By Andrew D. Beer, Chief Executive Officer of Beachhead Capital and Michael O. Weinberg, Adjunct Professor at Columbia University 

Well-documented advantages of alternative mutual funds include daily liquidity, lower all-in fees, greater regulatory oversight, lower minimum investment requirements and the absence of partnership K1s. These features make alternative mutual funds a viable investment for defined contribution plans and retail investors, an untapped multi-trillion dollar market for hedge fund managers.

The opportunity for fund of funds managers is clear. Post-crisis, funds of hedge funds faced a sharp decline in profitability due to a combination of disintermediation, declining fees and rising costs (e.g. customization). Gone are the days of managing a highly profitable co-mingled fund of hedge funds where each incremental dollar of revenue drops to the bottom line. Defined benefit pension plans – long-time investors in funds of funds – are in steady decline; by contrast, defined contribution plans are growing rapidly and current exposure to alternatives is de minimus. Alternative multi-manager mutual funds (AMMFs) could represent a new dawn for funds of funds:  co-mingled, highly scalable vehicles with strong potential investor demand.

However, mutual funds are far less flexible than hedge funds: all registered funds have structural limitations on leverage, shorting, illiquid assets, concentration and other criteria. This contradicts a core tenet of the hedge fund industry:  that talented managers perform better with fewer constraints. In fact, many early hedge fund managers were former mutual fund managers in search of a less constrained investment vehicle. By definition, structural constraints almost certainly will result in a performance differential over time:  the question is, by how much?  This paper looks at the evidence to date, some of the underlying causes, and raises some pertinent due diligence questions for potential investors.

1. Performance Drag: Evidence to Date

There is a limited amount of live data on AMMF performance. Of the thirteen funds that we currently track, only three have track records that extend back more than a year or two. Only five of thirteen have full year track records for 2012, while eight have full year track records for 2013. Any conclusions below should be taken in this context.

With that caveat, the chart below shows the full year performance of those five and eight funds, respectively. The magnitude of the performance drag is noteworthy:  the average AMMF underperformed the HFRI Fund of Hedge Funds index by 311 bps in 2012 and 420 bps in 2013, net of fees (the return figures are for institutional share classes only). The average AMMF also underperformed an index of liquid hedge funds (HFRX Global Investable Index) by approximately 200 bps in each year.

Full Year Performance Comparison 2012-13 

This is particularly surprising given that all-in fees in AMMFs are 150-250 bps lower than those in fund of fund funds; all things being equal, this should lead to higher performance. While the average AMMF charges slightly more than 200 bps per annum with no incentive fee,[1] the typical fund of hedge funds has all-in fees of 3.5% to 4.5% (75-150 bps per annum on top of underlying hedge fees of 1.6% and 20%, on average). On a fee equivalent basis, the performance differential rises to 448 bps in 2012 and 681 bps in 2013.

Estimated Fee Equivalent Performance Drag 2012-13

2. What Explains the Performance Drag?

When the HFRX GlobalInvestable Index was launched over a decade ago, performance drag initially was over 400 bps per annum, primarily due to adverse selection bias. That differential has come down over time, but still is persistently 100-200 bps per annum. Other liquid hedge fund strategies – investable hedge fund indices, managed account platforms, 130/30 funds, and UCITS products – have each underperformed hedge fund counterparts by around 200 bps per annum. This supports the general rule that liquid alternative strategies have a persistent long term performance drag relative to actual hedge funds.  (See The Performance Drag of Liquid Hedge Fund Strategies at www.beachheadcapital.com).

In the AMMF space, performance drag is likely to arise in two forms. First, following the HFRX example, hedge fund managers most eager to manage sub-accounts at reduced fees may be of a lesser quality. This may explain in part why the Hatteras Alpha Hedged Strategies Fund, the only fund with a ten year track record, underperformed the HFRIFOF since inception by 134 bps on an annualized basis since inception (including negative alpha of 1.8% given somewhat higher beta) and suffered much more pronounced drawdowns during the crisis (down 31.6% in 2008).[2]  On the surface, the current pool of subadvisors appears to be much more credible than the early participants in the investable hedge fund indices.

