Finding the right medium

Is the fund of funds route less risky than direct investment? Roxane McMeeken presents the arguments. An allocation to hedge funds is fast becoming de rigueur for the average balanced portfolio. Erwin Bruner, chairman of BrunnerInvest in Zurich, says when it comes to investing in Europe and the US, he is currently advising high net worth clients to put 100 per cent of their assets in hedge funds. For Asia, the former UBS director recommends a hedge fund allocation closer to 50 per cent. His reasoning? “At the end of the day, it’s performance that counts.” With European hedge fund assets predicted to grow from E60bn today to E300bn by 2005, there is no doubt these products are here to stay. But the question remains – which channel should private clients use to invest? While direct investment is usually deemed suitable only for large institutions with considerable expertise, investing through the much-hyped fund of funds route might not be all it is cracked up to be. Keen advocate Charles Hopkinson-Woolley, director at Deutsche Bank London is a keen advocate of the fund of funds approach. A typical product would be Credit Agricole’s arbitrage fund of hedge funds, Green Way Arbitrage. Registered in Luxembourg, the product invests with several hedge funds employing low volatility strategies such as fixed income arbitrage, equity and risk arbitrage, index arbitrage and market neutral equities. Major Hopkinson-Woolley argues that hedge fund strategies are difficult to understand and it is therefore best to leave it to experts – in the form of fund of fund managers – to select and monitor hedge fund managers. In addition, there are a huge number of hedge fund firms spread throughout the world and many only grant access to investors they know well. Thus, fund manager sourcing and relationship-building is a full-time job that is also best left to experts. “You need the headcount to be out on the road seeing managers and going to conferences. You need to be plugged into the industry,” believes the major. Lastly, if you leave it up to a fund of fund manager to select your hedge funds “you have someone to fire if goes wrong”. But these are arguments we have all heard before. More intriguing is the admission from Chris Woods, UK chief investment officer at State Street Global Advisors, that funds of hedge funds are not without potential problems. Despite being a fan of the products, he says many fund of hedge funds make promises that they fail to deliver. “Some fund of fund managers are better than others at monitoring, knowledge of the market, access to hedge funds and portfolio construction,” he argues. As a consequence, some are better than others when it comes to both performance and value for money. He says researching hedge fund managers can be cheaper than many fund of fund managers make out. Many of them simply buy a database. Another problem is potential conflicts of interest built in to the fund of hedge funds concept. “If you drop an underperforming hedge fund from the portfolio, will you get access to the next product launched by the same manager?” asks Dr Woods. A further issue is whether the diversification achieved through funds of hedge funds is desirable. If there are too many funds in the overall product this can decrease the influence of the best performers, he says. Mr Brunner at BrunnerInvest agrees. He says that a fund of funds is like a football team – it should be limited to around 11 funds. Two or three will be the real performing stars – the Zinedine Zidane or the Thierry Henry – and the rest will just help the team along. Heavy diversification can also increase the systemic risk, warns Dr Woods. While it decreases idiosyncratic risk, it intensifies the exposure to market-wide trends. High price Finally, there is the price of investing in funds of hedge funds, which is frequently deemed too high, especially for smaller investors. So perhaps it is time to give direct investment in hedge funds a second look. Simon Hopkins, founder of hedge fund research firm Global Fund Analysis, tipped a new entrant on the market: the Lumen Global Value Fund. Under the management of Simon Nocera, a former IMF economist and money manager at Soros Fund Management, the long/short fund is targeting returns of 18 per cent. It will exploit price inefficiencies in emerging market debt, equities and currencies.