By |Published On: March 20th, 2013|Categories: Uncategorized|

Version 1 (Version for FoF GP owners)

The Value of Funds of Hedge Funds: Evidence from their Holdings

  • Adam Aiken, Chris Clifford, and Jesse Ellis
  • A version of the paper can be found here.

Abstract from Most Recent Paper (November 26, 2012):

We examine the value of Funds-of-Hedge-Funds (FoFs) using a hand-collected database of the funds’ hedge fund holdings. This holdings level data allows us to examine the determinants of hedge fund selection by FoFs, as well the ability to gauge the FoFs’ skill at hiring and firing managers. We find that FoFs hire hedge funds that are more difficult for individual investors to access, all else equal. FoFs hire larger, younger hedge funds with more restrictive share liquidity and higher minimum investments. Contrary to the previous literature, we do not find that FoFs perform worse than their single manager peers. Rather, we find evidence that a primary source of FoF value comes via skillful monitoring of their underlying hedge fund investments after the hire date. Specifically, we find that hedge funds that are held by FoFs are less likely to fail. The hazard rate for hedge funds held by FoFs is 57% lower than comparable hedge funds. Further, funds fired by FoFs are more likely to underperform and subsequently fail more often; indicating FoFs have skill in their firing decisions.

Version 2 (Version for Investors in FoFs)

Do Funds of Hedge Funds Add Value? Evidence from their Holdings

  • Adam Aiken, Chris Clifford, and Jesse Ellis
  • A version of the paper can be found here.

Abstract from Most Recent Paper (January 17, 2012):

We examine the value of fund of funds (FoFs) using a new database of the funds’ hedge fund holdings. This data allows a first ever look at the types of hedge funds that FoFs select, as well the ability to gauge the FoFs’ skill at hiring and firing hedge fund managers. We find that FoFs hire larger, younger, and more illiquid hedge funds that have positive past performance. FoFs select hedge funds with complementary contract features to their own (e.g., liquidity.) However, we are unable to detect skillful fund selection by FoFs. The hedge funds selected by FoFs significantly outperform their peers prior to being hired by a FoF. After they are hired however, these hedge funds perform no better than comparable funds. The lack of skill in hedge fund selection suggests FoFs add value through other channels. We find evidence that one of the primary sources of value added by FoFs comes via skillful monitoring of their underlying hedge fund investments. Specifically we find that hedge funds fired by FoFs subsequently perform significantly worse than other hedge funds. Additionally funds that are held by FoFs are less likely to fail. The hazard rate for hedge funds held by FoFs is 57% lower than other comparable hedge funds, and funds fired by FoFs have a 25% greater likelihood of failure than other funds.

Conclusions

  • FoF provide a monitoring service value (which isn’t trivial) and allow investors “access” to 2/20 fees (yipee!)
  • Unclear they can identify high future alpha producers.
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About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.

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Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).

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