S&P highlights diversification benefits of funds of hedge funds

Standard & Poor’s Fund Services has warned about some of the risks of direct investment in hedge funds, thrown into sharp relief by the collapse of multi-strategy hedge fund Amaranth Advisors last September.

“Perhaps the most critical lesson coming from the Amaranth debacle is the importance of diversification – not only by strategy but also by manager,” said fund analyst Randal Goldsmith. He cautioned investors who might try to save costs by investing in a multi-strategy hedge fund rather than a FoHF, noting that this does not provide manager diversification and the range of strategies is limited by the manager’s skill set.

“The value of manager and strategy diversification was well illustrated last year,” said Goldsmith, pointing out that the S& P-rated FoHFs that had exposure to Amaranth all made money during 2006 and all but one of them actually made a higher return than in 2005. All these funds have tightened their investment processes in the wake of the collapse. For example, both Ermitage and Benchmark have taken action to increase portfolio diversification, respectively imposing a 5% ceiling per individual holding and a 10% ceiling per theme and region.

Goldsmith also warned investors that there is a lot more specific risk in a hedge fund than is widely appreciated. This can be partly because of incentive fees, allowing managers to benefit significantly if an investment works out well but without sharing in losses when things go wrong. “Managers benefit from volatility to an extent that investors do not,” he said. “This is a potential conflict of interest. However, FoHFs try to limit this by ensuring that the managers with whom they invest also invest in the funds they manage.”

FoHFs generally have similar incentive structures to the hedge funds they invest in. “We would have liked to see some review of this asymmetric fee structure post Amaranth but have been disappointed so far,” said Goldsmith. However, he pointed approvingly to the fee structure at S& P A-rated Absolute Fund Managers, because it has both a hurdle rate and a cap. The managers take a 15% share of returns over 6% but up to a maximum return of 24%. This gives the managers an incentive to back their convictions, but the 24% cap means that they could not gain significantly from betting the house.