pensions&investments_2010_publication_fund of hedge funds-easy to succeed
TRANSCRIPT
FUND OF HEDGE FUNDS - EASY TO SUCCEED
Pensions&Investments
February 19, 2010
http://www.pionline.com/white-papers/2373942
Rob Brown, PhD, CFA
I. INTRODUCTION
Over the last dozen years, the fund of hedge funds (hereafter referred to as FoF) industry experienced amazing
exponential growth, followed by collapse, and today, has once again embarked on a period of rapid growth. In 2000,
the size of the FoF industry was estimated to be $83.5 billion1. Over the subsequent seven years, it grew by 974%,
reaching total assets under management of $897 billion. By 2009, the FoF industry had fallen to $430 billion, a 52%
decline. Current projections call for the FoF industry to grow by 196% over the next four years, reaching $2,600 billion
by the end of 2013.
FoF grew fast, shrank catastrophically, and are once again following a path of exponential growth. This paper
attempts to identify why FoF have failed in the past, why certain isolated FoF will fail in the future, and what is
required for a FoF to succeed in both the short- and long-run. The framework presented here is directly applicable
to: (i) research and due diligence efforts designed to select FoF, (ii) those institutional investors who, instead of
hiring one or more FoF, decide to directly manage a portfolio of individual hedge funds themselves, and (iii) Trustee
Boards who must oversee, evaluate, and measure an internal hedge fund program directed by staff.
II. WINNING THE LOSER’S GAME
Charlie Ellis has been one of the investment industry’s more prolific contributors. He founded Greenwich Associates,
served as chair and governor of the CFA Institute, acted as associate editor for both The Journal of Portfolio
Management and The Financial Analysts Journal, and served on the faculty of the Harvard Business School, the Yale
School of Management, and the Investment Workshop at Princeton. In 1975, Charlie Ellis, famously observed that
investing was “a loser's game.” Like amateur tennis, he wrote in the classic Winning the Loser's Game2
(required
reading for past CFA candidates), investing is an activity in which the victor often prevails because he makes fewer
mistakes than his rival does. Ellis speaks to how short- and long-run success is most often a function of avoiding the
missteps made by your competitors as opposed to winning larger bets than the next guy.
But FoF are not your typical investment. Their short- and long-run success is driven and defined to a far greater extent
(a full order of magnitude greater) by the simple avoidance of a series of classic mistakes. Therefore, FoF are
unusually well defined by the Winning the Loser’s Game paradigm.
FoF stand out within the broadly defined investments industry as both one of its greater successes (growing by 974%
in just seven years) and one of its greatest failures (shrinking by 52% in just two years). These two opposing extremes
speak to the outsized investment opportunities available to FoF and the similarly outsized perils that they must
successfully mitigate in order to succeed. Profound opportunity and peril are the defining elements of the
environment within which FoF operate, and it is for this reason that the Winning the Loser’s Game paradigm holds
most strongly for this segment of the investments industry.
FoF operate within a far harsher environment that is located closer to the eye of the storm than more traditional
investment management structures. Hedge funds are generally defined by greater focus, concentration, and leverage.
They often make use of shorting and derivatives. Their trades or positions may make use of more embryonic and less
widely understood opportunities/risks. Hedge funds often push on regulatory boundaries. These attributes of the
hedge fund environment mean that their investment, business, and operational opportunities and risks are generally
better defined, better understood, far more potent, and arise with sharper edges. Frequently, these opportunities
and challenges have been poorly managed or inadequately dealt with by individual FoF. This paper applies the Ellis
framework to the management of a successful FoF, in the sense of identifying the primary missteps to which FoF are
most susceptible. Following the Ellis framework, and given the bountiful opportunities available to FoF, if a FoF can
avoid these specific missteps, then they are likely to experience significant investment success.
III. FRAMEWORK FOR CATEGORIZING VARIOUS FoF MISTAKES
The remainder of this paper identifies the primary missteps to which FoF are most susceptible. These mistakes vary in
terms of severity, probability of occurrence, and ability to recover from such missteps. As a result of these
differences, the identification and discussion of the alternate paths-to-failure benefits from a framework for
categorizing them and a specific chronology for their review. For this purpose, I adopt the framework provided by
Dante Alighieri in his The Divine Comedy3 from the fourteenth century. This may at first seem like an odd structure for
arranging a discussion of the ways that FoF can fail, but Dante’s framework offers three attractive attributes.
