Fund selection, style allocation, and active management abilities: Evidence from funds of hedge funds’ holdings

• DOI: http://doi.org/10.1111/fima.12258
• Date: 01 March 2020
• Author: Chao Gao,Timothy D. Haight,Chengdong Yin
• Published date: 01 March 2020

DOI: 10.1111/fima.12258

ORIGINAL ARTICLE

Fund selection, style allocation, and active

management abilities: Evidence from funds

of hedge funds’ holdings

Chao Gao1Timothy D. Haight2Chengdong Yin1,3

1KrannertSchool of Management, Purdue

University, WestLafayette, Indiana

2College of Business Administration,Loyola

Marymount University, LosAngeles, California

3China Financial PolicyResearch Center, Renmin

University of China, Beijing, China

Correspondence

ChengdongYin, Krannert School of Management,

PurdueUniversity, West Lafayette,IN.

Email:yin80@purdue.edu

Abstract

This study examines whether funds of hedge funds (FOHFs) provide

superior before-fee performance through managers’ fund selection,

style allocation, and active management abilities. Using reported

holdings of Securities and ExchangeCommission–registered FOHFs,

we find that FOHF managers have fund selection abilities, as hedge

funds held by FOHFs outperform their style indices and over half of

the individual hedge funds in the Lipper Trading Advisor Selection

System(TASS) database. We also find that FOHF managers add value

through active management of FOHFs’ holdings, while evidence on

their style allocation abilities is mixed. Our findings suggest that

FOHFs generate superior before-fee performance and that FOHF

managers’ skillset is broader than previously documented. Thus, our

studyhelps explain why FOHFs continue to survive and suggests that

FOHF fee structure reform merits consideration.

The Securities and Exchange Commission (SEC) defines a fund of hedge funds (FOHF) as a hedge fund that utilizes a

multimanager,multistrategy approach by investing all or a significant portion of its assets in hedge funds.1FOHFs offer

several benefits to hedge fund investors. First, they lower investors’due diligence and fund selection costs. Second,

they facilitate access to individual hedge funds by allowing investors to bypassindividual funds’ minimum investment

requirements and by providing access to funds that are otherwise closed to new investors.Third, they provide diversi-

fication against risks associated with individual hedge funds. These benefits helped to attract substantial capital to the

FOHF industry in the years preceding the most recent financial crisis, as total assets under management (AUM)in the

FOHF industry ballooned from $108.75 billion in 2000 to $1.2 trillion in 2007 according to Barclay Hedge.2

Nevertheless, a notable drawback to investingin FOHFs is their double-layered fee structure, where investors pay

both the fees charged by the FOHF and the fees charged by the individual hedge funds held by the FOHF. Using

reported returns in commercial databases, prior research shows that FOHFs provide lower returns than individual

c

2018 Financial Management Association International

1See“Implications of the Growth of Hedge Funds” (https://www.sec.gov/news/studies/hedgefunds0903.pdf)for more details.

2https://www.barclayhedge.com/research/indices/ghs/mum/HF_Money_Under_Management.html.

Financial Management. 2020;49:135–159. wileyonlinelibrary.com/journal/fima 135

136 GAO ETAL.

hedge funds on an after-fee basis and that FOHFs’ additional layer of fees contributes to lower returns (Amin & Kat,

2003; Brown, Goetzmann, & Liang, 2004; Liang, 2004).3Practitioners often deride FOHFs for their lackluster perfor-

mance and double-layeredfee structure and cite these factors as drivers of large-scale FOHF share redemptions in the

aftermath of the financial crisis.4Indeed, many large institutions are increasingly making direct investments in indi-

vidual hedge funds to bypass FOHF fees, and there is some evidence that large institutions’ direct investments are

outperforming their FOHF investments on an after-fee basis (Agarwal, Nanda, & Ray,2013).

