Five Questions for Your Fund-of-Funds Manager

MARCH 16, 2009

Barron's Jack Willoughby today posted an article entitled "Five Questions for Your Fund-of-Funds Manager."

This is very similar to a research piece released by Corgentum Consulting which was covered on SeekingAlpha and Conde Nast Portolio,which focused on 10 questions to ask your fund of hedge funds manager. In his article Mr. Willoughby makes the argument that the fund of hedge funds industry is on ever increasingly shaky ground. He cites an interesting statistic from Hedge Fund Research, Inc. that almost 100 fund-of-funds disappeared in 2008. He further explains that fund of hedge funds AUM dropped by 26% to $593 billion from $800 billion.

Mr. Willoughby cites a quote from Yale's endowment manager, David Swensen, which exemplifies some of the market frustration with the economics of the fund of funds industry. He called fund-of-funds a "cancer on the institutional-investor world."

Turning to the 5 questions outlined in the article, the first one advises to ask about the service providers including the custodian, prime broker, trading adviser, lawyer and accountant of the fund-of-funds under consideration and its subsidiaries.

The advice provided by the article is that, "if the same names keep turning up across these services, become extra-cautious." Taken at face value, this advice is counter to what takes place in practice, but is important taken in the context of portfolio construction.

To put a finer point on this, let us illustrate by example. Assume an investor is building a portfolio of five different fund of hedge funds and vets 25 fund of hedge funds as part of this process. Let's further assume that out of these 25 fund of funds, 20 of them use the same big four accounting firm. Following the logic of the Barron's article, I am now supposed to be extra-cautious.

What does this mean exactly? Should I, as our hypothetical investor, not allocate to these 20 fund of hedge funds? Should I reduce my overall allocation to those funds that all use this same big four accounting firm?

In the context of due diligence, from a counterparty and reputational risk perspective, it is expected that a big four audit firm would be used. If not, that would generally raise more eyebrows in a due diligence perspective than not.

Said another way, in practice when performing due diligence on a fund of hedge funds you should be more cautious for exceptions to the norm (i.e. - auditors which no one else uses) than the norm (i.e. - auditors which everyone is using). This of course does not imply that the big 4 auditors know what they are doing and of course each audit engagement is different, but in practice there is likely more commonality among service providers than the advice provided by Barron's suggests.

From a portfolio allocation standpoint, investor's would typically aim for diversity of service providers, but this is to minimize the contagion effects of overall counterparty risk of an investor's portfolio of fund of hedge funds, rather than on the individual fund of hedge funds level.

The third question which the article advises that investors should "feel comfortable" with the fund-of-hedge-fund's due diligence process. This is an interesting proposition. Clearly, many investors regret having felt "comfortable" enough with the host of "feeder" funds which put them into Bernard Madoff such as Maxam Capital Management (which was totally wiped out by Madoff). Incidentally Maxam was founded by Sandra Manzke who before Maxam's Madoff losses had created a Hedge Fund Investor United Forum to rally against hedge funds who had imposed gates. She has since abandoned the venture.

Certainly the minimum standard for due diligence to make people "feel comfortable" is a moving target which is still unsettled.

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