First, he breaks the various paths-to-failure (or sin in his parlance) into four distinct categories (self-indulgent
sins, violent sins, malicious sins, and the sins of the unrepentant). These categories help us understand the
relative criticality of the different FoF missteps – and speak to their origins.
Second, he provides a specific chronology for examining each sin (path-to-failure). Starting with the 9th most
egregious sin and progressing through ever more offensive violations, eventually reaching the single most
dire (all of which are located in Hell or Inferno). Dante than steps back and progresses through two final, but
significantly lesser sins, that although traumatic, do not doom one to Hell (they are located in Purgatory or
Purgatorio).
Third, Dante provides a description of each sin (or region of Hell and Purgatory) that proves disturbingly
relevant or eerily resonant for the different ways in which specific FoF have failed over the last several years
(think Madoff, Petters, Austin, Topiary).
The following schematic provides a representation of Dante’s categorization scheme and the chronology with which
he reviews those paths-to-failure, along with the parallel labels for how FoF can or have misstepped.
Dante’s Chronology of Sin
HELL (Inferno)“Lasciate ogne speranza, voi ch’intrate”
“Abandon all hope, ye who enter here”
SELF-INDULGENT SINS
9. Limbo
8. Lust
7. Gluttony
6. Avarice, greed
5. Wrath, sullenness
VIOLENT SINS
4. Heresy
3. Violence, usury
MALICIOUS SINS
2. Fraud, treachery, and falsification
1. Treason, traitors to their guests and benefactors
PURGATORY (Purgatorio)“Fa che lavi, queste piaghe”
“Take heed that thou wash these wounds”
LESSER SINS
10. Contumacy, disobedience
11. Late-repentant
- FUND OF HEDGE FUND HELL AND PURGATORY -
FoF Chronology of Paths-to-Failure
HELL (Inferno)“Lasciate ogne speranza, voi ch’intrate”
“Abandon all hope, ye who enter here”
GRAVE MISTAKES
9. Hubris - Failure to understand one’s role (i.e., through what typesof decisions does one add value)
8. Causality - Failure to separate alpha from beta (thereby identifyingtrue causality)
7. Operations - Failure to confirm adequate operational and backoffice integrity
6. Hiring - Failure to develop adequate & appropriate basis fordecision to hire new hedge fund
5. Self-awareness - Failure to identify and parameterize embedded factor exposures
DISASTROUS MISTAKES
4. Arrogance - Failure to adequately diversify, admit to one’s mistakes, and cut one’s losses
3. Leverage - Failure to preserve already established leverage duringtimes of stress
CATASTROPHIC MISTAKES
2. Deception - Failure to accurately price the portfolio
1. Fraud - Failure to match the “say” and the “do”
PURGATORY (Purgatorio)“Fa che lavi, queste piaghe”
“Take heed that thou wash these wounds”
MEANINGFUL MISTAKES
10. Termination - Failure to develop adequate & appropriate basis fordecision to fire an existing hedge fund
11. Rigidity - Failure to adapt one’s thinking and solutions to the ever -changing environment
The preceding diagram delineates the eleven most critical mistakes to which FoF are most susceptible. These eleven
are numbered according to their severity, probability of occurrence, and ability of a FoF to recover from – with the
lowest (highest) number being the most (least) critical. Following Dante’s lead, I have arranged these eleven into four
distinct categories, labeled: “Grave Mistakes,” “Disastrous Mistakes,” “Catastrophic Mistakes,” and “Meaningful
Mistakes.” Grave, disastrous, and catastrophic paths-to-failure are all located in Hell – signifying the lack of hope for
redemption or recovery. The last category of meaningful mistakes resides in Purgatory, signifying the egregious
nature of the sin or mistake, but leaving hope for the FoF to redeem itself and potentially recover. Obviously, the
coloration dovetails with the egregiousness of the FoF failure.
The remainder of this paper examines these eleven alternate modes by which FoF can fail. I examine them in the
order followed by Dante during his travels through the various regions of Inferno and Purgatorio.
IV. ELEVEN WAYS THAT FoF FAIL
GRAVE MISTAKES, SELF-INDULGENT SINS - MISTAKES 9. - 5.
We begin by examining five mistakes that will inevitably doom a FoF to eventual failure – although the day of
reckoning may be far into the future. These five failings, Hubris, Causality, Operations, Hiring, and Self-awareness, are
the direct result of a “self-indulgent” process on the part of the FoF.
