© 2005 Will Goetzmann and Ming Fang
In March of 2005, Tom Griggs was considering
adding a new product to the Cherry Partners’ lineup of investment
products. As the CEO of Cherry Partners, a hedge fund company located in
The goal of Orchard is to make a well-diversified portfolio of hedge funds across at least four major hedge fund styles, using only managers below $2 billion. The Orchard approach to selecting fund managers is to identify the “best in class” for each style of manager, then narrow these down to a handful of real stars with quantitative tools. Orchard would place money with them for at least a two year commitment. As an intermediary, it would provide on-going due diligence, including on-site visits, third-party credit reviews, calls to other clients and other investigation necessary to control operational risk. The fund could lever itself to achieve return targets, however the volatility goal is a maximum of 12% annualized standard deviation. The stated objectives of the proposed fund of hedge funds are as follows:
· To achieve consistent absolute returns in most market environments.
· To achieve a return exceeding S&P 500 over a market cycle.
To maintain a low correlation with the
However there were also several issues need to be concerned for proceeding cautiously.
The Background: Funds of Funds
Funds of funds are an increasingly popular avenue for hedge fund investment. Despite the increasing interest in hedge funds as an alternative asset class however, the high degree of fund-specific risk and the lack of transparency may give fiduciaries pause. In addition, many of the most attractive hedge funds are closed to new investment. Funds of funds resolve these issues by providing investors with diversification across manager styles and professional oversight of fund operations that can provide the necessary degree of due diligence. In addition, many such funds hold shares in hedge funds otherwise closed to new investment allowing smaller investors’ access to the most sought-after managers.
The diversification, oversight and access come at the cost of a multiplication of the fees paid by the investor. In addition to the fees charged by the FOF, they effectively pass on to the investor all fees charged by the constituent funds, since, in most cases, they report their raw returns after all of the underlying manager fees are paid. One would expect that the informational advantage of funds of funds would more than compensate investors for these fees. However, it could also be the case that individual hedge funds dominate fund of funds on an after-fee return or Sharpe ratio basis.
The Building Blocks: Hedge Funds
Hedge funds are only lightly regulated in the current environment, although major funds register as broker-dealers and retain top auditing firms. Funds vary tremendously by the type of securities they traded and by the amount risk they assumed. They also vary considerably in terms of their fundamental investment characteristics. Unlike registered investment companies, hedge funds are not required (indeed by most legal interpretations not allowed) to publicly disclose performance and holdings information that might be construed as solicitation materials. In addition, little public information exists about fund operations and their holdings and investment strategies are typically undisclosed for strategic reasons. Although some research institutions have surveys to classify hedge funds into different category based on their self-reported investment characteristics, there is no guarantee that these hedge fund characteristics are constant over the period of observations. Indeed, there is every reason to believe that these self-reported classifications vary as managers define themselves relative to favorable benchmarks.
Tom would like to know (i) whether there exist some distinct management styles among all hedge funds; (ii) whether these styles match their self-reported classification; (iii) whether these styles explain difference in performance; (iv) and whether there are any trends in these styles that investors and analysts should know about.
As the April meeting of Cherry Partners approaches, Tom is preparing a recommendation report on Orchard. His report will include a discussion of the expected risk adjusted rates of return for the fund, and a consideration of whether the performance is “repeatable,” i.e. will it be possible to pick future winners based on past performance. Tom’s report will also address the question of fees. He argues that the disappointing after-fee performance of some fund of funds might be explained by the nature of the fee arrangement, and there are some opportunities for FOF providers who can in fact absorb underlying hedge fund fees in return for a management fee/incentive fee charged at the level of the FOF. He thought this could make their fund a potential market leader. A typical FOF fee structure is ½ percent plus 3% incentive fee on post-fee performance of the underlying portfolio. He thought they might be able to do better by offering a higher incentive fee but charge it instead on the pre-fee performance of the managers.
Using the historical information of hedge funds in PerTrack database, prepare Tom’s report, put together of plan for Orchard by selecting some managers, and some portfolio weights. To begin with, assume a standard ½% and 3% fee structure.
Please address the following additional concerns:
· Do the funds in your portfolio represent different investment styles?
· Does Orchard meet you investment goals?
· What are the arguments for and against leverage?
· Does Orchard co-move with other major asset classes?
· How will you deal with investment withdrawals?