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The Strength of Multi-Strat Is No Mystery

alphasearchA midyear survey by Credit Suisse Capital Services says that most institutional investors plan either to increase or to maintain their level of hedge fund investment through the second half of the year, 2015.

That was the headline finding of the study. Two things that caught my own eye, though, were another point from the survey, and the commentary thereon. First, the CSCS survey says that appetite has increased of late in particular for multistrategy funds. Second, in the release that accompanied the findings, the global head of capital services, Robert Leonard, described this preference as reflecting a “reaction to the fast-changing investment environment we are experiencing at this time.”

That sounds anodyne and uninformative. A more substantive guess might be that the increasing interest in multi-strategy funds reflects the continued decline of the old-fashioned Funds of Funds. A single multi-strat fund looks like a way of getting the diversification benefits of FoFs, without the extra level of fees.

A More Substantive Guess

Some well-known numbers from the HFRI indicated four years ago that the historical performance of FOHFs is well below that of a composite of hedge funds for the 21 years before that. The HFOFs returned an annualized rate of 7.5% over that period, versus the HF composite of 11%.

Yes, the composite was somewhat riskier (volatility of 7% in contrast to HFOF volatility of 6%), but that seems a large loss of actual performance for the tranquility gained.

Yes, again, some pundits including those at the NEPC have defended the FOF industry against what it sees as the unfair implication of the HFRI findings. But the nature of its defense highlights the problem. The NEPC said that “the green line” on the HFRI chart “is dragged down by the second layer of fees charged by FOHFs whereas the blue line reflects only the fees from the underlying hedge funds.” With such defenders, one hardly needs critics. Why invest in that second layer of fees only to console one ’s self when one’s results are “dragged down” thereby?

Adding to the notion that the increased appetite in multistrategy funds is no mystery: a recent study by Adam Aiken of Connecticut’s Quinnipiac University and associates found what they authors describe as “only limited evidence that FoFs exhibit skill when selecting hedge funds.”

Thoughts on Diversification Among Managers

Yes, for a third time, I know what you’re saying. “There’s a difference between diversifying among managers on the one hand, and diversifying among strategies on the other.” True. And both sorts of diversification are valuable, as Alpha Male observed here four and a half years ago.

But the value of diversifying on managers is that it keeps an investor from becoming too dependent on crooks: that is, it does the work of due diligence. Surely, it would have been better to have a smaller percentage of one’s portfolio invested with Bernard Madoff than a larger proportion. Diversification might have achieved that, for some. But it would have been even better to have done the due diligence that would have kept one’s portfolio entirely separate from his, like two non-intersecting circles in a Venn diagram.

A Concluding Madoff Meditation

Surely that due diligence was possible, in foresight rather than in useless hindsight. Michael Ocrant pointed out the pertinent red flags in Madoffs reported results as early as May 2001. So: if multi-manager diversification does the work of due diligence, why not focus on multi-strategy diversification, let due diligence do the work of due diligence, save on fees and increase one’s liquidity?

Some historical perspective: after the crises of 2007-08, a good deal of talk sprang up about whether funds of funds were through as a business model. R. McFall Lamm Jr. for example wrote of the “withering” of that business, and added that “due diligence,” long the strong point of the model, was itself becoming commoditized, adding to the sense of wither, or at least a sense of wintry weather.

The UCITS framework in Europe, and the branding value it provides, has ridden to the defense of the FoHF model globally and has perhaps put a floor beneath it. Still …