A more serious issue, then, is that high quality managers simply may not be able to deliver comparable returns within the constraints of the ’40 Act structure.[3]  While it is impossible to make an apples-to-apples comparison,[4] one indirect method is to compare the performance of AMMFs to a portfolio of hedge funds managed by the same subadvisors. Here we find that AMMFs have on average underperformed an equally weighted basket of the “flagship” hedge funds of the subadvisors by over 200 basis points.[5]  On a pre-fee basis, the differential rises to over 500 basis points.[6]

Why is this?  In addition to investment constraints, hedge fund managers have a strong incentive to avoid cannibalizing their core businesses; therefore, given the general absence of incentive fees, the most attractive or capacity constrained trades are likely to wind up in higher fee vehicles.[7]  Irrespective, given the importance of the hedge fund managers’ reputations in marketing AMMFs, it is reasonable for investors to require AMMF managers to break down performance by subaccount relative to the most comparable hedge fund managed by the same subadvisors.

A final and important distinction is that AMMF managers directly pay the subadvisors:  unlike in a fund of hedge funds, each dollar of subadvisory fees comes directly out of the pocket of the AMMF manager. AMMF managers therefore have a strong incentive to select subadvisors who will work for 1% or less. A fair question for any AMMF sponsor is how many subadvisors/strategies were rejected due to high fee expectations, and why this does not lead to adverse selection.

Conclusion

In conclusion, while it’s still very early in the game, our analysis indicates that AMMFs are likely to be subject to a persistent performance drag over time. Based on the more robust data pool from other liquid alternatives, our expectation is that the performance drag should be around 200 bps per annum, net of fees. Fortunately, since return information is readily available on ’40 Act funds, it will be much easier to make ongoing comparisons, and we look forward to updating this analysis in the coming year or two.

This does not mean that AMMFs are necessarily inferior to hedge funds of funds. The structural advantages are very real, and will be worth more than 200 bps per annum for many investors. Further, investors who previously have been precluded from investing in hedge funds may find AMMFs to be a valuable diversifier.

As of early 2014, the evidence suggests that the performance drag will be higher than many investors realize and that the (real) advantages of greater liquidity, lower minimums and reporting simplicity are likely to come at the cost of diminished returns.

 

[1] Most funds currently include fee waivers and/or rebates to bring down all-in fees. The average rebate among 13 funds included in the study currently is 48 bps per annum. Note that fee rebates generally have a finite life, so a relevant due diligence question is the extent to which fee rebates will continue going forward.

[2] The institutional share class of the Hatteras fund was not introduced until late 2011, whereas the retail share class was introduced in 2002. The retail share class is referenced here.

[3] This is the principal reason the SEC does not permit prospectuses to show the hedge fund track records of the subadvisors. In fact, only one of the AMMFs (Balter) requires the subadvisors to run portfolios substantially identical to their hedge funds and therefore is permitted to disclose the track records of the subadvisors’ hedge funds in the offering documents.

[4] Due to a lack of transparency of manager weights in AMMFs and strategy overlap between AMMF sub-advised accounts and predecessor hedge funds, among other issues.

[5] More precisely, of the eight funds with full year performance for 2013, we have return data for the flagship hedge funds on at least 70% of the managers of four of them. Those AMMFs underperformed an equally weighted portfolio of the available hedge funds by an average of 314 bps, net of fees. Assuming that the AMMF managers are paid 100 bps of the management fee, the fee equivalent differential is 214 bps on average.

[6] At a conference in 2013, one prominent multi-strategy hedge fund firm analyzed the expected performance differential in their flagship fund and canceled plans to create a ’40 Act fund after determining that they would suffer an 800 bps drag.

