Your qualified clients want to get the benefits of hedging strategies. But where do you start? Nobody reports on the 6,000 or so hedge funds the way Morningstar and Lipper report on mutual funds. So, many retail brokers turn to funds of funds to give their clients some of the hedging strategies that big investors have while spreading the risk over a number of funds.

Still, brokers must sort through a universe of more than 400 funds of funds. Most people will think to probe a fund's performance and the quality of research staff and managers. But brokers should also pay particular attention to fund size, clarity of investment goals, research process, ownership and fees.

Fund Size

As a rule, large size is an enemy of performance. We reviewed funds of hedge funds from January 1994 through August 2001 for which we had monthly information. We divided the population into two groups: those larger than $500 million in assets and those smaller than $500 million. We examined the average performance of both groups on a rolling 12-month basis and compared the average monthly results.

We found that the smaller funds produced 17 basis points more return on average per month than the larger funds. The difference annualizes out to an extra 2 percentage points per year for the smaller funds.

Clarity of investment goals and strategic approach

Many funds of funds have been developed almost haphazardly to tap the demand for hedge-fund investing. Some fund operators simply amass a hodgepodge of managers without an understanding of how each contributes to a well-defined goal. To boot, loose definition invites a fund to shift character over time, possibly disrupting the fund's role in an investor's portfolio.

Funds of funds ought, therefore, to have an explicitly mandated goal. They should also have a clear plan for achieving the goal. A plan might, for example, detail the sub-manager strategies that will be sought for a given fund and how they will be combined.

Research process

Does the manager of managers have a sound research process? A research process should go well beyond merely meeting with the managers and talking to them regularly. Often, such meetings amount to uncritical reviews of a manager's sales pitch or recent market activity. Instead, a systematic method for comparing a manager to peers in the same strategy helps the fund of funds manager to avoid complacency.

Research should also extend well beyond analysis of a fund's performance record. The standards appropriate to selection of traditional money managers are often not appropriate in application to the non-traditional universe. A traditional manager's performance usually can be measured by known benchmarks. Such tools are not yet available for hedge funds, although efforts are under way to create them.

Brokers may feel hard pressed to evaluate a fund of funds' research. But as a prospective investor, a broker can ask to look at samples of research or participate in the occasional research meeting. At a minimum, investors need some assurance that such research and meetings exist. It also pays to determine whether the individuals involved in the research effort are distracted with many other duties.

Ownership

Large institutions see a marketing opportunity in the investing public's demand for alternative strategies, and are creating their own funds of funds. Often such ownership compromises the fund of funds' ability to run an objective portfolio. The pressure, explicit or implicit, to accommodate or use the parent firm's hedge-fund products can be irresistible. Investment firms with prime brokerage operations, for example, may be tempted to use — primarily or exclusively — prime brokerage clients. Some firms with fund of funds operations also own hedge funds. A firm that invests with funds it owns may find objective comparisons with competing managers impossible. It may also find firing the captive fund difficult. Some hedge fund of funds operations find, upon their acquisition, that the corporate emphasis shifts from research and management to sales.

Fees

One of the most common criticisms of funds of funds is that they layer fees on the already high fees of the hedge funds in which they invest. There are no widely accepted standards in the industry, but a review of over 300 funds of funds revealed an average management fee of 1.5 percent and an incentive allocation of 8 percent. Some funds of funds include the underlying manager fees in their own, and slightly more than half of the funds that charge incentive fees charge them only after a hurdle return is met.

What's reasonable? Alternative managers do face some problems that traditional managers do not. They cannot pursue business in traditional ways (advertising is forbidden). Generally, they must generate fees on smaller bases of assets than do traditional managers. Alternative investing frequently remains complicated and obscure. Hedge funds generally are stingy with the information they provide to the public. In fact, one reason the industry lives with the advertising ban is to escape regulations. Many funds provide spotty reporting even to their own clients. So, brokers who want to help their clients use alternate-investing strategies would do well to shop carefully for a fund of funds manager who can pierce the darkness.

Writer's BIO:
Brian C. Ziv is managing partner of Guidance Capital.