Ch8 Funds of Hedge Funds

1. Introduction
1-1. FOFs
- diversification benefits
- attractive risk-return characteristics
- low correlations to traditional asset
- allows easier access to small & institutional investors
- rapidly grown, now compose greater than a quater of all hedge funds

1-2. Crucial Aspect of an increase in the flow of institutional assets into funds
- comprehensive risk monitoring, control, significant improvement in existing risk management practices, effective disclosure, and timely reporting
- risk monitoring tools are used: VaR, stress testing, scenario analysis, and other quantitative tools

1-3. Benefits
- retailing: pooling overcomes denomination limitation
- access: overcomes limitation of small number of investors. easier cash out
- diversification: pooling allows greater diversification
- expertise: in identifying good hedge funds and soliciting information
- due diligence process: follow up and monitoring

**less survivorship bias: a better indicator of aggregate performance of hedge funds

1-4. Drawbacks
- fee: management fee is above each hedge fund's fees
- performance: may not be better than particular hedge funds
- diversification is a double-edged sword: lower risk may mean lower expected return

1-5. Risks
- structural risks: derived from operations; potential for deterioration in a firm's reputation, poor information reporting systems, inadequate management oversight
- strategy risks: derived from investment strategy; market risk, credit risk, trading liquidity risk, funding liquidity risk, etc

2. Set-up & Value added of FOF
- designed to blend different hedge fund styles & spread the risks over a wide variety of funds
- target: 10~15% returns & 5~10% volatility
- more challenge to be consistent with returns

2-1. Factors affecting performance
- less direct impact of survivorship bias
- issues with classification and style drift
- new FOFs and old FOFs behave differently
- may be less useful in asset allocation

3. Portfolio Management Strategies
3-1. Three core building blocks underpinning the integrated investment process of FOFs
- strategy sector selection and allocation
- manager selection, evaluation and ongoing due diligence
- continuous manager monitoring and proactive risk management

3-2. Classification of hedge funds by diversification characteristics
- Return-enhancer: high return, high correlation with stock/bond portfolio; equity market-neutral, convertible bond arbitrage
- Risk-reducer: lower return, low correlation with stock/bond portfolio; merger arbitrage, distressed securities, long/short equity
- Total diversifier: high return, low correlation with stock/bond portfolio, global asset allocation
- Pure diversifier: low or negative return with high negative correlation with stock/bond portfolio; short seller

4. Style Risk & Diversification: Selection of Strategy Sectors
An important source of alpha in a FOFs portfolio depends on sector allocation and the right selection of strategies.
- sector allocation: achieve & maintain effective diversification and match the targeted risk/reward profile
- diversification: sector & strategy correlations across the different sources of return
- balance between a predetermined sector allocation and an opportunistic switching between strategies
- qualitative understanding of the key performance drivers, main strengths/weakness of the relevant strategy is needed to select the appropriate mix of strategies in a portfolio
- dynamic risk/return profile of the different strategy sectors & correlations between strategies needs to be actively monitored and reassessed.

** Historical Performance
- superior return performance relative to other traditional asset classes

- considerable variation in the risk and return among styles

- hedge fund strategies performance depends on the market conditions affecting that strategy

***Historical Data Biases
- self-selection bias
- instant history bias or backfill bias
- survivorship bias
- smothed pricing: infrequently traded assets
- option-like investment strategies: not normal distributed
- fee structure and gaming

5. Risks of FOFs Manager Selection: Due Diligence Process
5-1. Investment Process
- manager selection
- evaluation & ongoing due dilegence
- continuous risk monitoring

5-2. Business Model
- careful assessment & analysis of the business model used by a FOFs manager

5-3. Quality & Depth of Resources
- pay attention to the credentials, experience and the incentive used to attract and retain top industry talent by the FOFs manager
- due diligence questionnaire by AIMA(alternative investment management association)

6. Post-Investment Risk Management Process for Multi-Manager Portfolios
** Pillars underlying successful & profitable hedge fund inveting:
- astute strategy sector selection and allocation
- pragmatic manager due deligence
- proactive & systematic manager risk monitoring

7. Defining & Managing Hedge Fund Portfolio Risk
* 2003 KPMG Financial Advisory Service Report
- FOFs dominated hedge funds
- Most common investment styles were multi-strategy and short selling
- 55% of participants distributed FOFs across several jurisdiction
- FOFs' NAV were mostly reported on a monthly basis
- Most FOFs managers used both an in-house system and one of the most common risk management packages to monitor risks
- Concentration measures(71%), sensitivities(62%) & VaR(54%) were the most common risk management measures
- 56% of FOFs managers used software programs to price some of the FOFs investment

8. Issue of Transparency
- most significant challenges for the industry

9. Active Risk Management & Issue of Liquidity
-integral part of the dynamic portfolio management process
- portfolio risk management team needs to identify, evaluate and monitor exposure limits to individual sectors and managers
- FOFs managers need to monitor the underlying market, liquidity and credit risks using qualitative and quantitative risk management

**FOFs manager needs to monitor individual managers as regards whether leverage limits are exceeded, stop losses are triggered, any significant style drifts occurred, or credit/liquidity/event risks emerged