Given the performance drag imposed by FOHFs’ additional layer of fees, pertinent questions arise as to whether

and how FOHF managers add value beforefees. To date, evidence on this point is scarce because commercial databases

do not provide holding-level data that would allow researchers to disentangle FOHF's additional layer of fees from

FOHF-level performance. Current literature only shows that FOHF managers add value through their monitoring

abilities, which help reduce investors’ exposure to downside risk (Aiken, Clifford, & Ellis, 2015). Whether FOHF man-

agers also have “upside” skills that facilitate superior performance before fees is unclear but is nevertheless impor-

tant to understanding the merits of FOHFs as investment vehicles. On the one hand, a lack of upside skills, combined

with FOHFs’ additional layer of fees, may drive investors away from FOHFs evenwhen they value FOHFs’ monitor-

ing and other benefits. On the other hand, if FOHF managers possess upside skills to go along with FOHFs’ down-

side protections, then FOHFs are likely to add significant value before fees, which would suggest that FOHFs’

additional layer of fees is largely to blame for FOHF underperformance. Thus, examiningFOHF managers’ upside con-

tributions would also be informative to debates on the merits of fee structure reform, which has been pushed hard in

recent years by investorsin individual hedge funds and has led many funds to lower fees and add flexibility to their fee

arrangements.5

In this study, we use a hand-collected set of holding-level data to investigatewhether FOHF managers add value

through their fund selection, style allocation, and active management abilities. Fund selection abilities refer to select-

ing individual funds that can deliver superior performance. Style allocation abilities refer to allocating capital based on

the performance of different investment styles. Active management abilities refer to directing capital flows of existing

holdings (i.e., additional purchases or partial redemptions of existing holdings) to maximize portfolio performance. We

obtain holding-level data for the years 2004 through 2015 from the quarterly filings of FOHFs that register with the

SEC, as these filings require FOHFs to report detailed information on their holdings.6Holding-level data provide key

advantages for addressing our research question. One advantage is that they allow us greater flexibility in examin-

ing the different channels (i.e., fund selection, style allocation, and active management) through which managers add

value for investors,as FOHF-level performance obscures the contributions of individual holdings.7Another advantage

is that we can measure before-fee performance with greater accuracy relative to approaches that add back fees to

FOHF-level returns. The “addback” approaches are likely to provide less accurate performance measures because we

do not know the high-water marks of different investors from commercial databases.

3Notethat there is debate about whether FOHFs “deserve” their fees. For example, Ang, Rhodes-Kropf,and Zhao (2008) argue that prior studies’ use of hedge

fund returns from commercial databases are inappropriate for benchmarking FOHF performance, as commercially availablehedge funds do not capture the

availableset of hedge fund investments an investor can achieve on his or her own without recourse to FOHFs.

4See Julie Steinberg, “Funds of Hedge Funds Come with Heaps of Fees,” Wall Street Journal, December 4, 2013 (https://www.wsj.com/

articles/funds-of-hedge-funds-come-with-heaps-of-fees-1386176762?tesla=y), and Carleton English, “Investors Say Stop Paying‘Funds of Hedge Funds,’”

NewYork Post, July 18, 2016 (http://nypost.com/2016/07/18/investors-say-stop-paying-funds-of-hedge-funds/),among others.

5See Jeff Cox,“Hedge Fund Fees Are Falling as Shutdowns Hit a Post-Crisis High,” CNBC, March 17, 2017 (https://www.cnbc.com/2017/03/17/hedge-fund-

fees-falling-as-shutdowns-hit-a-post-crisis-high.html); “Survey: Three Quarters of Hedge Funds Willing to Cut Fees,”Institutional Investor, March 21, 2017

(http://www.institutionalinvestor.com/article/3671205/investors-pensions/survey-three-quarters-of-hedge-funds-willing-to-cut-fees.html); Alicia McEl-

haney,“No 2-and-20? No Problem,” Institutional Investor, August 25, 2017 (http://www.institutionalinvestor.com/article/3745818/asset-management-hedge-

funds-and-alternatives/no-2-and-20-no-problem.html),among others.

6Overthe past decade, many FOHFs voluntarily registered with the SEC as investment companies under the Investment Company Act of 1940. The primary

incentive for an FOHF to register with the SEC is to bypass legal restrictions that unregistered FOHFs face when they raisecapital (e.g., restrictionsonthe

typeand quantity of investors that can contribute capital). See Aiken, Clifford, and Ellis (2015), among others, for a discussion.

7The skills FOHF managers employ to add value are likely to differ from those of individual hedge fund managers in that theypertain to the selection and

managementof hedge funds rather than individual securities.