9. Hubris - Failure to understand one’s role (i.e., through what types of decisions does one add value). The
mistake that some FoF make is to believe that they have the ability to predict the timing of when a beta (factor
exposure) or the timing of when a hedge fund style (alpha opportunity) will pay off. This false belief that they have
“Oracle of Delphi”-type powers that enable them to predict the timing of future events leads such FoF to time markets
or to time their allocations to hedge fund sectors.
FoF make this mistake when they forget the rule of relative comparative advantage. FoF do have a relative
comparative advantage to: (i) identify and parameterize the attributes of individual hedge funds, (ii) select superior
hedge funds, (iii) construct more efficient and well-behaved portfolios of hedge funds, and (iv) draw important
distinctions about the relative alpha opportunities across various hedge fund sectors. However, FoF have no particular
expertise (and probably operate with a meaningful relative disadvantage) in the prediction of when a beta or market-
imperfection (alpha source) will be rewarded.
An important distinction needs to be drawn between:
Claiming the ability to know in the advance the timing of future events –which leads one to time their
allocations to various hedge fund styles.
VERSUS
Developing a deep understanding of how pockets of imperfection and mispricing within markets vary in
terms of size, consistency, durability, and competition across the multitude of different market sectors.
The first of these is the mistake of “Hubris.” The second of these plays directly to FoF relative comparative advantage
in understanding how hedge fund strategies differ in terms of competition and opportunity resulting from the
breakdown of perfect market efficiency.
8. Causality - Failure to separate alpha from beta (thereby identifying true causality). The mistake that some FoF
make is to restrict their analysis to “total return” as opposed to breaking “total return” down into its component parts,
i.e., the portions that were caused by or are attributable to the various betas (or market exposures) inherent within its
strategy and the portion attributable to alpha (the harvesting of market imperfections). The mistake of “Causality”
applies to the evaluation of all active investment opportunities and applies just as much to long-only investment
managers as it does to hedge funds or private equity LBO funds.
If a large-cap value long-only manager returns +25% and I conclude that they have done a superior job, then I have
committed the mistake of “Causality” if the S&P 500 Value Index returned +26%. If a long/short biotechnology hedge
fund manager returns +20% and I conclude that they have done a superior job, then I have committed the mistake of
“Causality” if they were net-long 40% biotech stocks and the biotechnology index rose 55%.
All hedge funds carry with them one or more embedded betas. Although some hedge funds have labeled themselves
“market-neutral,” all this means is that this fund might potentially have a zero value with respect to one or more
betas. It does not mean that they have neutralized all betas – which would be virtually impossible and probably non-
economic. Some of the betas or factor exposures that hedge funds carry around include:
Interest rates (i.e., term structure of US Treasury bonds)
Credit spreads (i.e., term structure of credit spreads over Treasuries)
Equity risk premia
Currencies
Commodities
Volatility (i.e., term structure of implied volatilities across various capital markets)
Liquidity risk premia
To properly attribute performance to causal-skill versus simple market exposure, the FoF must first identify the factors
to which a hedge fund is exposed, and then second, parameterize the size of the factor loadings.
7. Operations - Failure to confirm adequate operational and back office integrity. The mistake that some FoF make
is to restrict their analysis and evaluation of hedge funds to purely investment-type issues. This is a mistake because
the investment success of a hedge fund portfolio also depends on business, operations, and back office
considerations. The following exhibit identifies the primary components of an appropriate evaluation of these non-
investment focused factors.
6. Hiring - Failure to develop adequate & appropriate basis for decision to hire new hedge fund. The mistake that
some FoF make is to hire a new hedge fund manager because the past returns were attractive, the fund has a good
reputation, the fund tells a good story and is staffed by highly pedigreed professionals, or the FoF likes the sector of
the market within which the hedge fund operates. These are all examples of making a decision to hire without
adequate basis. The objective of hiring a new hedge fund manager is to capture the benefits of larger, more
consistent, and more durable alpha. Given this objective, hiring decisions are then logically based on the very specific
causes of alpha. The following exhibit identifies the four specific causes of alpha.