[7] Note that one possible window into this may be which managers advise assets of wholly-owned offshore subsidiaries. In general, offshore subsidiaries can pay management and even incentive fees to managers without disclosure at the fund level. This is a relevant due diligence question for any funds with offshore subsidiaries.

EmailPrintLinkedInEvernoteShare/Bookmark

The recent launch of several mutual funds of hedge funds (or, more accurately, funds of managed accounts) geared to the US retirement market has turned attention to the question of how much investors should expect to sacrifice in returns for daily liquidity and pricing.  Since these products mostly have very short track records, the answer to this question is best found by looking at past efforts to introduce greater liquidity into the hedge fund investment model.

The historical record is not particularly promising.  Investable indices were first launched over a decade ago but initially suffered from adverse selection bias that caused one index to underperform its non-investable counterparts by 300-600 bps during its first four years of live performance.[1]  More recent innovations like managed account platforms and UCITS structures appear to have a lower performance drag, but making apples to apples comparisons is notoriously difficult.  In a recent study, Cliffwater sought to calculate the annual return difference between 148 hedge funds and their direct liquid counterparts, such as managed account platforms, 40 Act funds, bank platforms and UCITS structures.  They concluded that investors in the liquid alternative sacrificed approximately 1% per annum due to a combination of fees and lost alpha.  They noted that the annual cost was greatest for Event Driven managers (2.3% per annum) and lowest for Managed Futures (0.5%) and Macro (0.2%); Equity Long/Short was close to the mean at 1.1%.   However, the performance drag in the Cliffwater study – conducted in March 2013 and based on liquid alternatives that were still in operation at that time – likely is understated since it excludes liquid alternatives that were launched over the past decade but subsequently shut down due to poor tracking.

In this note we seek to estimate the performance drag associated with liquid alternatives to investing directly in hedge funds during the post-crisis period.  Rather than analyze individual managers, we look at the recent performance of several indices that track liquid alternatives.  As shown in the chart below, a composite of liquid alternatives underperformed the HFRI Fund Weighted and Fund of Funds indices by 3.08% per annum and 1.29% per annum, respectively, over the three and a half year period from January 2010 through June 2013.  Factoring in some of the data biases discussed below and variance due to fee structures and strategies, we estimate that it is reasonable for a typical investor in hedge funds to expect a performance drag of 150-250 bps per annum when electing to invest in highly liquid hedge fund strategies.

Performance Drag 1 (2)

Data Considerations

At the hedge fund index level there are two principal issues with the data.  The HFRI Fund Weighted index is slightly overstated due to reporting bias; that is, funds have a window in which to decide whether to report a given month’s returns.  Second, the HFRI Fund of Funds index includes a second layer of fees, which accounts for some of the recent performance differential.  In general, we assume that the HFRIFWI is a reasonable proxy for the direct hedge fund portfolio of an institutional investor, while the HFRIFOF is more representative of the returns expected by smaller investors.

With respect to the liquid products, we ideally would analyze the full universe of managed account and UCITS products that are (and have been) designed to track the performance of a given hedge fund so that we can make apples to apples comparisons on a fee equivalent basis – an expanded version of the Cliffwater study.  However, proprietary platforms generally restrict access to data and hence make such comparisons impossible or, alternatively, present the data in a self-serving manner.  Further, institutions that have negotiated special managed accounts typically do not publish comparative results.

Given these limitations, there are three principal hurdles in the data available to us:

  • Fee Equivalency.  In general, there is very little transparency into whether certain indices (e.g. Lyxor) include platform level fees.  Some products, such as the Credit Suisse AllHedge Solutions, are actual investment products, while others merely aggregate reported data.  UCITS and registered funds may have materially different fee structures than the actual hedge funds.
  • Selection Bias.  When first introduced, indices are often backfilled and historical results are replete with survivorship bias.  Hence, we focus only on live performance.  Further, indices that perform poorly can be shut down, as was the case with the Dow Jones Credit Suisse Core Hedge Fund index in May 2013.
  • Strategy Bias.  A liquid index may overweight certain strategies that are inherently more liquid and therefore more conducive to being offered in a liquid structure.  Certain strategies like managed futures have underperformed others (e.g. credit) and therefore may depress results.  To address this we look at a group of indices rather than focus on a specific provider.

