Multi-Manager Strategies

Fund-of-Funds

Fund-of-funds (FoF) managers pool investor capital and distribute it to a diversified portfolio of individual hedge funds with distinct and less correlated strategies. Their key responsibilities encompass diversification, occasional strategic reallocation, manager selection, due diligence, ongoing portfolio management, risk assessment, and reporting. FoF managers offer advantages like access to closed hedge funds, economies of scale for oversight, currency hedging, portfolio-level leverage management, and enhanced liquidity terms.

However, this approach involves drawbacks, such as dual layers of fees, limited transparency into individual hedge fund processes and returns, the inability to net performance fees from individual managers, and the introduction of an additional principal-agent relationship. Historical fee norms included a 1% management fee and a 10% incentive fee for the FoF portfolio. Yet, as the performance of FoFs has declined, fees have become more negotiable, with management fees of 50 bps and incentive fees of 5% or a flat 1% total management fee becoming increasingly common. Liquidity management in FoFs can occasionally result in liquidity challenges.

FoFs typically impose an initial one-year lock-up period and offer monthly or quarterly liquidity afterward, often with a 30- to 60-day redemption notice requirement. However, the underlying investments in FoFs may not align with these liquidity needs due to underlying managers or investments having their lock-up provisions or redemption gates. To address potential mismatches in cash flows, FoFs may establish a reserve line of credit to ensure they meet redemption requirements.

Investment Characteristics

Fund-of-funds (FoFs) are crucial for smaller high-net-worth investors and smaller institutions to access the hedge fund universe. Most hedge funds require substantial minimum investments, making diversification across 15–20 managers costly in terms of capital and resources. FoFs offer a more accessible entry point, allowing high-net-worth investors and smaller institutions to begin their hedge fund investments with as little as $100,000 while providing diversification through a mix of skilled hedge fund managers. They offer benefits for convenient access, diversification, liquidity, and operational tax reporting.

FoFs are valuable for individual investors and institutional clients like endowments, foundations, and pension plans. They offer expertise in selecting, due diligence, and allocating funds to individual hedge fund managers and in strategic and tactical allocation into various hedge fund strategies. This includes setting long-term allocations to different hedge fund styles and periodically adjusting these allocations based on market conditions.

Commercial banks provide leveraged capital to FoFs through prime brokerage services, allowing them to redeploy capital while awaiting returns from hedge funds efficiently. Leveraged capital is typically collateralized by hedge fund assets held by the banks.

Furthermore, larger FoFs can leverage their combined assets to negotiate better terms with underlying hedge funds, potentially securing fee breaks, improved liquidity terms, future capacity rights, and transparency provisions. These concessions may outweigh the additional layer of fees imposed by the FoF.

In essence, FoFs combine diverse and ideally uncorrelated strategies to enhance diversification, reduce extreme risk exposures, lower realized volatility, and generally lower tail risk than direct investments in individual hedge fund strategies. They may also offer economies of scale, access to skilled managers, research expertise, liquidity efficiencies, portfolio leverage opportunities, and valuable concessions from underlying funds.

Strategy Implementation

Constructing a Fund-of-funds (FoF) portfolio is a systematic, multi-step process that unfolds over several months. It begins with FoF managers familiarizing themselves with different hedge fund managers through databases and prime broker-organized events. They determine the portfolio’s strategic allocation across various hedge fund strategy groups.

The formal manager selection process follows, involving quantitative and qualitative top-down and bottom-up approaches. FoF managers screen the hedge fund universe, creating a peer group of potential investment candidates within each strategy grouping. They conduct in-depth interviews, review materials, including due diligence questionnaires, and conduct multiple meetings, often visiting the hedge fund offices.

For hedge funds that prove suitable for investment, thorough reviews of the Offering Memorandum and Limited Partnership Agreement are conducted. Service providers are verified, background checks are performed, and references are obtained. In some larger FoF firms, a specialized team may handle operational aspects of due diligence, which can lead to negotiations for concessions such as reduced fees, enhanced transparency provisions, capacity rights, or improved liquidity terms through side letters.