Business, Operations, and Back Office
Risk Assessment and Mitigation
Structure
Side pockets
Liquidity provisions
Lines of credit, leverage
Cashmanagement
ISDAs
Operations
Trade execution, authorization, reconciliation
Trade quality & cost
Information technology and
systems
Disaster recovery
Compliance officer,
procedures
Pricing
Valuation policy, methodology, pricing sources
Administrator’s expertise and independence
Fraud
Portfolio and security –level confirmation
Individual trade confirmation
Investment process
confirmation
Alpha opportunity viability
assessment
Monthly return consistency / plausibility
Business
Key person
Ownership structure
Regulatory actions
Auditor response
Service Providers
Fund Administrator
Prime Brokers / Custodian
Bank
Legal Council
Auditor
InsuranceProvider
Counterparties
For example, some FoF who hired Long-Term Capital did so on the basis of reputation, pedigreed professionals, and
attractive past returns. Such decisions to hire Long-Term Capital were made without adequate understanding of the
nature of the competition, the characteristics and properties of market’s mispricing, and the manager’s process for
harvesting the market imperfection. Similarly, those FoF who hired Madoff did so on the basis of past returns, a good
story, and manager persona. The decisions to hire Madoff were made without adequate understanding of the
manager’s process for identifying and harvesting the market mispricings or even the nature of the market inefficiency.
“Hiring” without adequate basis is a corruption of intellectual integrity.
5. Self-awareness - Failure to identify and parameterize embedded factor exposures. The mistake that some FoF
make is to ignore the embedded betas (factor exposures) carried forward into their portfolio by each of their
underlying hedge fund managers. Two seminal research papers, “Determinants of Portfolio Performance” 4, and
“Determinants of Portfolio Performance II: An Update” 5
initiated a stream of follow-on research and eventual
industry-wide understanding that the single largest determinant of return, both in the short- and in the long-run for
any reasonably diversified portfolio will be that portfolio’s asset allocation (i.e., the portfolio’s allocation to various
betas or factor exposures).
Because all hedge funds carry forward into a FoF portfolio embedded betas (factor exposures) this is a critical
determinant of FoF performance. However, the problem is made far worse by the speed and degree to which
underlying hedge funds change their embedded factor exposures (betas). Therefore, if a FoF fails to maintain “Self-
Alpha
(out-performance)
at the individual hedge fund level
How inefficient is the
marketplace (to what
extent is market-failure
present)
Where are the mispricings
and market-failures
located (what parts of the
marketplace)
How good is the
manager’s process and
tools for, first, identifying
and, second, harvesting
the mispricings
How many other hedge
funds are competing for
the same opportunity
Where does out-performance come from? – What causes alpha?
awareness” of its embedded betas, it delivers to its clients a potentially large and rapidly evolving determinant of
future returns that remains unidentified and therefore fully unknown.
By mid-2008, portable alpha had become a popular structure employed by institutional investors, including pensions,
foundations, and endowments. In many cases, the implementers made use of hedge funds as their alpha engines, but
they frequently failed to take into account the embedded betas carried forward by their underlying hedge fund
managers. As a result of their failure to maintain “Self-awareness” they unknowingly doubled-up on the beta within
the portable alpha structures that they built. Their failure to maintain “Self-awareness,” led them to assume that a
diversified portfolio of hedge funds was market-neutral. The market declines of 2008 and early-2009 brought to their
attention the mistake that they had made as they experienced excessive losses due to their excess beta.
DISASTROUS MISTAKES, VIOLENT SINS - MISTAKES 4. & 3.
We next examine two far more egregious mistakes, Arrogance and Leverage. Numerous examples of FoF failures over
the last several years can be directly traced back to these two sins which are truly “violent” in their impact.
4. Arrogance - Failure to adequately diversify, admit to one’s mistakes, and cut one’s losses. The mistake that
some FoF make is to believe too strongly in their own infallibility (i.e., they suffer from “Arrogance”) with respect to
the decisions they make and the portfolio structures they build. Most frequently, this path-to-failure takes one of the
following three forms: (i) over-concentration in individual hedge funds or hedge fund styles, (ii) unwillingness to admit
to one’s own mistakes with respect to decisions, analysis, and logic, and (iii) unwillingness to cut one’s loses.
This is a particularly insidious mistake, since it most frequently leads to the construction of unusually fragile portfolio
structures or analyses that are sub-optimal, or worse yet, inapplicable. The last two-hundred years of investment
industry history are rife with examples of Mr. Market eventually punishing those who suffered from excessive
“Arrogance.” Recently, a widely-publicized hedge fund manager made billions for himself and his clients as a result of
an isolated, concentrated bet that structured credit spreads would widen (mortgage backed securities and related
instruments). But today, this fund manager has established a new and similarly concentrated bet that gold will be the
next big winner. Such distilled and unrepentant “Arrogance” results in remarkably unstable, sharp-edged “solutions.”
