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.