THE FUND OF FUNDS IS A TOUGH CUSTOMER :Business Strategy /Financial Advisors

The conference itself was hard, grinding work. No afternoon golf or
tennis. I bugged out on parts of our investor meetings because Madhav
is much better at selling Traxis and himself than I am.The representatives
of the funds of funds are the most rigorous examiners. It’s
estimated that there are now almost 1,000 funds of funds, and as a
group they are the biggest buyers of hedge funds but also the most
fickle.After they have intensely probed and poked you, some will stick
with you even if you falter; others will dump you at the first sign of a
drawdown (a decline in your net asset value). As I said before, the Eu-
ropeans supposedly are the worst but the truth is everyone in this
business is performance happy. Considering the fees they are paying,
why shouldn’t they be?

A fund of funds typically selects and manages a diversified portfolio
of hedge funds that it sells to individuals or institutions that don’t feel
capable of making the choices and then monitoring the funds themselves.
They run all kinds of analytics on the individual hedge funds and
on their overall portfolio to monitor risk and exposures.A couple of years
ago, LTCM, a big hedge fund run by a bunch of pointy-headed Nobel
Prize economists, blew up when a series of three standard-deviation
events occurred simultaneously. The media loved it and published the
names of all the supposedly smart, sophisticated individuals and institutions
who had lost their money. Everybody was deeply embarrassed,
and ever since the big institutions have been obsessed with risk analytics
and throw around terms like stress-testing portfolios, value at risk (VAR),
and Sharpe ratios.

The funds of funds employ sophisticated quantitative analytics to
add value by strategically allocating among the different hedge-fund
classes.The hedge-fund universe is usually broken down into seven broad
investment style classifications.These are event driven, fixed-income arbitrage,
global convertible bond arbitrage, equity market-neutral,
long/short equity, global macro, and commodity trading funds. Each has
its own, unique performance cycle. One year a fund of funds will be
heavy in macro and long/short equity funds and be out of or have very
little in equity market neutral and convertible arbitrage. The next year
the allocation will be completely different. Getting these style shifts
right can make a substantial difference in the performance of an individual
fund of funds.

The funds of funds also claim they have developed programs that
combine sociological and statistical data to give early warning signals so
they can time switches from one manager to another.There is no question
that hedge-fund managers can run out of emotional gas.They are
prone to performance bursts when they are hot, often followed by cold
spells, but these swings are not easy to time. However, as one veteran
fund of funds manager said to me,“Actually, that quantitative stuff is all
window dressing BS.What we do is similar to being the manager of a
major league baseball team. The trick is to have the intuition to take
your pitcher out of the game just before, not after, he’s been hit hard.”