More frequently, at the FoF level, “Arrogance” takes the form of an unwillingness to admit that the logic underlying
the decisions that were made is either fundamentally flawed or patently sub-optimal. An example could include the
FoF who builds a portfolio of levered relative value trades while refusing to admit that such a structure inordinately
exposes their clients to an expansion of implied volatilities and liquidity risk premia.
There will always exist unknowns and never imagined relationships. “Arrogance” undermines proper appreciation for
the presence and potential potency of these unknowns – resulting in over-concentrated portfolio structures and over-
confident investment analyses.
3. Leverage - Failure to preserve already established leverage during times of stress. The mistake that some FoF
make is to hire underlying hedge funds that employ leverage, or to make use of leverage at the FoF level itself, that is
particularly susceptible to withdrawal at the worst possible point in time. This is not a new problem, and easily
parallels the stock-based margin account or the levered commercial real estate structure. Both are remarkably
susceptible to call (forced liquidation) at the worst possible time, i.e., forced liquidation when the relative valuation
opportunity is at its all time greatest and most attractive. This results in the investor being forced out of his position
when the forward-looking payoff is at its absolute greatest, and the pain of immediate liquidation is at its most
disastrous.
To avoid this mistake, FoF must hire only underlying hedge funds that have the ability to preserve their leverage when
market stress reaches its most extreme. Similarly, this also applies at the FoF level, if the FoF employs additional
leverage.
CATASTROPHIC MISTAKES, MALICIOUS SINS - MISTAKES 2. & 1.
There exist two final mistakes, Deception and Fraud, which are of such an extreme and offensive nature, that when
discovered, they result in almost instantaneous unraveling. Unfortunately, the last several years have offered several
examples of these two truly “malicious” sins.
2. Deception - Failure to accurately price the portfolio. The mistake that some FoF make is to succumb to the
“Deception” of smoothing their valuations in an attempt to deceptively (but legally, from an accounting standpoint)
make their month-to-month returns (and therefore, underlying portfolios) look less risky than they really are.
Numerous investment instruments exist that facilitate, avoid, or otherwise side-step the need to mark-to-market. The
last several years have provided a painfully long list of such instruments. Asset backed lending (ABL) has provided the
most widely recognized example. The playing field of ABL often allows participants to carry their exposures at “cost”
or “par value” instead of marking them to current and available market value. Any investment instrument, for which a
weak and relatively efficient current market exists, is susceptible to abusive manipulation of this type (e.g., trade
claims).
This is a truly “malicious” violation in that it is an intentional act, initiated and pursued with full knowledge, whereby
some party must mandatorily be harmed. If a FoF portfolio is over-valued, then new contributions are being
disadvantaged and already existing investors would be better served by liquidating their positions and reinvesting the
proceeds at current market values. If a FoF portfolio is under-valued, then already existing investors are being
disadvantaged whenever a new contribution arrives, and would be better served by closing the fund to new investors.
In either case, existing and prospective investors are being fundamentally misled as to the inherent riskiness of the
underlying portfolio.
Unfortunately, several FoF exist today that are following the path of the “living dead.” Prior to the 2008 debacle, they
loaded up on ABL and related “smoothing” instruments. They failed to mark-to-market and as a consequence gated
their investors in order to avoid paying out redemptions at their artificially inflated stated valuations. Today, they
preserve their gates (directly or more likely, indirectly via side-pockets or “liquidating trusts”), delaying the recognition
that their stated asset values significantly exceed their real-world current mark-to-market values.
1. Fraud - Failure to match the “say” and the “do”. The mistake that some underlying hedge funds have made is to
intentionally and maliciously deceive their limited partner, investor clients. Thankfully, to my knowledge, no FoF has
yet to engage in explicate “Fraud.”
“Fraud” occurs when the “say” and the “do” fail to match. Yes, we can equivocate as to the severity of the deception,
but nevertheless, intentionally saying one thing and then doing another is just plain and simple, “Fraud.” This is truly
the inner sanctum of Hell, and those who intentionally place themselves within this category, deserve what inevitably
results. 2008 offered several examples, perhaps the most widely publicized include Madoff and Petters.