We hope to overcome these limitations by looking at a broad enough sample of indices so that any fund level or platform specific bias has a limited impact on overall results.  In light of this, the data shows that there is a consistent and significant performance drag associated with liquid alternatives.

What Causes the Performance Drag?

There are several likely causes of the persistent performance drag.  Daily (or near daily) liquidity should limit the investment universe to positions that, by definition, lack an illiquidity premium.  If illiquid assets command a 3-4% return premium over time, we might expect a performance differential of perhaps 1% over time if we assume that a typical hedge fund with restrictive liquidity terms might hold a quarter to a third of its portfolio in less liquid instruments.  Note that certain liquid hedge fund proxies – such as the Lyxor managed account platform and factor based replication models – outperformed materially during the crisis, which supports the conclusion that at least a portion of the differential is due to a mismatch in the liquidity of the underlying portfolios.  However, this clearly does not explain the entire differential.

As noted, adverse selection among managers was very pronounced in the formative years of the investable index business.  More recently, established and highly regarded hedge fund managers appear much more willing to run liquid alternative products and the performance differential has narrowed.  The persistent performance drag even in recent years suggests that investment restrictions in more liquid products cause a portfolio-level form of adverse selection.

Another cause, as noted by Callan in a recent research report on alternative mutual funds, is that registered funds and similar vehicles restrict leverage, which can be a key contributor to returns in certain strategies.  A fourth likely cause is that managers need to retain a cash buffer to manage more frequent inflows and outflows.

The mix of factors clearly will vary from product to product and strategy to strategy.  Cliffwater’s conclusion that the performance differential is lowest for managed futures is consistent with the ease of running such strategies in multiple vehicles and the leverage available through the futures markets.

Conclusions

The initial appeal of the hedge fund model was that it enabled talented and motivated managers to pursue investment opportunities outside the constraints of registered investment products like mutual funds.  Managers were relatively unfettered to pursue compelling investment opportunities as market conditions warranted.  A talented merger arbitrage specialist in the late 1980s might have evolved into a distressed investor by 1990 and a buyer of nonperforming real estate portfolios within a few years thereafter.

The institutionalization of the business over the past decade has gradually introduced a series of new constraints into the investment model.  Institutional investors are wary of style drift and value consistency in the investment process, sometimes even in the face of an inferior opportunity set.  The concentration of capital among large firms post-crisis naturally has narrowed much of the investment universe to situations where managers can deploy hundreds of millions of dollars in a single position.  Post-crisis aversion to gating/suspension risk has led to intense scrutiny of the liquidity of underlying portfolios.

A rational question for investors is whether the structural constraints of liquid vehicles cause the underlying managers to deviate from the core investment strategy to such a degree that it undermines the original investment thesis – that is, to invest in strategies with a higher expected risk adjusted return than, or low correlation to, traditional investments.  Based on a cursory analysis, a recently launched mutual fund of managed accounts product appears to have underperformed the flagship hedge fund counterparts run by the same managers by 600 bps on a fee equivalent basis over just the first half of 2013.  If anything, this suggests that investors will be sorely disappointed if they expect the mutual fund to approximate the performance of a portfolio of those hedge funds over time.



[1]  The adverse selection issue was most acute with the HFRX Global Investable index versus either the HFRI Fund of Funds index or HFRI Fund Weighted index.  Credit Suisse’s Blue Chip investable index did not suffer from nearly as much of a performance drag; however, this product was never designed to offer daily or weekly liquidity.

[2]  The Dow Jones Credit Suisse Index, designed to track the universe of managed account and UCITS products, was launched in early 2011 but ceased reporting in May 2013.  Consequently, comparative statistics are for the live period only.