By Penny Aitken
For some time now there has been a glaring spotlight trained on
the funds of funds (FoHF) industry. Such scrutiny is clearly
justified in the context of the recent financial crisis, during
which many financial institutions were found wanting. However,
there comes a point at which constructive criticism, with all
its stimulus for positive change, tips over into a destructive
force. As Disraeli put it: "How much easier it is to be
critical than to be correct." What start out as useful
observations can quickly snowball into a wave of negative
sentiment whose momentum can carry perception too far adrift
from the evidence.
In the midst of the critical maelstrom, the fact remains
that funds of funds have the longest experience in both fund
selection and portfolio optimisation. This is evidenced
publicly in their track records that often span decades across
different market regimes. This historic data is something that
is absent in many new entrants and advisory business models,
making it hard to assess their relative quality of decision
making over a similar period. As competition around cost and
type of intermediation grows, there also remains a question
that perhaps only time will answer: how low can you go before
cost pressures erode the quality and value of service being
It remains likely that there will always be a significant
cost to intermediation in a universe that is by default
heterogeneous and highly complex. These qualities remain
endemic to hedge funds in spite of regulatory attempts at
standardisation and transparency. It is a segment that is
constantly evolving both intellectually – in terms of
strategies and risk – as well as geographically in
terms of global scope and jurisdictional diversity. Current
shifts in regulatory frameworks may change the types or
location of these investment opportunities but they will not
disappear. This complexity is not just limited to strategy or
risk, but pervades the business models themselves.
Reviewing the statutory documents for a wide range of hedge
funds today suggests little has changed in the content and
terms post Madoff: the language remains as ambiguous,
inaccessible and opaque as ever, arguably even more so in
response to the litigious backlash after 2008 and increasing
regulatory pressures. Business risks have also escalated with
higher start-up costs, break-evens and on-going capital
commitments to meet growing compliance and regulatory
requirements. All of this complexity comes with a cost of
analysis and expertise. Funds of funds have the experience and
skills to meet these challenges, but perhaps they have been too
slow to seize new opportunities to streamline and adapt their
Today’s broader asset management industry is
undergoing a metamorphosis: historic frameworks are being
overhauled and the new investment landscape is still emerging
and evolving in response. In the face of such pressures coupled
with the need to address a critical audience the impetus for
change and adaptation has never been greater. Adversity breeds
strength and as Churchill stated: "Difficulties mastered are
So what opportunities can be harnessed by a beleaguered
funds of funds industry?
The biggest and most dynamic source of change is surely
driven by the technological revolution of the past decades.
This has fundamentally altered the way we access, store and
respond to information, as well as how we interact and consume.
It has had seismic effects on business that continue to ripple
across industries and geographies. So are funds of funds really
exploiting the true power of technological and computational
The global hedge fund data set has grown larger, longer and
broader as strategies have evolved and expanded geographically.
This rise in both numbers of funds and diversity in trading
approaches has been well documented, but this universe in
itself provides a vast richness in data and information both
for those that have survived as well as, just as importantly,
those that have failed. The level of transparency is also
increasing, driven partly by regulatory pressures, so this body
of information is expanding and deepening all the time. This
provides enormous potential for the deployment of statistical
tools and techniques to help manage and filter this information
more efficiently and effectively as long as the quality of the
data is consistent and the tools are robust and powerful
enough. This in itself is no easy task given the general lack
of uniformity in standard information available on funds such
as strategy labels or asset information. However with the right
planning, programming and structure it is possible to start
unlocking the information to yield valuable insights contained
across multiple market regimes and asset classes.
All this has the ability to empower a deeper, richer
understanding of the drivers of hedge fund returns as well as
the risks they exhibit over different economic environments. It
fosters individuality and creativity of thought by casting off
the shackles of industry-imposed constraints such as standard
classifications and enables the user to let the numbers speak
for themselves. It provides an extensive source of quality data
to observe patterns and test hypotheses on hedge funds. It also
holds the answers to the questions that continue to be
- Does alpha persist in hedge funds?
- How can you find and evidence it?
- Does it exist in small or large funds or in all
- What causes it to erode over time and what are the
observed risk factors?
- How do you blend this fund to manage associated
- How do you blend this alongside more convent-ional
sources of beta and manage systematic risks?
- How can you calibrate a hedge fund allocation for
investors with different objectives?
Technological advances have the potential to help unlock a
better understanding of hedge funds and the role they should
play based on statistically significant evidence rather than
supposition or short-term theories.
However, none of this would be possible if the computational
power to support and run more diverse and powerful statistical
models had not also made huge advances. While hedge funds
themselves have been quick to see the potential and have used
this to develop powerful broad market models, has this increase
in capability been exploited enough by funds of funds?
Not only does this computational progress have repercussions
for the range and complexity of analytical techniques to test,
develop and understand characteristics of hedge funds more
fully but it has implications for business models also.
Powerful systems not only provide the ability to innovate and
differentiate through research and development on selection and
portfolio optimisation techniques, but they also provide the
capability to create productivity efficiencies within teams. A
well designed and implemented infrastructure has scope,
longevity, adaptability and efficiencies of scale against which
pure human headcount cannot compete. It also creates a more
sustainable, objective asset value for a business, key for its
long-term success: a feature highly relevant in an industry
likely to see on-going consolidation and mergers.
Powerful and structured systems are also vital to the core
activities in investment: analysis leading to decision making
and execution. They create an objective, transparent, auditable
record of decisions and thought processes that enable learning
and improvement. Scientific progress continues to increase our
ability to understand our strengths but also our limitations.
Most key activities in funds of funds are governed by decisions
such as fund selection or portfolio sizing. So the question is
how good are we at these decisions and how are we measuring and
improving this ability over time? As advances continue to be
made into neurological studies we are learning more and more
about both our conscious and unconscious biases with much
ground still to cover. What we are finding out is that, as
Daniel Kahneman states:
"We’re generally overconfident in our opinions
and our impressions and judgements."
Or put another way:
"We don’t see very far in the future, we are
very focused on one idea at a time, one problem at a time, and
all these are incompatible with rationality as economic theory
This understanding has important ramifications not just for
markets but also for how FoHFs manage their internal processes.
It suggests a need to create systems that foster a more
transparent, scientific approach to decisions that maximises
the quality of human judgement based on relevant experience but
minimises sources of irrational behaviour or personal bias that
may be detrimental.
Technology also holds opportunities for funds of funds in
developing relationships with clients. Sophisticated and
powerful systems create a more stable long-term platform upon
which to undertake a range of fiduciary responsibilities,
enabling greater product innovation and activities as well as
efficiencies in reporting. They facilitate a more flexible base
from which to be able to listen and adapt to changing client
demands over time. They can also foster a better working
partnership by supplementing investors’ existing
expertise by tailoring the powerful statistical tools and
techniques to enhance the clarity of their understanding and
A business should never stand still, and never more so than
when the opportunity set around it offers up such a wealth of
Penny Aitken is partner and head of investment research
at FQS Capital, a global multi-asset manager with offices in
London and the US.