Are Funds of Funds Simply Multi-Strategy Managers with Extra Fees?

Posted: 6 Jun 2008

See all articles by Girish Reddy

Girish Reddy

Prisma Capital Partners

Peter Brady

affiliation not provided to SSRN

Kartik Patel

Prisma Capital Partners

Abstract

In this paper, we compare two approaches that many institutions consider when investing in hedge funds: multi-strategy hedge funds and funds of hedge funds. Because it is difficult to directly compare performance for these two strategies at the index level due to data limitations, we use the TASS database to analyze a number of underlying drivers of risk and return. We begin by comparing hedge fund returns to the returns of traditional asset classes in order to understand the potential contribution from strategy allocation and manager selection. Unlike traditional asset classes, due to the relatively high dispersion of manager performance within a given hedge fund strategy and the relatively low dispersion of performance between strategies, we find that manager selection dominates strategy allocation for hedge funds. We estimate that the ability to rapidly move capital between strategies can potentially add 200 basis points per annum to the performance of multi-strategy managers. Funds of hedge funds have the potential to add approximately 300-700 basis points per annum to performance by picking 40th percentile and 30th percentile managers respectively. We also find that due to relatively low correlation between hedge fund managers within a particular strategy, the benefits of manager diversification for funds of funds are quite significant. A randomly created four-manager portfolio has a significantly higher Sharpe and Sortino ratio compared to the average single manager.

Finally, we discuss some of the differences between the business models of multi-strategy managers and funds of funds and the potential impact for investors.

Keywords: Fund of hedge funds, multi-strategy funds, manager selection

JEL Classification: O16, C15

Suggested Citation

Reddy, Girish and Brady, Peter and Patel, Kartik, Are Funds of Funds Simply Multi-Strategy Managers with Extra Fees?. Journal of Alternative Investments, Vol. 10, No. 3, 2007, Available at SSRN: https://ssrn.com/abstract=1140824

Girish Reddy

Prisma Capital Partners ( email )

208 Plaza Ten
Jersey City, NJ 07311
United States

Peter Brady

affiliation not provided to SSRN ( email )

Kartik Patel (Contact Author)

Prisma Capital Partners ( email )

208 Plaza Ten
Jersey City, NJ 07311
United States

HOME PAGE: http://www.prismapartners.com/

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