Do Funds of Funds of Hedge Funds Make Sense?
When I first heard about Funds of Funds of Hedge Funds, I thought there was something uncomfortably familiar about the terms and concepts, something along the lines of financial Déjà vu. The problem with Funds of Hedge Funds, according to D’Auriol Asset Management, which advocates such an approach and, perhaps incidentally, an extra layer of fees, is that there are just too many of them, over a thousand by their count. In return for that extra layer of fees, you avoid the hard work of selecting fund of hedge fund managers; they’ll do it for you. Recall that this is also the argument for the second level of fees; the second level allows you to avoid the hard work of selecting hedge fund managers. If a third level of fees is wrong, and most fund of fund managers believe it is, why, exactly are two levels of fees OK or even one? If three levels of fees are OK, what is wrong with four? The problem here is not with the number of levels of fees. The problem is more basic than that. The problem is this: when we are buying fund of fund management, what, exactly, are we buying? And how do we know when we have bought too much or too little?
Funds of Funds of Hedge Funds are also called, ‘F3’ or ‘F Cubed’ funds. I must admit I like the nomenclature; it makes it easier to analyze the issues and, of course, to heap abuse on anyone foolish enough to disagree with me on this issue. Notice that the basic argument for each F level is essentially the same. Each new F level provides the investor with more diversification, more due diligence, and more fees. With each new F level, the investor needs less knowledge and skill. By F3 or F4 or F5, at the most, there may be no issues left.
To be fair, there is a fairly obvious argument for F3, one I have yet to see such fund companies make, oddly enough. Each new level presupposes that not all of the managers on the previous level know what they are doing. And each new level implies that a new set of skills is needed. Several years ago, it was part of my job to read what fund managers and fund of fund managers said about themselves and their skills. My reading of the evidence is that fund of fund managers differ greatly in their skills and understanding of the issues. Most important, fund of fund management demands different skills than hedge fund management does. I see no reason why this argument should not continue up the F scale. In which case, the problem is where to stop.
Picking a fund of fund manager is not a trivial matter, but neither is it as hard as picking a hedge fund manager. Which implies that fees should go down as the F level goes up. Assume, for the sake of the argument, that hedge fund managers are worth 2 and 20, this implies that fund of fund managers are worth, say, 1 and 10. And this, in turn, implies that fund of fund of fund managers are worth, say, 0.5 and 5. Or, perhaps, less. When I try to think the issues through from the point of view of a product manager in charge of an F3 fund, I find almost no opportunities for product differentiation. In which case, the investor’s best strategy is to select the F3 fund with the widest diversification and lowest fees. This implies low fees, low profits and no F levels above three. I think I am ideally suited to start an F3 fund (I offer this website as evidence), but, considering the profit potential, it is just not worth my time.
Worse, if there really is value in F3, investing F2 managers can easily move into this area. All they need do is call one of their funds an F3 fund, dump some of their own funds into it and then start subscribing to some of their competition. More, as their funds under management grow, they can start replacing their competitor’s funds of fund with more hedge funds. F3 managers sometimes stress the broad diversification of their funds, but that is more apparent than real. Most Fund of Fund managers are pack animals at heart. In fact, I have met a number of Fund of Fund managers who brag about the fact that they invest in the same managers every one else does. There is less diversification value here than the F3 manager’s claim.
If F3 funds are not a good idea, and I do not believe they are, this only means that the investor is left with the hard work of selecting F2 funds. Unfortunately, I have no easy solution to this problem. In fact, in part, this is what the rest of my website is about.