. We suggest that the impact of incentive fees is less relevant given the historical performance of fund of hedge funds relative to the typical incentive fee hurdles that have been difficult to beat.
Considering the above, we can approximate the breakdown of return drivers and costs in the active benchmark. Given the similar factor exposures, first we assume that the returns of the underlying funds in each fund of hedge fund are roughly equivalent to that of the funds in the passive index. We accept that, due to some additional diversification effect, volatility of the fund of hedge funds will be lower, and therefore we would scale those returns up to match the volatility of the passive index. For illustrative purposes, we make the returns of the underlying fund of hedge fund holding equal to the returns of the HFRI 500 Index. We then subtract the fund of hedge fund management fee (a cost shown in chart 4), leaving an unexplained difference of 0.52% annually.
Chart 4: Breakdown of index attribution
Source: abrdn plc, 31 August 2021.
Fund expenses are more difficult to measure and vary based on a range of factors, including strategy complexity, arrangements with service providers and fund assets under management (AUMs). Of these, AUMs have the largest impact on the variation in fund expenses. As AUMs grow, certain fixed costs will have a proportionally smaller impact on the fund valuation. Conversely, when AUMs fall, these costs appear more material.
Chart 5: AUM breakdown of HFRI Fund of Fund Composite Index
Source: abrdn, August 31, 2021.
Because pooled fund of hedge funds have seen assets decline over the years as investors preferred customization, the majority of the HFRI Fund of Fund Composite Index constituents have small AUMs. In fact, more than two-thirds have assets of less than $200 million and nearly 60% have assets of less than $100 million. These smaller funds will likely feel the additional performance drag from higher fund expenses. If we assume that the unexplained difference in performance from our illustrative breakdown of index attribution is solely fund expenses, adding this back into the active benchmark return along with the management fees on a monthly basis produces an annualized return only 0.3% lower than the passive index, and an upside/downside capture ratio of 1.00.
2. Source: HFR, October 2021.
IMPORTANT INFORMATION
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.
Hedge funds use sophisticated investment strategies that may increase investment risk in your portfolio. Among the risks presented by hedge fund investments are: the use of unregistered investments, which may make it difficult to assess the performance of the holding; risky investment strategies, which may result in significant losses; illiquid investments that may be subject to restrictions on transferability and resale; and adverse tax consequences.
Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.
US-021121-160369-1