Frans A. De Roon, Jinqiang Guo and Jenke R. ter Horst
Available at http://ssrn.com/abstract=1571673
This paper investigates whether hedge fund of funds managers invest in single-strategy hedge funds in a random fashion. By examining the underlying single-strategy hedge funds from which a fund of funds can select, we find that single-strategy hedge funds added to the portfolio of funds of funds display some distinct characteristics:
(1) they tend to be larger in size, have longer operational history and are more likely to operate as offshore hedge funds; (2) they have higher incentive fees and are more likely to have a high watermark clause;
(3) they tend to have greater minimum initial investment requirements and a higher proportion of closed funds;
(4) their managers have more years of investment experience and
(5) they have a much higher risk-adjusted return or ex post alpha, a lower tracking error and a higher information ratio, in both the short run and long run. More importantly, a probit analysis of fund inclusion conforms the importance of several fund features and manager characteristics mentioned above, with the ex post alpha and the tracking error being the key factors to the inclusion decision.
In addition, there is a convex relation between the probability of fund inclusion and the minimum initial investment such that the probability increases with the minimum initial investment at a decreasing rate. Finally, the importance of those characteristics to the inclusion decision varies by fund styles.
Are the funds included in fund of funds systematically different from those not included? If fund of funds managers are adding value, they should be. This paper examines a large dataset of hedge fund data covering 15 years and concludes they are. While this doesn’t answer the question of whether fund of funds provide sufficient additional returns to justify the extra layer of fees, funds professionals and regulators will find this potentially useful in understanding fund of funds and for creating benchmarks for fund of funds performance.