Once approved and integrated into the FoF portfolio, the process transitions into the ongoing monitoring and review phases. The focus is on ensuring performance consistency with investment objectives, detecting style drift, personnel changes, regulatory matters, and any correlation or return shifts concerning other managers within the portfolio and in comparison to similar hedge fund peers.

Multi-Strategy Hedge Funds

Multi-strategy hedge funds merge various hedge fund strategies within a single hedge fund framework. Specialized teams of managers responsible for distinct hedge fund strategies collaborate within the same organizational structure, sharing operational and risk management processes.

Investment Characteristics

Multi-strategy hedge funds offer advantages over fund-of-funds, including quicker capital reallocation and better risk management. Their fee structures can be more investor-friendly and transparent. However, these funds carry significant leverage, operational risks, and limitations in strategy diversity. They have experienced notable left-tail risk events, contributing to their mixed reputation in the hedge fund industry.

Strategy Implementation

Multi-strategy funds invest in various hedge fund strategies, and their choice of strategies depends on their in-house expertise. These funds engage in strategic and tactical allocations, enabling quick capital shifts. They have the advantage of better risk insights due to familiar management teams and processes, which might be less apparent in a FoF structure. However, they may be less inclined to exit strategies they specialize in.

Risk Profile and Liquidity

FoF and multi-strategy funds aim to provide stable, low-volatility returns through diversification.

Multi-strategy funds have generally outperformed FoFs but exhibit more variability and occasional significant losses due to higher leverage.

Multi-strategy funds offer quicker tactical asset allocation and a more favorable fee structure, handling netting risk at the strategy level, but come with higher manager-specific operational risks.

FoFs offer a potentially broader range of strategies but have less transparency and slower response times for tactical adjustments.

Both groups usually have similar initial lock-up and redemption periods, but multi-strategy funds often have investor-level or fund-level restrictions on maximum quarterly redemptions.

Leverage usage

Multi-strategy funds typically leverage higher than most FoFs, favoring conservative leverage usage. This increased leverage makes multi-strategy funds somewhat more susceptible to significant losses in extreme market conditions. However, their enhanced transparency in strategy management and quicker tactical response times contribute to multi-strategy funds’ overall resilience in safeguarding capital compared to FoFs.

Benchmarking

FoFs performance can be monitored through sub-indexes like HFRX and HFRI Fund of Funds Composite Indices, Lipper/TASS Fund-of-Funds Index, CISDM Fund-of-Funds Multi-Strategy Index, and the comprehensive Credit Suisse Hedge Fund Index.

Multi-strategy managers’ performance can be assessed using indices such as HFRX and HFRI Multi-Strategy Indices, Lipper/TASS Multi-Strategy Index, CISDM Multi-Strategy Index, and CS Multi-Strategy Hedge Fund Index.

Question

How does the use of leverage in multi-strategy funds compare to that in most FoFs, and how does it impact their resilience in extreme market conditions?

1. Multi-strategy funds employ lower leverage levels, making them less susceptible to significant losses.
2. Multi-strategy funds and FoFs use similar leverage levels, resulting in comparable resilience.
3. Multi-strategy funds use higher leverage levels, increasing their susceptibility to significant losses.

Solution

The correct answer is C.

It correctly states that multi-strategy funds use higher levels of leverage. As mentioned in the original statement, this increased leverage makes them more susceptible to significant losses in extreme market conditions.

A is incorrect. It suggests that multi-strategy funds employ lower leverage levels, which contradicts the information in the original statement.

B is incorrect. It implies that both multi-strategy funds and FoFs use similar leverage levels, which is not in line with the information provided in the statement.

Reading 38: Hedge Fund Strategies

LOS 38 (g) Discuss investment characteristics, strategy implementation, and role in a portfolio of multi-manager hedge fund strategies.