It was Benjamin Franklin who said, An investment in knowledge pays the best interest. For anyone considering an alternate investment strategy, this tidbit of wisdom is particularly relevant.

In the previous Fiduciary Focus , we looked at hedge fund-of-funds and examined some of the characteristics that differentiate these investment vehicles from more traditional assets in the investing universe. In this second article of the series, we will evaluate the success fund-of-funds managers have had in delivering superior performance, risk reduction and diversification characteristics.

Fund of Funds. Mixes and matches hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk and volatility can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration. Volatility depends on the mix and ratio of strategies employed. Hedge Fund Association

Why Hedge Fund-of-Funds?

For purposes of analyzing the broad hedge fund universe, we have selected the HFRI Fund-of-Funds Composite Index. This index is a broad market measure that contains the performance of more than 500 hedge fund-of-funds.

In aggregate, these fund-of-funds invest in several thousand individual strategies, providing a diversified measure of the industry and eliminating some of the bias that is present in other hedge fund indexes. (See Hedge Funds: Six Important Considerations Before Investing for more detail on the bias found in hedge fund performance.) A hedge fund-of-funds index is generally the most relevant for nonprofit investors, as many initiate an allocation to hedge funds using a fund-of-funds approach.

Objective One: Superior Performance

Whether it is John Paulson generating nearly $15 billion for investors during the collapse of the housing market or George Soros averaging a 20% annual return over a 40-year period ending in 2011, the hedge fund titans have captured the imaginations of the investing public. The media often focuses on success stories, leading many investors to hedge funds in pursuit of similar exceptional returns. In fact, a recent study found that 15% of those who invest in hedge funds state increased portfolio returns as their primary objective. Unfortunately, most managers are unable to exceed a broad market benchmark, let alone provide returns far and above those of the equity markets. Figure 1 shows the performance of the HFRI Fund-of-Funds Composite Index relative to a traditional 60/40 market portfolio over the three-year, five-year, 10-year and 15-year periods ending Dec. 31, 2013.

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It is important to note that while the performance of the market portfolio has been superior in the more recent time periods, the outperformance begins to fade over the 15-year time period and beyond. This can likely be attributed to the increase in the number of managers as well as changes in the regulatory environment. Increased competition in the space, increased transparency and a decline in available leverage within funds over the last decade have made it ever more difficult for fund managers to add value.

Objective Two: Risk Reduction

Another popular reason for carving out an allocation to hedge fund-of-funds is to improve the overall risk-return profile of the investment portfolio. Many fund managers strive to achieve steady investment returns with low volatility, resulting in an investment that produces lower returns than the equity markets but provides a greater amount of return per unit of risk assumed. One popular method of measuring the risk-return profile of an investment portfolio is through the Sharpe ratio. The Sharpe ratio is simply the amount of return (more technically, the amount of return in excess of some risk-free asset, typically short term U.S. Treasury securities) over a given time period divided by the volatility of the investment over the same time period. A higher Sharpe ratio is considered more attractive, as a higher figure indicates more return provided for a given level of risk.

The Sharpe ratio of the 60/40 portfolio discussed in Figure 1 compared to a portfolio that includes a 20% allocation to hedge fund-of-funds as measured by the HFRI Fund-of-Funds Composite Index, can be seen in Figure 2. The weightings of the market portfolio with the hedge fund-of-funds allocations are based on a 2013 study by the National Association of College and University Business Officers (NACUBO). The results of which found that the allocations to equities, fixed income and alternatives in university endowments between $1 million and $100 million averaged roughly 55%, 25% and 20%, respectively. This group of investors does not normally allocate to individual hedge funds, but rather prefers to diversify hedge fund strategies using a hedge fund-of-funds. Notice that while many investors begin an allocation to hedge fund-of-funds with the hope of improving the risk-return profile of the entire portfolio, adding this allocation would have actually lowered the risk/return ratio over the most recent three-year, five-year, 10-year and 15-year periods.

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Objective Three: Diversification

The arguably most popular reason for investing in hedge funds and fund-of-funds is to improve diversification and/or lower total volatility within the portfolio. Before we examine the success managers have had in delivering on this objective, it is important to have some understanding of correlation. Correlation, for purposes of this analysis, measures the relationship between the returns of two investments. A high correlation (approaching positive one) indicates that the returns of two investments move in a very similar pattern. A negative correlation (approaching negative one) indicates that the returns of two investments tend to move in opposite directions. A correlation of near-zero indicates that there is no discernible relationship between the two sets of returns. The total volatility of a portfolio can be mitigated by adding assets that have low correlations, particularly near-zero or negative correlations. This concept of lower volatility through low correlations drives many hedge fund managers to target low correlations to traditional asset classes, particularly the equity markets.

The 15-year correlation of the U.S. equity market to the HFRI Hedge fund-of-funds index as well as several additional asset classes is shown in Figure 3. Note that adding an asset to the portfolio with a higher correlation is counterproductive, as there is little diversification or risk dampening benefit experienced in the portfolio by adding that investment. Over the 15-year period ending Dec. 31, 2013, hedge fund-of-funds maintained a relatively high correlation to the U.S. equity market, particularly when compared to other asset classes.

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Unfortunately for many investors, it appears that the broad hedge fund-of-funds universe has been generally unsuccessful in delivering superior returns, improving the risk-return profile or adding diversification benefits. Nonprofit investors should be sure to examine their objectives and other potential methods for accomplishing these objectives when considering an allocation to hedge funds or hedge fund-of-funds.

This article is part two of a three-part series on hedge funds and alternative investment strategies. In the next Fiduciary Focus. we will consider different approaches to alternative investments and examine a variety of ways that nonprofit investors may be able to more successfully accomplish their objectives.