The fact that no FoF has yet to engage in fraud does not, in any way excuse them from having invested their clients’
assets in hedge fund frauds such as Madoff, Petters, or Westridge. Frequently (but not always), fraud is detectable, in
advance (as it was with Madoff, Petters, and Westridge), by determining what the hedge fund does, why the market
imperfection they claim to exploit exists, what they do to both identify and harvest the market mispricing, and by
confirming the existence and vitality of each relationship and position that the hedge fund claims to be present.
MEANINGFUL MISTAKES, LESSER SINS - MISTAKES 10. & 11.
After traveling through the nine rings of Hell (mistakes 9. through 1.), Dante progressed to Purgatory on his continuing
journey of understanding and enlightenment. He next traversed the two final and lesser sins located on the outer
periphery of Purgatory. Purgatorio, unlike Inferno, allows for the redemption from one’s mistakes. For this reason, I
have segmented out two final missteps to which FoF are most susceptible to, i.e., Termination and Rigidity.
10. Termination - Failure to develop adequate & appropriate basis for decision to fire an existing hedge fund. The
mistake that some FoF make is to terminate their underlying hedge fund managers without an adequate basis for their
“Termination” decisions. This mistake closely parallels the 6th
path-to-failure (see above), i.e., that of hiring a hedge
fund without adequate basis. However, the damage done by firing a manager without an adequate basis for the
decision is generally, significantly less onerous than the damage that is frequently wrought by the hiring of a hedge
fund without adequate basis.
By way of an example, perhaps a FoF has been investing with a long/short equity sector hedge fund dedicated to the
micro-, small-, and mid-cap equities of US-based banks. Hypothetically, this hedge fund delivered double-digit
negative returns in 2007 and 2008 and as a result the FoF terminated their relationship with this hedge fund manager.
Then, the return to normalcy of 2009 unfolded, and this long/short bank-sector specialist delivered a +39% return and
is expected to continue to deliver double-digit returns for the next couple of years as the US bank sector heals and
fundamental relative valuations (both negative and positive) are logically rewarded.
This example of the termination of a hedge fund without having first developed an adequate and appropriate basis for
the decision, results in the sacrifice of future alpha. However, to the extent that new hedge funds are hired on the
basis of sound, forward-looking analysis, the extent of the damage may be significantly reduced. Nevertheless, it’s
much preferred to retain an existing value-added hedge fund than it is to identify and hire a new replacement
manager.
11. Rigidity - Failure to adapt one’s thinking and solutions to the ever-changing environment. The mistake that
some FoF make is to rigidly maintain the same perspectives that they first established a dozen years earlier. This
mistake will inevitably erode the foundational vitality of a FoF, but at the same time, it is the most forgiving and
recoverable of the paths-to-failure.
Market inefficiencies and associated market failures evolve at a remarkably rapid pace and to an unusual degree. This
is as a result of the evolutionary pace of individual: (i) macro economies, (ii) capital markets, (iii) investment vehicles,
instruments, and securities, (iv) information sources, and (v) regulatory constraints. The rapid pace and diversity of
evolution serves as a primary reason for the fundamental existence of hedge funds. Hedge funds are present, in part,
because they provide a structure that adapts more quickly and to a greater extent to the evolving capital market
environment than any other investment management structure.
Andrew Lo of Massachusetts Institute of Technology comments6: “Hedge funds are the Galapagos Islands of finance.
The rate of innovation, evolution, competition, adaptation, births and deaths, the whole range of evolutionary
phenomena, occurs at an extraordinary rapid clip.” In 2006, for example, 1,518 new hedge funds were launched, but
717 folded; academic studies suggest that almost half of hedge funds fail to last five years7.
FoF parallel underlying hedge funds in their need to evolve at a rapid pace or else become victim to extinction. Events
of the last several years provide a ready example. By the end of 2006, fixed income markets had become unusually
efficient, offering little in the way of alpha opportunities. As a result, many FoF concentrated their portfolios on
long/short equity hedge funds (sometimes exclusively). But, by January 2009, the broadly defined fixed income arena
had experienced a degree of market failure and disassembly not witnessed since the 1930s. The tide turned, and fixed
income now offered many times the alpha opportunities then available in long/short equity. Those FoF who failed to
evolve during this time were placed at a meaningful competitive disadvantage to their more flexible and adaptive
brethren.
V. SUCCESS IS EASY - AVOID FAILURE AND YOU WILL WIN
This paper set forth the proposition that the design, construction, and ongoing management of a successful FoF, in
both the short- and the long-run, is a relatively easy task. The ready ease of this task is a direct function of the vast
opportunity set available for the harvesting of alpha – in size, with consistency, and with durability. Nevertheless, FoF
have frequently failed in their mission. I argue that these failings are in the Ellis, Winning the Loser’s Game, sense --
not the result of any lack of opportunity, but instead are the result of making one or more of eleven specific mistakes
along the way.
As Ellis observes, investing is an activity in which the victor often prevails because he makes fewer mistakes than his
rival. I suggest that FoF will experience success if they avoid the following missteps:
11. Rigidity 9. Hubris 4. Arrogance 2. Deception
10. Termination 8. Causality 3. Leverage 1. Fraud
7. Operations
6. Hiring
5. Self-awareness
The last several years have provided numerous examples of FoF failures. In each case, the reasons for their collapse
can be directly traced back to one or more of these eleven paths-to-failure.
Some investors have reacted to recent FoF and hedge fund collapses with poorly developed thinking that fails to tie
their proposed solution with the root cause of the original mistake. Consider two examples:
1. Some have suggested that the solution for fraud and illiquidity is to abandon limited partnerships and instead
use only separate accounts. This of course is a flawed line of reasoning – as we all recall, Bernie Madoff’s
clients all had separate accounts. And if one’s separate account holds the same securities as every other
client of the specific hedge fund manager in question, then all investors are still left with the same liquidity
problem – only worse, for now no General Partner is present who could step in and control the behavior of
the crowd so as to better protect each individual interest, i.e., prevent the elephants from all attempting to
race through the door at the same moment.
2. Some have suggested that the solution for the problem of knowing your factor exposures is to install new
quantitative systems or models that will inform us as to our forward-looking risks. Those who suggest such
“solutions” are obviously unaware of how the vast teams of analysts and risk managers making use of
complex Value-at-Risk models failed to identify factor exposures at financial institutions around the world
during the 2008-2009 global economic collapse. The problem of identifying and parameterizing embedded
factor exposures is generally not one of insufficient data or analytics. Instead, it is more often a challenge of
properly evaluating and interpreting what is already present in abundance.
Finally, the framework presented by this paper was designed to provide a template for use by Trustee Boards at
pensions, foundations, and endowments that are responsible for the oversight of internal hedge fund programs. It is
also meant as a road map for the management of an internal hedge fund program as well for use by those who are
performing due diligence on and making selections of external FoF.
Victory is already yours – you have only to avoid eleven classic missteps.
Rob Brown, PhD, CFA
Chief Investment Officer, Senior Vice President
United Capital Financial Advisers, LLC
Email [email protected]
FOOTNOTES
1. “The Hedge Fund of Tomorrow: Building an Enduring Firm,” Thought Leadership Series, April 2009, CaseyQuirk, The Bank of New York Mellon, Pages 7 – 22.
2. “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” Charles D. Ellis, McGraw-Hill, 4th edition (March 14, 2002).
3. “The Divine Comedy” (Italian: La Divina Commedia) is an epic poem written by Dante Alighieri between 1308 and his death in 1321 (sometimes referred to in colloquial American culture as “Dante’s Inferno”). It is widely considered to be the central poem of Italian literature, and is seen as one of the greatest works of world literature. It is divided into three parts, the Inferno, Purgatorio, and Paradiso. The poem is written in the first person, and tells of Dante’s journey through the three relative realms of the dead. The Roman poet Virgil guides Dante through nine rings of Hell and the nine circles of Purgatory. Hell is divided into three main regions: Upper Hell (the first five circles) for the self-indulgent sins; Circles six and seven for the violent sins; and Circles eight and nine for the malicious sins. Dante called his poem “Comedy” (the adjective “Divine” was added later in the 14th century due to the nature of the material addressed by this epic poem) because poems in the ancient world were classified as either High (“Tragedy”) or as Low (“Comedy”). Low poems had happy endings (as does Dante’s The Divine Comedy).
4. “Determinants of Portfolio Performance,” Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, The Financial Analysts Journal, July/August 1986.
5. “Determinants of Portfolio Performance II: An Update,” Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, The Financial Analysts Journal, 47, 3 (1991).
6. “Capital Ideas Evolving,” Peter Bernstein, John Wiley & Sons, May 2007.
7. “Guide to Hedge Funds: What they are, what they do, their risks, their advantages,” Philip Coggan, The Economist, Bloomberg Press, 2008.